How to waste less money on liquidity incentives

Background

It is common for protocols to provide incentives to those who provide liquidity on their platforms.

How liquidity incentives work

For example, Stargate allows users to transfer assets (e.g. USDC) from one chain to another, e.g. from Ethereum to Arbitrum. This is done by having other users provide a pool of USDC liquidity on each chain.

To incentivise this liquidity, Stargate protocol allocates a certain amount of Stargate tokens to liquidity providers each month. So, people who provide USDC liquidity earn Stargate tokens. Typically, these tokens are immediately sold by the liquidity providers, converted to USDC and put back into the liquidity pool to earn more Stargate — this is called yield farming.

The “yield” that liquidity providers earn is the value of STG rewards they earn, divided by their liquidity. For a mature platform, there might be a yield of a few percent. For a newer less-trusted platform, yields of 50%+ might be required to incentivise liquidity.

Yields shift around all of the time between different protocols, so yield farmers move their liquidity around to chase the highest yield.

The problem with this approach

Issuing governance tokens (like STG) as an incentive for USDC liquidity is horribly inefficient:

  • There is no way to accurately target a given rewards rate (because STG is volatile).
  • Since yield varies, liquidity providers are constantly dropping in and out of the pool, which means that liquidity varies wildly as the price of STG changes.

The long term game here is to use incentives to initially grow the liquidity pool and then ease off on incentives when transaction fees in the pool become large enough to sustain liquidity by themselves. Protocols also generally don’t think about incentives in this way and so they often start with aggressive incentives and then liquidity plummets when incentives go away.

Proposal:

There is one simple improvement to the above, which is to pay incentives in the same currency as the liquidity pool. If it is a USDC pool, then the protocol should swap STG and pay out incentives in USDC. This allows the protocol to target a much more precise level of yield for the pool — that is predictable to liquidity providers — and so will result in less swapping in and out of the pool. Ultimately, it should result in a lower amount of rewards needing to be paid because they are less volatile.

I’ve provided a specific example on the Stargate forum.

Longer term issue for liquidity

Right now, I think the liquidity market in DeFi is a bit like Uber/Lyft.

A few years ago, Uber and Lyft were paying out massive subsidies to beat out each other and any competitors. This is a negative EBITDA strategy.

I see the same thing in DeFi. All protocols are competing — via liquidity incentives — to get liquidity and low fees to their platform. Until competition is reduced (through consolidation or failure of weaker protocols), it will be hard for exchanges to survive on fees. Probably the single chain DEX market (e.g. Uniswap, Sushiswap) is closer to this situation than omnichain DEXes like Stargate that are newer.

To be clear, all of this is very good for the consumer.

Still, from the standpoint of a protocol, at least if you’re going to subsidise rides/meals/liquidity, at least do it in a more stable way and not by issuing volatile governance tokens.

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