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DeFi Liquidity Wars and Capital Efficiency
I’m moderating a panel on Wednesday at Messari’s Mainnet with Zooko, Peter Van Valkenburgh and Mario from placeholder on decentralized governance. Panel starts at 11:20am ET; tickets and more info here.
Asset allocation has taken a back seat to manager selection. Investors these days are not spending their time researching what assets to hold, but where to hold them. DeFi has searched for a killer app and providing liquidity seems to be what its most useful for.
Leverage, of course, was the first thing users could do with a crypto asset. Bitcoin and later Ether served as great collateral for extending loans through centralized means, either for margin-trading platforms like Bitmex or business-like financing through BlockFi. Maker was the first to port this model and decentralize it on Ethereum and was later joined by the likes of Compound, dYdX and Aave amongst others.
Crypto dollar deposits were next as the companion for leverage. If a user holds Dai or USDC with no plans to spend, it makes sense to park that wherever it can earn a return. With funds and access tied to an Ethereum address, there is little difference for a user. Switching costs are literally just transaction gas costs.
Capital, like water, flows to the lowest point. Investors’ search for capital efficiency was the driving force behind management fee cut in traditional finance with the simple question, “What’s the most cost-efficient way to gain exposure to this asset?”
What makes DeFi (and crypto) different is the Uber-style incentivization schemes that can be cooked up to reward early liquidity providers. Some refer to this as liquidity mining, in reference to the inflation incentives that blockchains use to reward miners for providing security to the network in its early days.
Uber needed to subsidize rider costs and overpay for drivers to build its network effect, while Bitcoin needed lots of people running the Bitcoin software and securing the network. For DeFi, it’s liquidity.
Synthetix was perhaps the first project to launch a liquidity mining incentive scheme in July of last year:
A deep pool of liquidity enabling frictionless conversion between ETH and sETH will enable users to exit the system in a cost effective manner and provide confidence in Synthetix.exchange.
We currently pay SNX stakers staking rewards out of a weekly pool of SNX tokens created via inflation. These tokens are used as an incentive to drive the desired behaviour within the network, and they have been incredibly effective. Over 75% of the total SNX supply is currently staked. We want to test whether diverting some of these protocol level rewards to users staking sETH in Uniswap will be an effective incentive mechanism.
The campaign was wildly successful; the sETH/ETH pool became the largest on Uniswap. The foundation initially provided the rewards, but SIP 8 later integrated the inflation incentives directly into the protocol, and last month the program was altered to direct liquidity to Curve’s sUSD pool to help maintain the peg of Synthetix’s stablecoin.
Uniswap vs. Balancer
Uniswap v1 expanded liquidity yields outside of stablecoins and brought them to any ERC20 asset. It charged a small fee to exchange assets (0.3%) given to the liquidity providers (LPs) of that pool. While impermanent loss is a risk, returns from trading fees are more than lending yields – ETH’s borrowing rate is typically less than 0.1%.
Balancer is a recently launched decentralized exchange that uses liquidity pools like Uniswap, but users can deposit 3 or more assets into a pool at whatever preferred allocation percentage. Balancer executes trades through these pools, which rebalances the portfolio to the set allocations and why Balancer calls its product an ETF. Unlike an ETF, fees are paid to the liquidity provider.
Balancer is also taking a page out of the Synthetix playbook and rewarding liquidity providers with its soon-to-be launched BAL governance token. LPs would receive trading fees plus BAL for depositing assets.
According to IDEO’s Dan Elitzer, Balancer will dish out $4.5m of BAL in the first year using Balancer’s valuation at its seed round. In comparison, Uniswap fees distributed to its LPs amount to $8-9m on an annualized basis in fees to its LPs and of course there’s no UNI token (yet). Compound, meanwhile, just announced that COMP will be distributed to addresses that borrow and lend on Compound.
Liquidity is a network effect. Liquidity begets liquidity, so it’s no wonder that DEXs realize that an asset under management today is 2x more valuable than one in a year (5x? 10x?). The liquidity wars are already here, and to speculate, this perspective may have expedited both Balancer and Uniswap’s plans: Uniswap’s v2 launch was a small surprise when it launched on mainnet two weeks ago, while Balancer announced that users can start earning BAL tokens now even though the BAL token won’t launch for “weeks, not months”.
Capital efficiency is Ethereum’s black hole
Balancer vs. Uniswap will be the DeFi battle to watch in 2020, followed closely by Compound and Aave on the lending side, but there is a broader argument for Ethereum’s product-market-fit in extracting the most economic value out of capital assets.
MakerDAO founder Rune Christensen:
Some have also called this a “liquidity blackhole that sucks in all idle assets” and new Bitcoin synthetics on Ethereum exemplify this point. The inclusion of WBTC as collateral in Maker unlocked additional economic value for Bitcoin as an asset class, while Curve.Fi is offering attractive yields for those that deposit WBTC or RenBTC into its liquidity pools.
In the centralized world, Grayscale Bitcoin Trust has been a popular way for large investors to gain exposure to Bitcoin; investors want exposure to BTC the asset and are not particularly interested in storing Bitcoin the digital currency.
Gold is similar; most investors gain gold exposure through an ETF, which is likely why liquidity pioneer Synthetix’s latest scheme is to attract gold bugs. It is providing liquidity incentives to any user that deposits into Uniswap v2’s USDC-sXAU pool, hoping to create a liquid entryway for anyone to get gold exposure. Expect other synthetic asset liquidity mining initiatives to bring real-world assets to Ethereum.
I’d be remissed if I didn’t mention Hummingbot, who (I think) actually coined the term “Liquidity mining”. It builds software to allow users to earn fees while providing liquidity on centralized exchanges. It has DeFi coverage but is focused on exchanges with the most volume.
Token-economics is baaack [Dose of DeFi/Sept. 11, 2019] – old Dose that explores some of these same issues and discusses Bancor’s incentive liquidity scheme and how it compares to Synthetix’s.
Tweet of the Week: Stablecoins and compliance
Finance blogger JP Koning followed this up with a much more in depth piece in CoinDesk. Paxos is not involved with the Ponzi but the use of its stablecoin is not a good look. It won’t take any action unless directed by a government, so this could be a good test case for what regulated stablecoins can be used for.
Chart of the Week: Declining rewards
PoolTogether’s prizes from Leighton Cusack in OurNetwork newsletter. Low interest rates squeeze those trying to build businesses on top of the higher yields. The yield premium will likely stick around, just much tighter.
Odds and Ends:
mStable launches, aims to “unite stablecoins” Link
DeFi777 hopes to bring 777 token wrapper to DeFi Link
Maker’s Oasis trading portal offers leverage for traders Link
Notes from call on EIP 1559 Link
Centrifuge launches Tinlake and Centrifuge chain to bring real-world assets to DeFi Link
DeversiFi announces v2 of its DEX Link
Loopring Monthly Update Link
Thoughts and Prognostications:
DeRisking DeFi: Guarded Launches [Ken Deeter/Electric Capital]
UniswapProtocol v1 DAI LP net returns since market inception [Teo Leibowitz/The Block]
Governing Synthetix's competing factions [Chris Powers/Govern This]
10 signs were headed for an ETH bull market [Spencer Noon/DTC Capital]
It’s not about the tech (yet?) [Gavin Andresen]
That’s it! Feedback appreciated. Just hit reply. Written in Brooklyn. Hoping for more compassion and understanding. Subscribe to Govern This. Time for euchre?
Dose of DeFi is written by Chris Powers. Opinions expressed are my own. All content is for informational purposes and is not intended as investment advice.