[DISCUSSION] Protocol owned liquidity & future of liquidity mining incentives

Background

When launching a new token one of the key things to put in place is sufficient liquidity for the dominant trading pair (usually ETH/token) to establish a liquid and balanced market. Most protocols solve this by doing some form of liquidity mining - rewarding users for putting up capital in this new trading pair.

FOX is currently doing this as well with a reward programme in the form of 15 million FOX until October 13th. This is a substantial amount that is needed to bootstrap the market, but at the same time is also unsustainable (or, at the very least, undesirable) in the long-term since it is a drag on the treasury funds. And, in any case, liquidity mining is always a short-term game since as soon as the rewards dry up yield farmers will probably move on to new opportunities.

So, in short, you could argue that the current liquidity mining scheme for FOX does not lead to a sustainable solution for a liquid market pair in the long term. (For sake of completeness I will say that this is not always true and that having market makers, being listed on CEXes, or incentivized DEX trading pairs - like Sushi does - could work as well without FOX liquidity mining.)

Hence I think it’s worth having a discussion on FOX token liquidity and how we want to manage and incentivize this in the future.

Protocol owned liquidity

Other DAOs are of course facing similar issues, and several protocols are starting to experiment with alternative solutions. As an example, you can look at what Tokemak is trying to do but this is still in the launch phase and so not relevant to the discussion currently.

But a battle-tested way to solve liquidity mining is having protocol owned liquidity - that is: authorizing the treasury to buy the dominant LP tokens.

Arguably the protocol that is using this to the fullest extent possible & the protocol that has been most successful with this is Olympus DAO (OHM), so I will use them as an example for this post. I’m sure there are other DAOs doing similar things so if there are any other good examples please let me know.

In the case of OHM, their treasury currently owns 99.5% of the OHM/DAI trading pair and 99.0% of the OHM/FRAX trading pair (source). Hence there is no need to do any form of liquidity mining.

Other benefits

Besides the fact that protocol owned liquidity solves the liquidity mining problem fully or partially, there are other benefits that we can think of as well. Here’s just a few:

  • Most treasuries only own their native token which is a massive risk (as highlighted by Messari research earlier in the year). The current ongoing discussion/proposal with UMA solves this, but owning the FOX/ETH LP token would only strengthen the treasury in my view.

  • It gives the treasury exposure to ETH. I think everyone is familiar with the bull case for ETH so I won’t waste too much space on this. But besides that, I would also argue that it’s important to own a piece of the land you’re building on, and so it makes sense that the DAO treasury has a bit of ETH exposure.

  • Also, it leads to a nice ongoing income stream for the DAO. If the treasury owns a significant part of the FOX/ETH LP trading pair then it will accumulate fees from users swapping these tokens. Again, as an example from OHM, you can see that on an average day the treasury is earning ~20k in trading fees from OHM/DAI trading pair alone (Dune Analytics) (and on good days triple that amount!).

How to (potentially) manage this

If you agree that having LP tokens in the treasury makes sense, then the next question would be: how do we manage this in practice? I’m sure there are several ways of doing this, but I see 3 main possibilities:

  1. The quick and dirty way: A simple solution could be for the treasury to market buy ETH and manually create an LP position. The downsides are that it would require a few transactions from the multi-sig, and that it - in a way - will be detrimental to current FOX holders and LPers (i.e. FOX sell pressure will lower prices, and LPers could potentially experience temporary IL).

  2. The clean way: A second way could be to authorize the treasury to buy LP tokens directly from current stakers. We can think of a methodology in which sellers receive 105/110% of the value of the LP token in FOX - i.e. they are incentivized to sell them knowing that 1) the LM programme will end soon, and 2) by selling the LP tokens to the treasury they receive a higher return than manually unwinding their positions. This could be done over a longer period of time to slowly increase the DAOs LP position (with perhaps a curve that rewards sellers on how early they sell their tokens or based on the amount of protocol owned liquidity already.)

  3. The elegant way: Finally - and this is more a variant on buying LP tokens directly - we could think of a bonding mechanism like OHM uses. In OHM’s case bonding roughly works as follows: you buy OHM from the protocol at a variable discount (based on demand, so a negative discount is possible when the treasury is “overstocked” or “overbought”) with LP tokens and your bonds then vest over a period of 5 days (For more info see here, here and here).

For FOX this could work similarly in that buyers get a discount on the current FOX price by buying it through the treasury with LP tokens (quite similar to the previous mechanism). But this is an option that is more automated, autonomous and that can be used in the long term to keep buying LP tokens as the total market for FOX/ETH increases. The downside is that this would be more difficult to implement since for OHM bonding is critical for their protocol, while for FOX it would just be for treasury diversification/liquidity mining. (As a side note, if this option is attractive I think we can open a discussion with the OHM team to potentially use their bonding contracts in exchange for a donation of FOX for example.)

The other thing we need to discuss as well is how much liquidity the protocol should own. Is the goal to own the vast majority of the LP tokens? Or are we aiming to own “just” a significant share of the pool so we can reduce or stop the liquidity mining incentives?

Conclusion

Let me end by saying that this is not a proposal in itself, but more a way to kickstart a discussion on liquidity mining (incentives), protocol owned LP tokens, and how to create a liquid FOX/ETH market after October 13th.

I fully realize there are also risks involved in doing this & that the development of a buying/bonding mechanism would require not just treasury funds but also dev & testing time.

And on that note I will end - I would be very curious to hear your thoughts on this!

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I LOVE this idea, and hadn’t heard of this before! The DAO owning a bunch of LP tokens for the FOX/ETH pair has all sorts of wonderful positive feedback effects.

The default plan that we (several ShapeShift execs) would’ve proposed by default would be to continue the liquidity mining incentive but perhaps at a lower rate, just akin to slowly reducing the “stimulus” in the system. Liquidity mining is a fantastic bootstrapping mechanism, but shouldn’t be relied on for long-term planning.

Regardless of an extension of the liquidity mining, the DAO itself actually beginning to build a position in LP tokens is really cool.

I’ll absolutely support a good formal proposal around this idea once the parameters have been discussed.

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I think this idea makes a ton of sense! I would love to hear what people think are the benefits/detractors of owning the vast majority of the LP tokens vs owning ‘just’ a significant share of the pool. To me, this is the biggest question right now (at least that I can think of).

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I put some more thoughts in the discord directly to @Felix , but I really like this idea. It does seem that the DAO owning LP units of the pool brings a bunch of benefits, including diversity towards ETH, accruing fees, and helping support liquidity for everyone involved.

I think the main thing to move anything forward on such a proposal is a more detailed discussion/proposal about how this would actually be executed.

E.g. should the DAO use some of its stablecoin treasury (once raised) to purchase LP units from interested community members at a small premium? How much and how exactly would this work? Or other ideas of how to engage in this pro-actively? Looking forwrd to further discussion on this topic!

I appreciate @Felix for writing out such a thorough and thought provoking discussion started.

I think the DAO holding LP tokens is a great idea. Treasury diversification, revenue, and support for trading are the main reasons for me.

Seems simplest way to start is to work our treasury diversification proposal for stable coin addition to our treasury. We could use some portion of stable coins to buy ETH for
the purpose of LP providing.

The other methods are worth considering, and for now I’d prefer to stay focused on the RT/ST sale, see how that goes, and then look at LP options.

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Would love to see this evolve into a formal proposal with the details worked out!!

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