The purpose of this post is to outline Index Coop’s philosophy towards liquidity mining.
Over the last 6-9 months, Liquidity Mining (LM) has become widely accepted as the best method for bootstrapping a new product and incentivising liquidity. Many products have been launched, however, very few of them have successfully transitioned to “life beyond liquidity mining”.
DeFi products, like every other product, go through multiple phases during their life cycle. At Index Coop we see LM as a tool for successfully progressing through the Product Launch phase to the Product Growth Phase. During the growth phase we should strategically recycle capital from liquidity mining into other growth initiatives. Our end goal is to build products that address the needs of our customers, while remaining profitable and self-sustainable in the long-run.
Liquidity mining is an incentives scheme whereby users supply liquidity in order to receive both trading fees and token rewards.
We hope that most readers are more or less familiar with the concept. If not, this article from the Bollinger Investment Group is a good read.
Why Do Liquidity Mining
We believe that a superior user experience comes down to two key attributes:
- Having a superior product
- Providing an easy and cheap way to buy said product
The main consideration for the latter is the price spread. We want to make sure our customers and traders can access any quantity of our product, without significantly moving the market and facing high slippage.
The size of the trade relative to the pool size determines the amount of slippage. Intuitively, large trades in small pools create more slippage than comparably sized trades in large pools. To create a great user experience, our products need a deep and liquid market for users to interact with.
Referring back to the product life cycle, liquidity mining successfully gets us through launch and into the growth phase. We envisage LM to occur during the first 90-120 days after seeding the initial liquidity pool. Successfully launching a product can be capital intensive and the reinvestment rate is very high. Liquidity providers (LPs) need to be compensated for their exposure to divergence loss and the pool needs an competitive APY to attract capital.
As the pool grows in size, the risk of divergence loss diminishes as large trades create less price movement and less opportunities for price arbitrage. Large pools are safer for LPs and require much less investment to maintain than smaller pools.
At this point, we would like to introduce the liquidity targeting framework which we borrowed from Mechanism Capital. This framework will help us set quantifiable goals for our LM programs, gauge their effectiveness and provide a structure around their ongoing management.
The framework has the following steps:
For a given protocol’s product offering, determine the market-leading rate of performance.
Establish the liquidity level required to achieve or surpass the desired rate of performance.
Determine the rate of yield (APR) that would attract the requisite liquidity level.
If LM is already in use, back out the updated emissions rate that would, at current prices and a target APR, sustain the optimal liquidity level. If LM is not in use and/or if the network token is not in circulation, map out various emissions schedules assuming different token prices.
Source: Mechanism Capital
Some consideration should also be given to the following:
Duration of the LM schedule
Let’s briefly run through what this framework means for us and how we, at Index Coop, should think about it.
As a first step, we need to determine the market-leading rate of performance for a product. For our products, this would be the optimal price spread for a given $ size transaction. This is the concept of managing slippage we briefly discussed above. Ie: $20K trade with <0.5% slippage.
Next step is simple, we can review various Uniswap and Sushiswap pools to establish the liquidity level, or the pool size, that allows our customers to trade in their preferred size with the market-leading rate of slippage determined in step 1.
Now that we know how much liquidity we need in our pool, we can consider the necessary rate of return that will allow us to attract that optimal liquidity. This would be trading pair specific and best determined by assessing various liquidity pools with similar characteristics, specifically similar impermanent loss profiles. For example, highly correlated trading pairs are less likely to experience significant divergence loss.
All of the above steps are interconnected and related to each other. Having worked through the described framework for a product, we should roughly know the size of the liquidity pool we are targeting and have an idea about necessary APR. At this point, we can determine the number of INDEX tokens needed to attract the required liquidity.
We know DeFi is notorious for users chasing yield and, often, once incentives are removed, liquidity tends to flow elsewhere. Therefore, it would be prudent to air on the conservative side, targeting higher liquidity levels and APR. As we are using INDEX tokens to provide the LM incentives, we also need to consider the volatility in the INDEX price and what implications that could have on APR.
Structure for ongoing management
Once the desired liquidity level is achieved, the incentives are to be tapered off. Whilst tapering incentives pay close attention to the trading fee APR, as this is what will sustain the liquidity pool during the growth phase. Each 30-day period the liquidity level meets the predetermined criteria, the APR from just INDEX tokens should be halved. Incentives are tapered off gradually, as any abrupt change could lead to a sudden drop in liquidity.
We believe that a 90 to 120 day LM program, consisting of three to four 30 day blocks, is realistic for getting a product through the launch phase and into the growth phase. Given a 90-120 day LM duration, the ideal scenario is to be in a position to start reducing incentives during either the second or third 30 day period. By gradually tapering off incentives we aim to reduce the APR generated from just INDEX rewards by 50% each period.
We should be aware of fragmentation. Decentralised finance is a fragmented market with many protocols offering a similar service. Fragmentation ultimately damages the user experience.
A single large pool offers great trading conditions for all trades in all sizes. Although two or three separate pools might serve the majority of clients just as well, a single combined pool facilitates trades of all sizes. Furthermore, if all trading volume flows through one pool, it improves our chances for integrations where DEX volume is a consideration. While there are extrinsic benefits from being listed on different DEXs, a single large pool leads to a better user experience for all.
Therefore, integrating our product across different protocols, targeting extrinsic benefits, needs to be performed in such a way as to not fragment liquidity.
As a product transitions from the launch phase to growth phase, our LM strategy should transition with it. When liquidity pools reach equilibrium size, they will require far less capital expenditure. During the growth phase, we should look to strategically recycle capital from LM into other growth initiatives such as partnerships, exchange listings, marketing, and community. We believe these initiatives will have a much higher impact on growth than ongoing LM incentives.
Like every other product, crypto indices go through the typical product life cycle. The framework presented above directly shapes our liquidity strategy for launching and growing products. It suggests a high initial capital investment to provide optimal customer experience, using slippage as our primary KPI.
Once the liquidity pool reaches equilibrium, the capital used for LM incentives can be redirected to supporting other product growth opportunities. This is the growth phase, where strategic growth initiatives are likely to have higher impact on growing AUM of our products.
We believe that the above framework will allow us to launch, grow and maintain our products in a way that is structured, analytical and capital efficient.
Following the analysis above, we see a need for a dedicated team, to manage LM programs for our products and optimise their utility through intrinsic and extrinsic productivity initiatives.