Liquidity Mining Framework

Authors: @verto0912 , @Matthew_Graham & @BigSky7

Introduction

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

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

User experience!

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.

Implementation

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:

  1. For a given protocol’s product offering, determine the market-leading rate of performance.

  2. Establish the liquidity level required to achieve or surpass the desired rate of performance.

  3. Determine the rate of yield (APR) that would attract the requisite liquidity level.

  4. 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:

  1. Fee APR

  2. 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.

Other considerations

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.

Growth Phase

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.

Conclusion

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.

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Pulling out basic** notes for my own understanding :slight_smile:

When? Product Launch phase → Product Growth Phase (approx. days 1-120)
Why? User experience - Make it easy/cheap to buy Index Coop products
How? Use a liquidity targeting strategy
Key Consideration? Avoid multiple liquidity pools (see: “user experience”) **

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The driver for creating the primary liquidity pool during the launch phase is user experience.

Thereafter, we pivot capital allocation towards growth initiatives. Growth initiatives can include other liquidity pools like Loopring’s layer 2 DPI pool, but such decisions are growth driven.

Underlying theme is to maximise capital allocation efficiency towards growing AUM across product life cycle.

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This is awesome, wholeheartedly agree with this strategy!

First, thanks to everyone involved.
Second, I am egotistical here and happy for myself that I was able to follow every argument and explaining because as someone still new to crypto finance these things are often not easy to understand :slight_smile:
Third, this good to read because it is an attempt to give practical experience a retrospective with some well-thought conclusions.
This is essential to us as organisation to proof, rethink, and rebuild structures and mechanisms where necessary.
—-
My question what I have is: What happens if these steps won’t work because product is not successful as thought or market has changed in a way drastically way?

thanks @Martin, glad you were able to follow the post!

This is a great question. I don’t think we, as a community, have thought about it at all. The way I see it, a product failing to gain traction would be an outcome of either 1) poor product market fit or 2) faulty assumptions used in the above framework (for example, assuming that LPs will need 25% APY to provide liquidity for a certain pair when instead, they want 50% APY.) I think the latter is easier to fix than the former, simply by adjusting the incentives. The former is more complex. If a product doesn’t have product market fit, we have some choices, like changing it, if possible, focusing on a different demographic, or limiting our support for it.

@Martin this is a really good question. In my mind it really boils down to the equilibrium level for a pool. Liquidity incentives could theoretically help any A<>B pair reach any size of liquidity. However, if the product is not successful for whatever reason we should expect the amount of rewards required to reach targeted liquidity to be higher than comparable pools.

So when talk about product failure, we are really talking about failure to reach our liquidity target. While liquidity should rise alongside incentives, it will rise much less for a bad product because LP’s will not want exposure to that product. What this really means is that we are forced to remove liquidity incentives at a sub-optimal liquidity level.

Because of liquidity pool dynamics as long as there is some demand, trading fees alone will maintain some level of liquidity without anything more required from us. Capital in crypto is both very free and very sticky. We can expect to see movement away from pools with unattractive APY’s, however that is counterbalanced by rising trading fees to each LP as the pool grows smaller.

At the end of the day what this all means is LM investments are not sunk costs even if used on an unsuccessful product. The expense incurred to build to a certain level of liquidity is not wasted even if LM is ended at a sub-optimal liquidity level. As capital leaves the pool trading fee APY’s will rise incentivizing re-entry until an equilibrium level is reached again.

TLDR: LM is essentially just the process of building liquidity to that target equilibrium level - even if LM is ended at a sub-optimal level as long as there is some demand liquidity levels should remain mostly flat.

@overanalyser does this match your understanding of liquidity pool equilibrium levels?

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I think this discussion needs to add another dimension to the definition of User Experience; gas fees, not just slippage for large trades. Fragmenting liquidity is bad, but user experience for small transactions is more sensitive to gas fees than slippage. I am LPing DPI on both Uniswap and Loopring L2. How does tapering incentives over time interact with the need to move more liquidity to L2 pools? Also, Bancor pools have IL protection…Uniswap definitely do not. Leveraged tokens like ETH2X-FYI seem like IL waiting to happen?

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Competitor seeking whitelisting on Bancor:

I would say that this is incorrect.

LP’s ear exposed to divergence loss no matter what size the size of the pool. It’s purely based on the change in the ratio of the two prices - something we have no control over.

A deeper pool means that the pool should keep closer to the net asset value (i.e. for a fund, sum of the price of the underlying tokens times their weights). This is because the optimum size of arbitrage is based on the offset to NAV and the size of the pool. (a 1% error in a $100M pool is 100 time the value of a 1% error in a $1M pool).

So, large pools benefit traders / holders as it reduces the price impact their trades will have and the risk of the trade being off NAV.

If the volume is constant (a big IF), LP’s would prefer to be part of a smaller pool as they will get a larger proportion of the fees.

This is great work, and I can see we are all learning more about Liquidity mining and how we can best manage it :pray:

Looking at FLI and the DPI : ETH pool on loopring I find myself asking more questions around my assumptions.

Loopring LM incentives stopped about a week ago, but we still have $3M in the pool and the fees are less than 1%

If liquidity is entirely rational and liquid, then we would expect this to drop rapidly as LP’s realise that rewards have stopped (TBC).

  1. Does this mean we have alutrusitic LPs? who want to see more action on Loopring / want to help smaller trades?
  2. Does it mean we have lazy LP’s who cant be bothered to move to uniswap and stake.
  3. Does it mean the LP’s are happy to sit in ETH:DPI pools long term, even if the rewards are minimal because they are Long both ETH and DPI and 1% extra is better than nothing.
  4. Are LP’s staying in the pool to avoid another tax gain event?

[I’m LP’ing in loopring, and I would say it’s a mix of all 4…]


For FLI, my first take was that we would need to heavily LM the product as it’s going to see divergence loss. However, we currently have $4.8 m AUV with 47% in Uniswap with no incentives (with 31% APY from trading fees…).

This may be due to LP’s positioning in expectation of planned LM rewards, or it may be the high Fees from the pool.


In both cases it is simply a case of, for some users, the LP pool is a better product than being 100% product?

It combines the product with being Long ETH, with fees a nice bonus. (and divergence loss ignored/considered an unlikely outcome).

It’s possible that we may see FLI become huge with 50% of sitting in LP pools earning what we may consider poor income (< 5%).


My thinking to date has been that LMP’s are rational and that they consider:

  • Preference for both assets in the pair.
  • Value of Fees
  • Value of LM rewards
  • Risk of divergence losses

For DPI:ETH, Se see that the market is settling at ~20% from liquidity mining, and ~6% fees (Chroco finance average for the last 30 days for my LP position).

So, if we stop LM on the uniswap pool, then to maintain ~26% net income, the pool should shrink by 77% (=20/26) so the fees increase to ~26% of the pool value.

However, that assumes the LP’s are rational. And the loopring data indicates that they aren’t.


I think it’s entirely possible that we end up with three types of product:

  1. Need LM support on launch to get liquidity ($5 M), which can be reduced over 90 to 120 days (DPI, GCI, MVI…)
  2. Need long term LM support to maintain liquidity in the face of adverse trade fees / divergence losse.
  3. Become self sustaining without LM rewards because the LP pool is more attractive than holding 100% product.

#1 is my mental picture for DPI, MVI etc and probably the default at launch.

I would consider #2 entirely acceptable, so long as we recognise it and the streaming fees, intrinsic productivity, issue redemption fees are greater than the LM costs.

#3 is an ideal case. However, then the question is: If we have high liquidity due to the L being attractive, what happens if we add some LM rewards? Does a 30 guaranteed income boost the AUM and liquidity by a factor of x10, or is the product-market fit already optimum so that LM rewards have no effect?


So what data can we consider:

  • Target liquidity (as per the framework above).
  • LP income from fees / LM.
  • Long term price divergence risk (I’m not sure daily correlation matters so much).
  • LM costs vs coop income from the product - if LM costs less than income do we need to eliminate LM?
  • % of product that is unincentivised
  • % of product in liquidity pools - if the LP is a good product, do we care if 90% sites in pools (so long as we arent paying for it)
  • Do we dominate the product liquidity for the sector (i.e. DPI has more liquidity than other DeFi index funds)

We really are learning this as we go, but it’s clear we are improving our understanding as we do more and analyse more.


Apologies for the brain dump, but there are lots of moving pieces (and I’ve not started on Uniswap v3 yet).

@gregdocter TLDR: LP’s may not be rational :slightly_frowning_face:, THe LP may be a better product than the product :thinking:, We are working on improving our collective understanding :owl:

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I think your analysis of the Loopring DPI LP dilemma* as ‘stickiness’ needs to reflect the (lack of) alternatives for L2 rewards…not a lot at the moment on Loopring? I want to leave some capital on Loopring but not seeing a lot of other attractive pools (you?) Is the competition for Loopring DPI liquidity really L1 Uniswap pools soon to move ?

* should I stay or should I go?

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