The goal of the second pool design is not to set high rewards to gain attention, but to provide liquidity that satisfies investors’ free access.
Written by: Eva Wu, who works at Mechanism Capital; the author authorized Chainwen to publish the Chinese version of this article. Compiler: Perry Wang
Why do cryptocurrency projects need native tokens to have liquidity?
Fundamentally speaking, it is very important for tokens to have liquidity, because it allows new investors to easily support the project and allows inactive investors to withdraw. However, even if the liquidity of the native token is weak, it will not destroy an originally stable project; even if the liquidity of the native token is strong, it will not be able to achieve a project that is not highly compatible with the market.
This article will introduce the complexity of “pool 2” and how each project should consider the liquidity of its native tokens.
The content covered in this article includes:
- Liquidity ceiling target + other mechanisms to improve the second pool
- Use imbalanced liquidity pools to cater to long-term participants
- Use idle capital in the treasury as a guiding mechanism
Wait a minute, what is “two pools”?
The second pool is the liquidity fund pool of the project’s native tokens. They exist on the decentralized exchange (DEX) and provide liquidity in the decentralized exchange by rewarding liquidity providers (LP) with native tokens. Realize artificial cold start. These liquidity pools are currently attracting attention as the default strategy for project parties to achieve token liquidity. They are one of the most subtle and unintuitive mechanisms in the field of decentralized finance (DeFi), and therefore require careful attention.
How to incentivize the liquidity of native tokens?
The reality is that DeFi is full of mercenary capital purely chasing high profits and no loyalty. This is something that the project party needs to consider when setting up the second pool of rewards.
The project may consider the second pool’s annual income (APY) as a major marketing point to draw attention to its own agreement. This is not only uncreative, but also usually has nothing to do with the agreement itself. Our research results (see Appendix I) show that Erchi is a bad marketing tool because they only attract the liquidity of early incentives purely chasing income.
Among the dozens of historical second pools we sampled, almost all of the fund pools had their liquidity dropped by more than 50% only 30 days after the end of the early incentives.
This volatile liquidity shows that instead of focusing marketing on the second pool and its token liquidity, setting high rewards in order to get more attention, it is better to focus on using the second pool to meet basic needs: protecting investors Freely choose entry/exit items in the best environment (low slippage).
Think about it: how to do it under the premise of fully understanding what the LP thinks and thinks?
From the perspective of LP, the second pool is very complicated, because the project’s income paid to LP must be cashed in the original token, and the LP also needs to hold the token. This is a delicate balance, because LPs are essentially short-selling price movements, and only when they expect the token to trade within a price range will they be truly incentivized to provide liquidity.
If they expect the token price to appreciate rapidly, it will become more profitable to stop providing liquidity and hold the token; at the same time, if the LP expects the token price to show a downward trend, they will scramble to close their position first. If such tokens are relatively new, price discovery may go to extremes in either direction, thereby exacerbating so-called impermanence losses. This risk of impermanence also makes it difficult for the long-term supporters of the project to contribute funds to the second pool, because they may lose the gains from the increase in the price of the token.
Nevertheless, the liquidity of project tokens plays an important role in opening the project to the community. The liquidity of the native token is worth paying a certain price, because it can start a reflective flywheel to bring more users and attention to the agreement. (There are other ways to achieve token distribution outside of the second pool. For a comparison of these alternatives, see the appendix.)
However, it is worth noting that the liquidity of native tokens will not make or break an otherwise stable project. Even if there is no proper liquidity of native tokens, projects with strong product market fit can succeed, and for projects with poor product market fit, even if the native tokens are highly liquid, they will fail. Therefore, just as traditional companies need strict budgets, projects should strive to find the right balance between using tokens to incentivize the core behavior of the product and incentivizing the liquidity of native tokens.
As far as the second pool is concerned, the main challenge is to determine the appropriate cost and pay for the appropriate amount of liquidity.
How to better motivate the liquidity of native tokens?
Although there are subtle differences between the projects, it is undeniable that the level of liquidity of the original sound tokens through the use of the two pools is uneven.
If the project determines that the second pool is the most suitable method for them, here are three suggestions:
- Run a short incentive plan (30-90 days), allowing reconfiguration and fault tolerance testing
- Try strategies such as lower APY (<100%), block reward installment unlocking, and non-transferable tokens to ensure consistency with the interests of long-term participants
- Introduce a liquidity ceiling target to prevent excessive payment of fees to attract liquidity
Regarding the first point, the project should conduct shorter back-to-back experiments, rather than being tied to an incentive plan that lasts for several years.
The shorter plan allows the project to analyze the second pool plan more effectively, and provides the project with the option to reconfigure and re-evaluate its leverage/reward (please refer to Appendix III for the potential second pool indicators that need to be measured) . It can also allow the community to play a role in determining the project’s token incentives. Interesting case studies worth studying include PancakeSwap, 1inch and CREAM.
Regarding the second point, the project should introduce a function that focuses on the interests of long-term participants. In particular, the project should incentivize LPs who are already satisfied with holding tokens, rather than pure income miners who purchase tokens to inject capital into the second pool because of the high APY. By making it more difficult to quickly mine and sell to harvest revenue, these strategies can force LPs to be more united and become stakeholders instead of mining and selling mining miners.
In addition to Aave’s second pool (which we will discuss in the next section), another case study is Ribbon Finance , which experimented with withdrawal fees, non-transferable tokens, and capped total lock-up value (TVL) for its early liquidity pool. And other measures.
We will discuss the third point in the rest of this section, which is the liquidity ceiling target. Let’s start with why it is important to have a liquidity ceiling target.
If the project does not set this goal, it will be at a loss to determine whether there is sufficient liquidity and whether higher costs should be paid. When a liquidity ceiling is found, the problem is reduced to finding the smallest acceptable transaction size for larger investors, and ensuring that the fund pool has sufficient liquidity within the acceptable slippage range (<2%). .
Under normal circumstances, increased liquidity can support the revaluation (rising) of the token price of the agreement, because the liquidity scale is large enough to attract institutional funds and larger investors to buy in the secondary market. The introduction of the liquidity ceiling target should ensure that the project has sufficient token liquidity to attract larger investors without paying excessively high costs.
How to launch a liquidity cap target
A framework for considering the liquidity ceiling target is to consider the depth of liquidity relative to market value.
In the table below, we have classified different types of projects based on market capitalization and estimated the percentage of total market capitalization that large investors would like to trade within the 2% slippage range.
step:
- Determine which market value range the project belongs to
- Take the lower limit of the nominal transaction size
- Use this formula/spreadsheet to determine how much liquidity is needed to facilitate the scale of these transactions at different slippage levels
For example: I am the founder of a low-to-medium market capitalization project with a market capitalization of US$50 million. I hope at most that large investors can trade 0.1%-0.3% of the project’s market value with a 2% slippage. This means that the transaction size is USD 50,000-USD 150,000 (50 million * 0.1%, 50 million * 0.3%).
The formula in the spreadsheet will calculate that a US$5 million liquidity pool (50/50 weight) can contribute to a transaction size of US$50,000 if the slippage is less than 2%. This means that I don’t need more than 5 million US dollars in my fund pool to facilitate large investors. It also means that I need up to 2.5 million US dollars in my own native tokens and 2.5 million US dollars in USDC/ETH.
Please note: This is designed for the traditional AMM liquidity pool. Uniswa p V3 changed these figures and asked for more confidence in price changes.
When considering the upper limit target, the project may fall into the trap of treating it as an indicator of success. In fact, having high token liquidity is not always beneficial. Although the liquidity cap target can be used as a weather vane to prevent over-payment of token liquidity costs, it is not a goal. For early-stage projects, it is more important for token liquidity not to focus on products and to find product market fit. Low-market value projects that pay too much attention to the liquidity of tokens are always willing to risk attracting traders/speculators at the expense of the interests of long-term investors and stakeholders.
The power of an unbalanced pool of funds
It can be seen from the statistics of the second pool that Aave’s incentive token mining pool is one of the only mining pools that can maintain long-term liquidity and does not have a high APY (<5%).
In this Balancer Smart Pool with an 80/20 ratio of AAVE/ETH assets, LP provides liquidity to obtain transaction fees and rewards paid by AAVE and BAL. The success of Aave allows us to see the benefits of the unbalanced capital pool over the traditional 50/50 balanced capital pool.
The main benefit: less impermanent losses incurred by the unbalanced fund pool.
Source: Balancer Labs
The reduced risk of impermanent loss means that LPs are more willing to provide liquidity for lower yields. From a cost point of view, the number of rewards required by the agreement will decrease accordingly.
At the same time, the unbalanced fund pool limits the risk of impermanent loss when the price of tokens rises, and token holders can invest funds. This leads to better consistency of incentives, because token holders can provide liquidity, receive transaction fees and rewards, without losing most of their exposure to tokens, and do not need to buy/get what they may not have Another token, to form a mandatory exposure of 50% of the value of the balance pool.
Although an unbalanced weighted fund pool is more friendly to LPs, it requires a trade-off of interests. The main disadvantage is that a higher TVL is required to achieve the same slippage environment. As shown in the figure below, in terms of controlling slippage, a 50/50 fund pool is the most effective.
Source: Balancer Labs
In addition, as the project matures, the imbalanced fund pool will also affect the price of tokens, because the fund pool requires more stablecoins/ETH (compared to the 50/50 fund pool) to increase the price. After the initial issuance of the original token is completed and the project matures, the project can consider adjusting to gradually move closer to the 50/50 liquidity pool (such as 70/30, 60/40) to achieve better slippage and more effective prices Find. In terms of platforms, Balancer is currently the only agreement that provides an unbalanced capital pool, but Sushiswap plans to launch Trident, a forked function in the next few months.
Use idle treasury funds to create a mixed strategy of liquidity
Mature projects that have raised funds or have healthy and diversified funds should consider using their treasury to advance all or part of their initial liquidity, and convert part of the funds in the treasury to ETH/USDC to provide bilateral liquidity. This has many benefits, including:
- Allow the project to earn additional income from transaction fees
- Allows the project to better control liquidity, so that liquidity is not only affected by APR
- If the token price drops, create an automatic “repurchase” mechanism
- Diversify the funds in the treasury (including other currency pairs, such as ETH/USDC)
But there is a caveat: the project bears the risk of impermanent losses.
dHEDGE is a good example. The agreement started with a reward of approximately 10,000 DHT per week (approximately US$20,000 at the current price), but it quickly turned to provide 3.5 million US dollars of USDC on its own (to a 50/50 pool of funds) Provide most of the liquidity. By using their treasury to achieve liquidity advancement, they can reduce the dilution of their governance tokens, but instead use it to incentivize people to use their platform.
In terms of revenue, dHEDGE charges USD 500-1,000 in transaction fees per day, and has collected more than USD 45,000 in transaction fees in the past 2.5 months.
Next are some out-of-the-box means that the protocol can use the two pools to implement a hybrid strategy:
- Use idle funds in the vault to provide 50-80% of its liquidity target, and then use protocol tokens to incentivize additional liquidity when necessary.
- Use the vault to provide liquidity and use transaction fees to incentivize additional LPs.
- Use the long-term idle funds in the treasury to provide liquidity in the first 6 months to 1 year, while conducting short-term experiments on liquidity incentives.
Or simply launch a liquidity ceiling target and use the idle funds of the treasury to maintain liquidity without the need for incentives to attract any additional LPs.
Summarize
There is currently no precise scientific method to achieve the liquidity of the protocol’s native tokens. But between the various methods explored in this article—liquidity cap targets, imbalanced (ie 80/20) pools, and liquidity provision, thoughtful founders and investors can find a variety of ways to solve the original token Liquidity issues.
Most of the content of this guide is just the tip of the iceberg, but we hope it will drive discussions and brainstorm ideas for designing sustainable and more efficient token liquidity.
Many thanks to the Mechanism team (Andrew, Ben, Marc, Daryl, Alec) for helping refine these ideas and filtering the data, and thanks to Tristan, Zaheer and Julian for their helpful feedback. Nothing in this article constitutes investment advice.
Appendix I: Pool Research
Nansen ‘s research analyzed all token transfers from 400 profit-growing farms and found that a large percentage of farmers (36.4%) withdrew within 5 days of entering the market, and today only 13% of addresses continue to use profit-growing. *
Source: Nansen Research
Similarly, the above heat map allows us to intuitively understand the financial loyalty of these income farmers. So, don’t think about the multi-year incentive plan. Most farming farmers have already divested their capital on the 75th day. To quantify it further, almost half of the profitable farmers (for example, the farmers at the top of the information funnel) who entered the field at the start-up left the field within 24 hours, and a total of 70% of them left within 3 days. With the reduction and dilution of LP rewards, profit-only farmers simply take their token rewards and transfer them to the next income farming farm.
*Although this data includes all masterchef.sol forks (pool 1 and pool 2) and cannot directly infer the situation of the second pool alone, it still clearly shows that this kind of capital is fully considered when designing token liquidity incentives Profit-only is the importance of the essence of the graph.
The analysis of more than a dozen historical second pools also tells us that although the liquidity of most fund pools that provide incentives has temporarily increased, in just 30 days after the incentives ceased, most of the liquidity levels have dropped by more than 50%. A typical example (many) is the second pool of the Badger protocol launched during the peak of the bull market.
Here, the data shows that projects that tried to guide the liquidity of the token pool in early December (see the red area) were largely unsuccessful, when the bull market sentiment promoted the liquidity of the fund pool. Since March, the liquidity of the fund pool has decreased in proportion to the decrease in rewards, which indicates that they have attracted profit-seeking LPs, who sold the native tokens of these projects when the rewards were reduced. The figure also highlights the reflexive nature of these incentive fund pools, because as LPs sell tokens, their APR will decrease, causing more LPs to withdraw from the fund pool. We have seen similar patterns in the two pools of $DHT, $ALPHA and $1INCH.
Appendix II: Comparison of Treasury OTC, CEX and DEX Trading
*For projects with a good growth trajectory, some exchanges will exempt their listing fees
Appendix III: Examples of indicators for the second pool
Core Indicators of Liquidity Digging (LM)
- Total number of unique users
- LP vs number of stakeholders
- The average duration of LP capital injection, the number of profit-only traders (people who withdraw their capital in a short time)
- Number of LPs withdrawn due to dilution/reduction of APR
- Customer acquisition cost (CAC) vs long-term price
fluidity
- Percentage increase in total TVL
- Percentage increase in pool liquidity
- Pool liquidity after the launch of LM incentives
- APR to liquidity ratio
- Market value to liquidity ratio
Statistical relationship
- What is the relationship between the time of LP entering the farm and the time of continuous capital injection and mining? (Understand the length of time)
- What is the relationship between LP size and length? (Understand TVL/Address upper limit)
- What are the common observations in long-term LPs that are not reflected in the profit-only LP?
Off-chain
- Website traffic and user traffic (website clicks, time on page)
- Community activities/plans/proposals (non-staff projects, discord activities)
- New interactions on social media (number of tweets, new followers, tags)
Source link: www.mechanism.capital
