The Liquidity Incentive Problem

Sufficient liquidity is the key to a flourishing financial ecosystem. Without liquidity, the entire OpFi vertical would not subsist. It’s the most important element in the OpFi stack.

OpFi primitives and composability amplify contract functionality; however, without liquidity, the entire OpFi vertical would not subsist. It’s the most important element in the OpFi stack.

The two largest use cases for OpFi, and by extension the products with the most product market fit (PMF).

• Borrowing & lending

• DEXs

In a highly competitive market, the fight to conquer and win market share was influenced by the utilization of aggressive emissions.

Projects scaled extremely quickly as a result, however in the search for attracting fast liquidity, they traded longevity for:

• Mercenary capital

• Speculation (greed & FOMO)

• Impatient userbases

• Incredibly high CAC (considering the % of total token supply spent to acquire users and attract liquidity)

With a multitude of products and services, there are many games to be played and rationale for accruing liquidity.

Liquidity	Example	Benefit
Borrowing	Collateral	Leveraging assets
Lending	Asset	Supply liquid market for borrowers
Pegged Asset/Liquid Staking	ETH-stETH	Minimize opportunity cost of converting assets
Wrapped asset	WBTC-USDC	Maintain value of native asset from one chain to another
Native token	ETH-USDC	Treasury access to capital markets
Stablecoins	DAI-USDC	Ensure stability by maximizing "real world use" and liquidity and minimizing depeg risk

Liquidity Games

OpFi is often likened to playing a game, and how can it not? Considering the fact that game theory plays such an integral part of designing a product’s architecture and protocol mechanics.

The main game is obviously about how to attract and retain liquidity. Projects have gone through various stages of liquidity incentivization experimentation. The challenge for new OpFi projects is to incentivize liquidity and optimize the game theory mechanics which will have positive outcomes for users and still be a sustainable business model for the project.

So far, we have seen three main liquidity games. Each one fosters its own drawbacks, and problematic outcomes for all market participants.

Game 1: Pool 2

Promotes mercenary capital, by attaching a reward to staked LPs. Liquidity and users are fleeting and move on after Pool 2 has been farmed and dumped.

Game 2: Protocol Owned Liquidity

Protocol-owned liquidity in the bonds + the (3,3) model (popularized by Olympus DAO) is highly dependent on market psychology rather than sustainable economic incentives. Bonds mean (3,3) projects consistently buy assets below market value over time, while also inflating their own token supply. Meaning paying dollars on the cent to acquire assets. Results in running a debt deficit where the debt is the outstanding project token supply. During a macro market downtrend, these mechanics are not financially sound.

Game 3: Curve Wars

Building new protocols in order to direct and control liquidity via incentives/voting for the market-leading liquidity marketplaces e.g Curve. In this system, the incumbents hold a clear first movers advantage and hold a moat for entry into the CRV/CVX system. Bribing voters in the CRV/CVX system remains expensive by itself. The markets available to users are also limited based on the fact that this is a liquidity game.

The Holy Grail

Offering liquidity incentives and a sustainable business model for the longevity of a protocol.