Protocol Owned Liquidity and Alchemix
The different ways of maintaining liquidity for assets
This article is a guest post written by community contributor @juwonloblaze.
DeFi relies on liquidity for smooth operation. Without liquidity, there is no DeFi. Over the years, various ways of generating sustainable liquidity have taken center stage in DeFi discussions. Each method hopes not just to provide liquidity, but also to provide long-lasting sustainable liquidity. To achieve this would mean mitigating the need for mercenary capital.
With DeFi 2.0, the idea is that a new breed of DeFi protocols come together to solve existing pain points. By experimenting with protocol design and tokenomics, the dynamics by which users interact with digital assets can be improved. This experimentation aims to innovate liquidity mining by enabling protocols to own their liquidity instead of renting it.
Liquidity mining has been seen to bring opportunistic liquidity that is usually not “permanent.” Liquidity mining also tends to create huge selling pressure for the native token. The inclusion of vesting incentives merely puts off the problem instead of solving it. The same issues will resurface in the future, demanding more sustainable solutions. The Total Value Locked (TVL) is one of the most important metrics in judging the overall health of a DeFi protocol and represents the current valuation of assets being staked.
Comparison between protocol-owned liquidity and liquidity mining using Olympus DAO and Uniswap as an example
Uniswap was developed toward the end of 2018 by Hayden Adams. With a total value locked of more than $4.5 billion, Uniswap ranks as one of the most popular and biggest platforms for liquidity pools on Ethereum. Liquidity providers create a market by depositing an equivalent value of two tokens (ETH or ERC-20 tokens). Common stablecoins used in providing liquidity are USDC, USDT and Dai. In exchange for providing liquidity, the liquidity providers receive liquidity tokens, which represent their share of the total liquidity pool.
Consider the ETH/USDT liquidity pool; for this example, the number of tokens in the pools of ETH and USDT will be designated as x and y, respectively. The fundamental premise of Uniswap is that x multiplied by y must be equal to k, where k is constant. This concept is commonly referred to as x*y= k. It must however be noted that the balance between x and y can be shifted when the order is larger. This can lead to excessive slippage when a user makes a trade.
The launch of Uniswap v3 in May 2021 introduced the concept of concentrated liquidity. Concentrated liquidity provides individual liquidity providers precise control over the price ranges to which their capital is allocated. With the introduction of concentrated liquidity, users can select the price range they want to provide liquidity. In UniV3 pools, liquidity providers (LPs) only receive a portion of the fees for swaps that fall within their liquidity range, encouraging them to manage their holdings to offer liquidity at the market price.
Uniswap has experienced an increase in the number of liquidity providers without having to increase the Annual Percentage Yield (APY). Their first-mover advantage in this category has given them a significant leg-up that new protocols have difficulty matching.
Of late, the possibility of protocols garnering millions in liquidity and going bankrupt, especially in the ever-competitive DeFi space is considered to be very high. This is because it becomes hard to maintain the initial momentum and when there is no innovation, liquidity moves to new and more “innovative protocols”, especially when it offers better incentives. The frequent influx of mercenary capital and the near-impossible task of replicating the feat Uniswap has attained has led to the quest for more viable options in the long run. The need for a more sustainable option led to more innovative ideas and solutions. This birthed the creation of protocol-owned liquidity.
Olympus DAO is one of the pioneers of protocol-owned liquidity. Olympus aims to build a decentralized reserve currency. Originally, this was done by offering a discount on its native token by using a bonding system with a vesting period that distributes the discount to buyers over five days. Put simply, the bonding process involves the protocol selling their token (i.e. OHM) in exchange for another token (e.g. ETH) or a liquidity token (OHM/ETH) from a buyer. This helps to mitigate the risk of people constantly reselling tokens for profit, which gives an advantage in controlling the protocol’s liquidity. Bonding also helps the protocol to hold a large amount of valuable tokens in its treasury. Due to Olympus DAO owning a large amount of valuable tokens in the treasury, a drastic fall in price can be mitigated. Behind every created OHM token, there is a metaphorical basket of at least one Dai. When the price falls below one Dai, the protocol buys back OHM and burns it. With this mechanism in place, users can be assured that there will be liquidity to trade their tokens. Olympus later created Olympus Pro to allow other top DeFi protocols like Alchemix to sell their tokens at a discount in exchange for liquidity and other tokens. In return, Alchemix paid Olympus a small fee in the form of its native ALCX token. Because of this partnership, Alchemix was able to build up a reserve of protocol-owned liquidity in the treasury. However, the Alchemix bonding program was terminated during the bear market, as tokens were being sold for bonding at increasingly discounted prices relative to the bull market.
While protocol-owned liquidity is an excellent alternative to liquidity mining and a step in the right direction, it is not without tradeoffs. One of these is over-reliance on incentivising users to bond by giving discounts. As competition increases, a bond loop is created where tokens are sold to get bondable assets which are used to bond more tokens leading to the market selling all of the emissions at the detriment of other holders. Issues of scalability in the face of decreasing yield is also an issue that needs to be addressed. Additionally, protocol-owned liquidity is gained by effectively selling tokens. In the short term, this can be significantly more expensive to a protocol than liquidity mining or “renting” liquidity.
Role of the Algorithmic Market Operator in improving scalability in Alchemix using protocol-controlled liquidity
With the help of an Algorithmic Market Operator (AMO) the protocol can deploy reserve assets in ways that are profitable, while ensuring that these assets are available as needed to keep the system whole. The Alchemix AMO (also called the Elixir) is inspired by Frax’s AMO and is taking a similar path in market operations, but excludes some features such as the ability to mint aIUSD into the LP pools. The Alchemix AMO receives underlying assets, such as stablecoins and ETH, from the Transmuter and can withdraw alAssets to burn. Both actions help trend the price of alAssets towards 1:1, while expansion of supply from new loans or the sale of alAssets will trend the price away from/below 1:1.
The Elixir plays a big part in revenue generation and building long-term liquidity by operating a self-sustaining Convex flywheel strategy to create value around the CVX tokens and accumulate these tokens. There is more power to direct rewards from the Curve and Convex protocols helping to increase sustainable incentivisation of the primary liquidity pool. Traditionally, excess alAsset backing would be held idle by the Transmuter but with the Elixir, these will be sent to the Elixir pool which is then sent to Curve to stake LP tokens on behalf of the Elixirs.
Because the Elixir represents a large share of each alAsset liquidity pool, Alchemix can receive a significant portion of the value it bribes back in the form of CRV and CVX - in some cases, even more than it bribes with. The large accumulation of $CVX is locked into Convex. The locked $CVX can then be used to vote for alAsset liquidity incentives through votium, which allows Alchemix to recoup a portion of the ALCX it uses to bribe CVX voters. Alchemix also stakes CRV in stakeDAO’s sdCRV, which lets Alchemix access voting power without being fully locked in $veCRV. A portion of earned rewards is also sold to purchase other assets for the treasury or fund DAO operations.
Alchemix Elixir also plays an important role in maintaining the price of alAssets by the selective withdrawal of alUSD or alETH. These single-sided withdrawals can help rebalance the pool and restore the price. The withdrawn tokens are removed from circulation and can be redeployed to the Curve pool if the price ever goes above 1:1, or they can be burned.
Note that the Elixir does not technically own the assets in the pool, because they serve as backing for the alAssets. Instead, the Elixir only controls the deployment of the assets and has the right to earn yield with them, but must return the assets when required to be redeemed as backing. This is a form of liquidity management called Protocol-Controlled Liquidity.
Alchemix treasury management
Because so much of Alchemix revolves around managing alAsset liquidity, the treasury is very focused on accumulating and managing assets that help direct liquidity in efficient ways. Aside from stablecoins and ETH, which the treasury holds to preserve the runway to fund operations, the treasury holds almost exclusively liquidity-driving assets, which can increase the scalability and profitability of the protocol. Liquidity-driving assets are another form of protocol-owned liquidity, where the asset itself is not liquidity, but the asset does allow the owner to direct emissions indefinitely to incentivize liquidity. If accumulated at the right time, liquidity-driving assets can be precious for the treasury and be used to vote for Alchemix liquidity. A good example of this is Alchemix’s veVELO position, currently worth $600k, which was obtained for under $100k and can direct VELO emissions to alAsset pools on Velodrome so long as Alchemix continues to maintain the accumulation and add to their $veVELO position.
About Alchemix
Alchemix is a DeFi lending protocol that offers self-repaying loans helping you to collateralize your assets and earn future yields without the risk of forced liquidations. Alchemix helps you fully harness money's time value and tokenized value on their deposits. Since its inception in 2021, Alchemix has proven revolutionary in DeFi. With routine testing, auditing, and a bug bounty program to prevent security breaches, and provide secure and transparent access to decentralized finance, Alchemix has proven to be a game changer in decentralized finance. Alchemix also assigns you voting power as an ALCX holder to take snapshot votes and eligibility to earn dividends in the future.
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