For anyone who’s been keeping an eye on DeFi in recent weeks, it’s hard to miss the myriad of different liquidity incentives popping up all over the place.
In the past month alone we’ve seen incentive programs from DeFi projects like Compound, Balancer, Synthetix, Curve, mStable, bZx, UMA, Ampleforth, Pillar, Auctus, and Akropolis. And, as a first for crytpo-collectables (NFTs), we saw the marketplace, Rarible, join the conversation with their unique mining scheme for a new governance token – RARI.
What these programs all share in common is the premise of rewarding users for actions that add value to the platform. These rewards have kickstarted growth at a scale that very few expected.
In this article, we are going to take a deeper look at how these incentive programs work and, ultimately, how this all ties back to ETH the asset.
What is Liquidity Mining?
Liquidity Mining, Yield Farming, Alpha stacking, you name it. While the meme has many different names, the notion of earning passive income by putting your capital to work has existed in the Ethereum ecosystem for well over a year but has only recently made headlines.
At its core, liquidity mining allocates platform tokens (often governance tokens) across different ecosystem actors relative to their activity, with a goal of using this activity to bootstrap protocol growth.
Most commonly we’ve seen liquidity mining used to bootstrap (you guessed it) liquidity. These projects have rewarded users who pool their tokens in decentralized exchanges (DEXs) like Uniswap, bootstrapping liquidity for the project’s token and kick starting all-important network effects.
Given ETH’s long-standing position as the primary settlement asset on Ethereum, projects often incentivize users to pool liquidity in token-ETH pairs. These liquidity pools have been largely split between Uniswap and Balancer, with Balancer also distributing their BAL governance token to those that pool funds there (allowing users to “stack yields” in the process).
Most programs take a fixed amount of tokens and share them pro-rata with liquidity providers (LPs) over a fixed period of time. These programs are then modified to adjust for increased demand, ultimately driving growth back to the project.
Here’s a look at a couple of Uniswap pools before and after liquidity incentives were introduced. Can you spot when the liquidity incentives start?
Now, what happens when we generalize these principles?
Using Incentives to Bootstrap Growth
Outside of secondary market liquidity, properly designed incentives can act as a catalyst for growth in virtually any ecosystem. The only major prerequisites are having a functional project and an active community that can generate the necessary interest to set the flywheel in motion.
In the case of Rarible, buyers and sellers will earn RARI retroactively, offering a direct reward to those who were active prior to the announcement of incentives. Now, content creators on Rarible stand to earn a secondary form of value on top of their sales, giving it a direct advantage over competing marketplaces like SuperRare or Open Sea which benefit from a wider user base but have no similar incentive program (yet).
Let’s pause there and look at why Ethereum makes this work.
ETH as a Backbone
As a project launching a liquidity mining program, you need a protocol capable of launching secure and fungible representations of rights to your product or service. ERC-20 tokens? Check.
Next, you need a way of programmatically distributing these tokens across thousands of addresses in an automated fashion with ever-changing variables. Smart contracts? You betchya.
Once those tokens have been distributed (using ETH as gas of course) you need a way to offer tangible value. With DEXs, anyone can create a trading pair which can be connected to a range of other liquidity pools using aggregators like 1inch – a direct benefit over relying on some obscure centralize exchange offering siloed (and in most cases sketchy) trading pairs. Uniswap markets? No problem.
Lastly, you’ll need a trusted asset for people to trade against. While most projects design incentives to encourage holding, it’s naive to think that many liquidity miners will not immediately look to sell their rewards. As the largest asset on Ethereum, ETH and its vast liquidity meets the mark for 99.9% of base pairs.
Stepping Beyond DeFi
While DeFi has been a hotbed for liquidity mining, we’re reaching a tipping point in which many other sectors are starting to join the discussion.
And some of these sectors are beginning to blur. The recently announced Aavegotchi project provides a crossover between DeFi and NFTs, creating interest-bearing digital collectibles that are composable and unlike anything we’ve seen before (in traditional or blockchain markets). Plus, these types of baked-in incentives create network effects which encourage other developers to integrate Aavegotchi’s into their games, as they literally earn interest for doing so.
Taking a wild guess, I’d be willing to bet that the most widely adopted crypto-native projects of the coming decade will be those that sufficiently distributed value to their communities using tokenized incentives.
Jesse Walden put it best in his latest post – The Ownership Economy – stating that “rather than a platform’s inner circle of founders and investors taking home the value, users are able to earn the majority of value generated from their collective contributions.“
When pairing these incentives with community-owned and operated home bases like DAOs, it’s possible to imagine the world’s first sustainable public goods taking shape.
Where Are We Today?
Coming back down to reality, there’s no denying we’ve still got a way to go before tokenized incentives are frictionless. As it stands today, gas prices have made it so that many of these programs are only profitable with ~$1,000 of capital to start.
To this end, I’m keeping a close eye on layer 2 projects like xDAI, which allow for these incentives to happen off-chain at low costs. While Reddit’s community points are great in practice, the main reason they’ve worked so far is because they’re on an unconstrained testnet.
Regardless, all of this layer 2 value eventually gets settled on the Ethereum chain, and for that to happen – you’ll need ETH.
Until then, be sure to keep an eye out for new incentives popping up in a project near you, as it’s almost always the case that the early adopters stand to gain the most upside!