Efficient capital management and liquidity provision are central to the sustainability and growth of DeFi protocols. Protocol-Owned Liquidity (POL) and Liquidity Mining have emerged as key strategies embraced by projects across the ecosystem to help boost trading volume and overall activity.

Liquidity Mining incentivizes participants to provide liquidity in exchange for rewards, usually native tokens. POL, in contrast, represents a shift in approach whereby protocols themselves maintain liquidity reserves, ensuring healthy markets and reducing reliance on external providers.

Today, we explore the importance of onchain liquidity for protocol growth and discuss the mechanics, benefits, and challenges of both POL and Liquidity Mining. We’ll cover:

1. Onchain liquidity and protocol growth

2. Liquidity Mining

3. Protocol-Owned Liquidity (POL)

4. Choosing between Liquidity Mining and POL

Onchain liquidity and protocol growth

What is onchain liquidity?

Onchain liquidity is the liquidity available to trade directly on a blockchain. Liquidity is typically made available through decentralized exchanges (DEXs), enabling traders to buy and sell tokens directly onchain without using an external, centralized venue. Deeper DEX liquidity drives improved price execution for traders lowering the cost to buy or sell a token.

Why should a protocol care about on-chain liquidity?

Increased DeFi adoption

Low DEX liquidity can hinder the adoption of a native token across DeFi. Lending and perpetuals protocols may rely on liquid onchain markets to support functions like liquidations. Without corresponding DEX liquidity, the ability to support a native token through a DeFi ecosystem can be extremely limited.

Entry into the token ecosystem

Low liquidity may also have a chilling effect on DEX traders interested in buying and holding a protocol’s native token due to high slippage preventing traders from obtaining large positions cheaply. Increasing the liquidity provided on DEXs facilitates new market entrants in a token ecosystem encouraging protocol growth.

Increased token price stability

Thin liquidity can result in larger trades having an outsized price impact, known as slippage. One large sell order on a DEX may blow through multiple price ranges resulting in price instability and increased uncertainty within the market. Robust liquidity can enable DEXs to absorb these larger unexpected sales and prevent unnecessary price volatility.

DEX liquidity flywheel

For tokens with low liquidity, bootstrapping liquidity on a DEX can generate a flywheel effect driving long-term growth and value for native tokens. Generally, more liquidity drives more transactions, which generates additional fees to liquidity providers (LPs) for that token. This can attract more liquidity in the future, generating a flywheel that builds token adoption and viability.

Liquidity Mining

Liquidity Mining is a common strategy for bootstrapping onchain liquidity. It functions by incentivizing users, often referred to as liquidity providers (LPs), to deposit their cryptocurrency assets into a liquidity pool. These pools facilitate decentralized trading, lending, and other financial activities. Incentives offered to LPs are typically in the form of additional tokens.

Liquidity Mining amplifies capital inflows by offering direct financial incentives for participation. It can also lead to a significant inflow of transaction volume based on spending. As our research has shown, Liquidity Mining can boost daily liquidity increases by high multiples per $1 of incentives, varying greatly on market conditions and the profile of the supplied token.

Advantages of Liquidity Mining

High Leverage

The key advantage of liquidity mining is obtaining high leverage for your spending. One dollar in incentives can generate thousands of dollars in liquidity for relevant pools, a relatively small spend for an outsized impact on DEX liquidity.

Disadvantages of Liquidity Mining

Fleeting Liquidity

While Liquidity Mining can drive a rapid increase in total value locked (TVL), this TVL often does not prove to be “sticky.” Once the Liquidity Mining program ends and rates normalize, “mercenary” LPs are likely to pull their liquidity in search of another mining program, potentially destabilizing the protocol and negatively affecting TVL.

Unstable Liquidity

During market turbulence, LPs may withdraw their liquidity despite incentives when liquidity is most in demand. This results in liquidity leaving DEX pools the moment it is most important.

Cost

Liquidity mining incentives are expensive, given they are unreclaimable payments directly to LPs. These LPs generally sell out of these native tokens, putting significant downward pressure on token price and shrinking a protocol’s treasury over time.

Protocol-Owned Liquidity (POL)

Protocol-Owned Liquidity, or POL, is a native derivative of Liquidity Mining and refers to the strategic acquisition and management of onchain liquidity by a protocol itself rather than relying solely on external liquidity providers. This approach offers protocols more direct control over a portion of their market's liquidity, ensuring stability, reducing slippage, and generating revenue from trading fees.

Similar to Liquidity Mining, POL enables a protocol to kickstart trading activity or maintain a baseline level of liquidity without depending on external incentives to attract LPs. Unlike Liquidity Mining, where users are motivated to contribute liquidity in exchange for rewards, POL places the responsibility on the protocol itself to act as the LP, utilizing its own resources to ensure market liquidity.

Advantages of POL

Stable Liquidity

POL, provided directly from the protocol, is immune to skittish LPs reacting to market events. Liquidity deposited into a POL position is guaranteed to be there in a market crisis and can act as liquidity of last resort, even when third-party LPs flee.

A protocol may decide to employ a POL strategy if it wants to control and maintain consistency over the liquidity levels in relevant markets. In times of market uncertainty, a protocol can be confident that liquidity is available when truly necessary.

Generating Revenue

POL generates revenue for the protocol in the form of LP fees. Dissimilar to Liquidity Mining, where incentives are spent once and gone forever, POL will usually increase in value over time as LP revenue is generated and can be withdrawn once it is no longer needed. This turns Liquidity Mining, which has historically been a cost center, into a revenue center for a protocol.

Disadvantages of POL

Treasury Opportunity Cost

The strategy may tie up a large portion of the treasury in POL positions in the short run due to its reduced leverage. One dollar in POL generates $1 in liquidity for a given pool. This means that throughout the duration of a POL deposit, the treasury is not generating yield through other sources and faces the opportunity cost of holding tokens directly, often referred to as impermanent loss or loss versus rebalancing (LVR). While this is not a direct cost in the sense that Liquidity Mining is lost spend, it is a cost as the capital tied up in POL could be otherwise used for potentially higher-yield generating activities.

Choosing between POL and Liquidity Mining

The core difference between POL and Liquidity Mining is a “rent versus buy” decision. POL enables a protocol to buy its own LP positions directly, whereas Liquidity Mining allows a protocol to rent liquidity from third parties.

Liquidity Mining is an effective solution for protocols looking to bootstrap a very large amount of liquidity quickly and are less concerned with the cost and price impact of their spending or the potential for liquidity to flee in adverse market conditions.

POL, on the other hand, is a powerful solution for protocols with a large diversified treasury interested in providing stable liquidity for their users during periods of market crisis while earning diversified yield.

Overall, a mixed strategy is often appropriate. Liquidity Mining incentives are used to bootstrap large amounts of transient TVL on top of POL positions, which provide a cheaper and consistent source of liquidity to desired pools that are shielded from market pressures.

Aera vaults have the unique ability to run both Liquidity Mining and POL strategies in a unified and seamless manner. Stay tuned in the coming days for a blog outlining how Aera can do this for your protocol.

Aera Team