How protocols can own their token's liquidity
Hi friends, welcome back! A couple of weeks ago, I did a deep dive on OlympusDAO and its quest to become a crypto-native reserve currency. If you haven’t read that piece, you may want to do so before reading this week’s article. It may also be helpful to read last week’s piece on automated market makers. Today, I want to go deeper into the Olympus ecosystem and explore their new product, Olympus Pro.
Olympus Pro helps protocols solve their token liquidity problems without paying expensive liquidity mining incentives. Let’s dig in.
Let’s imagine you’re launching a new web3 protocol on Ethereum. You create a governance token - $XYZ - in order to govern and coordinate changes to the protocol. Perhaps you airdrop this token to early users of your product. But you also want people to be able to buy and sell those tokens.
In order to do so, you need to create liquidity pools on decentralized exchanges like Uniswap and Sushiswap. But how do you incentivize your token holders to provide liquidity in those pools? They’re not willing to do it for free. Even if they wanted to, it probably wouldn’t generate much buzz. So how do you solve this problem?
Historically, the most common way to attack this problem was to do something called liquidity mining. In liquidity mining, a protocol will reward liquidity providers for adding their tokens to liquidity pools. In our case, we’d like people to add their $XYZ tokens to the $XYZ/ETH pool so that other people can buy and sell the $XYZ token. To get people to be liquidity providers in the $XYZ/ETH pool, we’ll give them some free $XYZ tokens as long as they’re providing liquidity to the pool.
Liquidity mining is great in a few ways. First, it creates ample liquidity for the token. Because people want to earn more $XYZ tokens, they’re likely to contribute their existing $XYZ tokens to the liquidity pool. Second, it creates a lot of buzz. Some of these liquidity mining rewards can be extremely lucrative - liquidity providers can earn more than 100% of their initial investment in a year! That’s awesome and it works really well in the short term, drawing eyeballs to your project and creating lots of liquidity for people to buy your token.
But there are some other very harmful effects of running liquidity mining problems, as some protocols have discovered.
First is the so-called “mercenary” problem. Instead of attracting real believers and users of the protocol, liquidity mining incentives attract speculators and short term liquidity mercenaries. These mercenaries don’t actually care about your protocol, they care about the lucrative liquidity mining incentives that the protocol. Because the rewards are so lucrative, it costs a lot of money for protocols to run these types of incentives. And before long, the money runs out. It’s unsustainable to pay rates above 100% in the long term. That said, there’s a lot of money floating around in early stage crypto today. As soon as we stop offering liquidity mining incentives for the $XYZ token, all of our liquidity providers will drop our token and go on the hunt for another attractive liquidity mining program. We’d be much better off giving tokens to long term thinkers and users of the protocol.
Next is the sell pressure associated with liquidity mining. Because we aren’t attracting liquidity mercenaries, not missionaries, we aren’t attracting real believers in the protocol. That is, as soon as they receive or liquidity mining rewards (in the form of our $XYZ token), these mercenaries proceed to dump the token on the market, causing sell pressure and driving the token price down.
Liquidity providers are also exposed to the risk of Impermanent Loss (IL). If our $XYZ token skyrockets in price relative to ETH, our liquidity providers will lose money. This means that we’re going to be attracting shorter-term liquidity providers rather than long-term LPs. Learn more about IL here.
Finally, in market crashes, liquidity providers are typically quick to remove their liquidity from the market. In such a case, all of our liquidity mining incentives have gone to waste.
The Solution: Olympus Pro
Olympus Pro offers a new solution to this liquidity problem. After using the bonding mechanism for their initial product, they’ve productized it for use by other protocols and DAOs. From Olympus Pro’s docs:
Olympus Pro solves for liquidity problems by providing bonds-as-a-service for a small fee.
Instead of staking their LP (liquidity provider) tokens for farming rewards in a pool, users can exchange their LP tokens for the protocol's governance tokens at a discounted rate. This is done through a process called Bonding. As the protocol never sells these LP tokens, the liquidity is effectively locked within its treasury.
In short, Olympus Pro relies on the same bonding mechanism that Olympus itself uses. Let’s dig into the bonding mechanism for Olympus Pro by continuing with our example $XYZ token.
As the XYZ protocol, we’ll approach OlympusDAO and ask to partner with them. Once all the behind the scenes work is sorted out, we’ll then be featured in Olympus Pro’s bond marketplace. Today, the bond marketplace highlights partnerships with a number of protocols:
The protocols shown above are all partnering with Olympus to offer bonds on their tokens. Navigating to the market place itself, we can see all the options we have for buying bonds.
These bonds allow users to buy tokens below the market rates. For instance, one could buy the POOL token for $10.96 even though it’s currently trading at a market rate of $11.89. This raises 2 questions: where are these discounted tokens coming from, and why is someone willing to sell tokens below the market price?
These tokens are coming from protocols who want to accumulate and own their token’s liquidity. Owning your token’s liquidity - referred to as Protocol Owned Liquidity (POL) - has a number of benefits that we’ll explore later, which explains why protocols are willing to give loyal users discounts on their tokens. In short, it’s much cheaper and more well-aligned for a protocol to use Olympus Pro bonds than to run a costly liquidity mining incentive program. (Note: one nuance to this is that bond prices are set based on supply/demand and a few other factors. Sometimes bond prices are actually more expensive than the underlying token, in which case it doesn’t make sense for the user to purchase the bond. Learn more about bond pricing here.)
Let’s say we want to buy a PoolTogether bond from the Olympus Pro marketplace. Here are the steps we’d take to do so:
Go to the POOL/ETH liquidity pool on Uniswap and become a liquidity provider. Uniswap will give you a token that represents your claim on the fees generated by the pool, as well as your initial token deposit.
Take that Uniswap token (it’s actually an NFT) and deposit it on Olympus Pro’s website.
In return, you’ll receive vested PoolTogether tokens. These tokens will become fully available to you after 7 days of vesting.
The vesting period noted above is important. It prevents people from bonding and then immediately selling the tokens they received for a quick profit. In exchange for offering you discounted tokens, the protocol receives your Liquidity Provider tokens.
Now that we’ve explored the nuts and bolts of bonding, let’s consider why this mechanism is useful to protocols and DAOs looking to control their liquidity.
Benefits of the Olympus Pro Model
As mentioned above, much of the benefits of the Olympus Pro model arise from Protocol Owned Liquidity (POL). As opposed to renting out liquidity (i.e. traditional liquidity mining), owning one’s liquidity gives the protocol important benefits. For one, the protocol can ensure that users will always have enough token liquidity. The protocol won’t pull the liquidity in market shocks, unlike most liquidity miners. Also, by paying to own liquidity rather than rent it, the protocol can save money and realize long-term benefits (the liquidity doesn’t dry up as soon as liquidity mining rewards stop).
Second, the protocol gains another revenue source. Rather than paying out liquidity mining incentives to liquidity providers, the protocol instead earns fees on the liquidity positions they’ve accumulated. As liquidity providers in Uniswap and Sushiswap pools, they’ll earn anywhere from 0.3% to 1% of the transaction volume in fees. This can actually be quite significant!
It’ll be exciting to see how widely Olympus Pro is adopted in the coming months and years. To me, it seems like a huge improvement over existing solutions.
Any questions on Olympus or Olympus Pro? Feel free to shoot me a message or leave a comment :)