As Liquidity Management Evolves, DeFi Protocols Gain More Flexible Ways to Scale

Liquidity is often said to be the lifeblood of the DeFi industry, as it dictates the ease with which digital assets can be bought and sold at stable prices.

Digital assets require sufficient liquidity to create efficient markets, as it’s what facilitates speedy, seamless transactions. When a digital asset has high liquidity, it means it can be traded in large volumes with little impact on its price, contributing to a stable market and greater confidence among investors. On the other hand, low liquidity causes enormous problems, with erratic price movements that create significant risks for market participants, lower investor confidence.

It’s for these reasons that the availability or lack of liquidity has such a major influence on investment strategies and market perception.

For DeFi to become mainstream, it’s necessary to attract enough liquidity to support massive capital inflows from institutional investors, investment banks, hedge funds and venture capital firms, and that’s why this key segment of the market has been buzzing with innovation.

Without sufficient liquidity, the idea of investing in digital assets is a non-starter for many of these institutional investors. A famous example of how the lack of liquidity can hold the industry back occurred in late 2021, when it was reported that a large family office wanted to invest in the tokenized carbon credits marketplace KlimaDAO. It heard about KlimaDAO on Twitter (now X) and was keen to invest millions of dollars into the carbon credit economy, only to discover that the protocol couldn’t possibly support an investment of that size without crashing the value of its NFT assets.

That example demonstrates how the lack of liquidity can cripple DeFi protocols that simply aren’t ready to scale for mass adoption.

The evolution of capital efficiency in DeFi

Fortunately the DeFi sector has come a long way in terms of enabling greater capital efficiency to support the inflow of more liquidity. One of the earliest gamechangers was Uniswap V3, which was created to place concentrated liquidity to support existing market prices. It succeeded in improving capital efficiency in key digital asset markets by 4,000-times, allowing liquidity providers to benefit from higher returns on their capital.

It was viewed as transformative for the DeFi industry, but later many liquidity providers found that they were being priced out of their pre-set ranges. The problem stems from unbalanced transaction fees that can flit between 0.3% and 1% on Ethereum, which can make it inefficient for investors to deploy their capital on the Uniswap V3 price curve given that network’s expensive transaction fees.

The solution to this problem came from a number of protocols that introduced automated active liquidity provisioning. The likes of Visor Finance, Unipilot and Lixir pioneered the idea of smart vaults that allow investors to deploy assets in Uniswap V3s’ liquidity pools, with capabilities for fee optimization, options to reinvest fees and optimize liquidity mining.

Another key development in liquidity provision came with the arrival of chain-specific DEX aggregators, which facilitate price discovery across multiple decentralized exchange platforms before executing trades via the most optimal route to ensure the best possible price. They were followed by the emergence of cross-chain liquidity aggregators, which further reduced friction, enabling cross-chain arbitrage and flash loans.

Meanwhile, other projects have arisen that focus on analyzing the concentration of trading volumes across DEX platforms, so investors can use automation to benefit from the most profitable market-making strategies. An example of this is oX’s RFQ (request for quote) algorithm, which facilitates the inflow of liquidity from centralized exchange platforms to DEXs.

Next-generation liquidity incentives

Such innovations have gone a long way towards boosting the DeFi industry’s ability to support institutional investments and scale to the next level, but protocols continue to seek superior solutions that will support smoother operational and capital efficiency.

That’s why there’s a lot of hope in next-generation liquidity governance models such as Thena’s V3,3 model, which was inspired by an earlier project called Solidly and is designed to support the dynamic allocation of capital into liquidity pools based on veTHE token holder votes.

Thena positions itself as the liquidity layer of BNB Chain and the “protocol of protocols”. With ve(3,3), the main stakeholders of its ecosystem, include veTHE token holders, users, LPs and protocols are aligned by dynamics that determine the emission rate of its native $THE token, together with the “bribes” deposited by protocols and the fees generated by each liquidity pool. It’s designed to incentivize maximum liquidity for each project.

The key element introduced by Thena V3,3 is “decentralized emissions”, where emission distribution is based on a free market model that provides third-party protocols with the ability to incentivize liquidity through two different methods.

The main method is “bribery”, where protocols can deposit additional rewards based on their gauge within Thena’s bribing interface, providing stronger incentives for veTHE holders to vote for their LP. Additionally, they can also acquire veTHE tokens themselves and use these to vote to allocate more $THE emissions within their own pool.

In both cases, these mechanisms are fully permissionless and decentralized, with the market price of bribes determined by free market forces.

Additionally, Thena V3,3 supports a number of “value creating strategies” for protocols, including protocol-owned liquidity deposits or POLs that enable projects with veTHE to deploy their own liquidity on Thena. Through this, they can then farm $THE tokens and lock the proceeds as veTHE to increase their share of the total supply.

A second strategy called market buy and lock gives protocols the opportunity to purchase $THE and lock it up to increase their share of emissions. Meanwhile, bribe deposits enable protocols to deposit customized reward amounts for any pool, so they can be claimed by veTHE token holders who vote and allocate how many $THE emissions go to each pool. This provides a way for protocols to influence the amount of emissions for their native tokens, and is one of the most affordable ways to incentivize liquidity.

Other methods for protocols to incentivize liquidity include depositing revenue generated from Thena’s pools as bribes, or selling their voting power to generate more revenue, which can then be deployed as they see fit. Protocols can even employ a combination of strategies, such as POL and bribe deposits.

Powerful tools for liquidity management

Innovations such as decentralized emissions, protocol-owned liquidity deposits and bribes can be powerful tools, enabling protocols to increase their influence over Thena’s emissions while supporting virtuous value creation for every stakeholder.

By giving protocols more control and flexibility over liquidity management, they can devise customized strategies and scale in a more sustainable way. Thena V3,3 provides multiple options for protocols to tailor their growth strategies while maximizing the value of their tokens and providing strong incentives for long-term liquidity.

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