Mercenary Liquidity & Impermanent Loss Thesis - DeFi
Oct 13, 2023
Liquidity mining, known as yield farming, is a crucial component to enable innovation in the DeFi ecosystem. This is how emerging protocols have bootstrapped their user base, incentivizing early investors with unsustainably high APY earnings and token emissions. These early investors and their capital are inherently mercenary; they have no loyalty to any project. They hop from various DeFi farming pools in search of the highest APY.
This is problematic because if a protocol keeps rewarding liquidity mining with large quantities of its token, the value of its tokens will surely be diluted. Furthermore, these mercenary investors are highly incentivized to dump these token rewards on the open market, further exacerbating downward price pressure.
Additionally, projects are sacrificing healthy protocol revenue generating initiatives for adoption of mercenary capital, even if that mercenary capital is not sticky.
TLDR: Liquidity is scarce and expensive
The flaws of this incentive system have bred new proposed solutions; the first being Olympus Pro. OHM introduced the concept of protocol owned liquidity, where a new project can exchange their token for another asset at a discounted price. Olympus had to offer insanely high APYs to incentivize protocols to do this, which in practice looked much like a ponzi scheme(OHM is down 99%)
Before we look into other proposed solutions to this issue, let's look at another problem in DeFi.
Impermanent loss is the net investment loss that can occur due to a change in price of the asset you deposited. This impermanent loss becomes permanent when an investor withdraws their tokens from a liquidity pool, and the price of the asset you deposited has risen or fallen. This is a risk that investors generally assume by providing liquidity to DeFi protocols.
Ok, let’s go back to the mercenary liquidity problem. Is there another way to provide liquidity as a service(in a decentralized manner) to newer Defi projects without unsustainable APYs?
Tokemak allows projects to provide a single token to a reactor, which is then paired with a base asset such as ETH or USDC in liquidity pools. TOKE holders direct this liquidity towards the venues that need it most, and cover any impermanent loss that projects incur.
This impermanent loss coverage presents a great benefit to depositors. Tokemak accumulates assets for itself through trading fees. This ultimately reinforces its ability to provide sustainable liquidity. Initially, TOKE is emitted as a reward for users, and TOKE holders ultimately have a claim over the Tokemak Protocol Controlled Assets (PCA).
TOKE tokenomics encourage long-term value-aligned participation in the network. By acquiring a stake in TOKE, projects can direct their liquidity to whatever venues they need. This represents an upfront investment, but far better than traditional liquidity mining.
Projects looking for long term sustainable liquidity would do well to acquire a TOKE stake and seed a Tokemak reactor. They can use the TOKE to pair their project tokens in whichever supported liquidity markets they choose, without risk of impermanent loss.
It is important to note that these DeFi 2.0 tokens, like OHM and Tokemak, live at a step up in the DeFi tech stack(you could think of it like a L2 scaling solution). Tokemak has the potential to become core infrastructure for liquidity “renting” to enable innovation and bootstrap liquidity in the Defi space for years to come.
PS: ONDO finance is also a very compelling solution that is similar to Tokemak, but caters to a more institutional type of audience. However we are unsure whether value will accrue to the token or the equity. We are currently undergoing due diligence to evaluate the $ONDO token.