Why DeFi Should Make Markets Like Wall Street Banks
The DeFi Ecosystem Needs to Solve the Liquidity Challenge
By: Tarun ChitraOp-ed
The core promise of DeFi is a global financial system, open to all. It eliminates the need for banks and central control, saving consumers and small businesses tens of billions of dollars in fees collected by intermediaries from everyday financial transactions like buying a cup of coffee or sending money across borders.
Like every paradigm-shifting innovation, the DeFi ecosystem has experienced growing pains, but its long-term value is already coming into focus. With new protocols introduced each month that offer higher returns with fewer barriers to entry than traditional finance, DeFi is attracting new users at a rapid clip.
However, a core challenge has already emerged for DeFi developers: attracting consistent, long-term liquidity. Exchanges in DeFi (decentralized exchanges or dexes) require a flow of assets to enable the efficient exchange of tokens — many of which raise seed funds through token issuance to support DeFi platform development. To date, the easiest way for dexes to attract liquidity has been to incentivize participation through high yields that generate rewards for investors in return for the capital that powers the protocol.
The problem is that many investors care less about deploying their capital to build a new financial system than pocketing the highest returns possible. As a result, many DeFi investors quickly withdraw and transfer their capital once they find a separate project with higher yields or rewards.
This creates a cycle where unsustainably high incentives are offered, leading to enormous volatility as investors move from project to project based on who has the highest yield. Meanwhile, promising DeFi projects see funding evaporate as their token fails to generate a market for buying and selling and becomes worthless.
But DeFi innovators have uncovered a potential solution: protocol owned liquidity. With protocol owned liquidity, a DeFi protocol can create its own treasury to support the token meant to be exchanged on its platform, rather than relying on yield-hungry investors.
Traditional major banks have long served as market makers by injecting enormous amounts of capital into trading venues. This approach can be applied to DeFi as well.
It works like this: fees generated by protocol transactions are placed in a common treasury instead of being solely distributed to investors as liquidity incentives. As the treasury grows from fee generation, the protocol’s liquidity expands, generating increased transaction volume and additional fees that build the treasury: a self-sustaining cycle (known as “flywheel”).
Problem solved? Not quite.
Important questions remain: Who manages this treasury? What incentives are used to attract users and more capital into the treasury beyond fees generated?
Protocols that own their liquidity still need to provide incentives and long-term value to be competitive with the incentives offered by other dexes and DeFi protocols. In addition, protocols must build trust amongst their community of users through a transparent smart contract that distributes incentives and rewards, and a clear governing structure where users have confidence in any human decision making impacting the project.
Solving these challenges is easier said than done. 2021 was a record year for “rug pulls,” where a protocol developer abandons the project, taking invested funds with them, a scam that is “particularly common in the DeFi ecosystem.”
I partnered with colleagues from the University of California at Berkeley, Stanford University, and Bain Capital, the VC firm, to explore this problem in a recent paper, “DeFi liquidity management via Optimal Control: Ohm as a case study.” In our paper, we explored how the DeFi project Olympus DAO has approached liquidity management.
We formulated the bonding mechanism that Olympus DAO uses for creating protocol-owned liquidity in the language of control theory. Control theory, which is used in mission critical applications such as airline autopilot and self-driving vehicles, provides a way to measure how the protocol’s liquidity responds to automated changes in incentives.
We concluded that the bonding mechanism within Olympus’s smart contracts can “improve capital efficiency and reduce risk to protocol users, provided it maintains proper dynamic tuning and adjustments.” In other words, the technical design of Olympus DAO’s approach to self owned liquidity appears to solve the key challenge of liquidity management in DeFi, providing a place where investors can realize value in an environment where the design reduces risk.
Our paper is one of the first to analyze the strength and resilience of a smart contract that governs a protocol that owns its own liquidity, such as Olympus DAO. These findings will help strengthen existing protocols like Olympus DAO while also opening up a new world of possibilities in DeFi for other developers to find ways to solve the liquidity management dilemma. By doing so, they will bring the dream of an accessible decentralized financial system closer to reality than ever before.
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