Why DeFi Should Make Markets Like Wall Street Banks

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 all paradigm-shifting innovation, the DeFi ecosystem has experienced growing pains, but its long-term value is already coming into focus. With new protocols introduced every month that offer higher returns with lower barriers to entry than traditional finance, DeFi is attracting new users at a rapid rate.

high yields

However, a central challenge for DeFi developers has already emerged: attracting consistent long-term liquidity. Trades in DeFi (decentralized exchanges or dexes) require a flow of assets to enable efficient token trading, many of which raise initial 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 returns that generate rewards for investors in exchange 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 about 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 returns or rewards.

This creates a cycle in which unsustainably high incentives are offered, leading to enormous volatility as investors move from project to project based on who has the highest return. Meanwhile, promising DeFi projects see funding evaporate as their token fails to generate a market to buy and sell and loses its value.

Large traditional banks have long served as market makers by injecting huge amounts of capital into trading venues. This approach can also be applied to DeFi.

But DeFi innovators have discovered a potential solution: protocol-owned liquidity. With protocol-owned liquidity, a DeFi protocol can create its own treasury to back the token intended to be traded on its platform, instead of relying on yield-hungry investors.

Large traditional banks have long served as market makers by injecting huge amounts of capital into trading venues. This approach can also be applied to DeFi.

Liquidity Incentives

It works like this: fees generated by protocol transactions are placed in a common treasury instead of being distributed solely to investors as liquidity incentives. As the treasury grows from the generation of fees, the liquidity of the protocol expands, generating higher 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 to the treasury beyond the fees generated?

Protocols that own their liquidity still need to provide incentives and long-term value to be competitive with incentives offered by other DeFi dexes and protocols. Additionally, protocols must build trust among their user community through a transparent smart contract that distributes incentives and rewards, and a clear governance structure where users have confidence in any human decision-making that affects the project.

Solving these challenges is easier said than done. 2021 was a record year for “carpet pulls”, where a protocol developer leaves the project and takes the invested funds, a scam that is “particularly common in the DeFi ecosystem”.

I teamed up with colleagues from the University of California at Berkeley, Stanford University, and Bain Capital, the venture capital firm, to explore this issue in a recent article, “DeFi Liquidity Management via Optimal Control: Ohm as a Case Study”. In our paper, we explore how the Olympus DAO DeFi project has approached liquidity management.

We formulate the binding mechanism that Olympus DAO uses to create protocol proprietary liquidity in the language of control theory. Control theory, which is used in mission-critical applications such as airline autopilot and autonomous vehicles, provides a way to measure how protocol liquidity responds to automated changes in incentives.

technical design

We conclude that the linking mechanism within Olympus smart contracts can “improve the efficiency of capital and reduce risk to users of the protocol, as long as it maintains proper tuning and dynamic adjustments.” In other words, the technical design of Olympus DAO’s approach to proprietary 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 article is one of the first to look at the strength and endurance of a smart contract governing 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. In doing so, they will bring the dream of an accessible decentralized financial system closer to reality than ever before.

Tarun Chitra is the founder and CEO of gauntlet webs

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