Financial liquidity incentive options

A number of decentralised finance (DeFi) protocols already exist in the Web3 industry. A financial liquidity incentive could provide a compelling solution for creating longer term demand for network money that has adopted demurrage.

Staking related protocols will not be mentioned below as a separate approach as solutions should emerge that enable someone to stake their coins whilst also using those coins as liquidity in DeFi protocols. The remaining and most relevant protocols for a financial liquidity incentive are highlighted below. Some relevant objectives that could help with improving the effectiveness of a liquidity incentive could include:

• Increasing long term demand - The incentive should help with creating more long term demand for the network money. This should be achievable with any of the protocols below by using liquidity lock-up periods.

• Increasing the utility of network money - The incentives should help to drive more demand for network money by increasing the amount of utility the money has in financial protocols. All of the approaches below could help with increasing the utility of network money. However it is more a case of whether the use case is essential or not as a responsibility for network money in generating long term success for the network. Only the most important use cases should be incentivised.

• Improve any network effects - The incentivised use cases should be ones that make the network more sticky due to better network effects. The most effective digital asset networks will likely be the ones that can align the incentives for using network money with the most important use cases that benefit the network. Achieving this should result in the network becoming the best place for creating, maintaining, using and exchanging digital assets.

• Easier access to network money - It is desirable to make network money easy for people to access as everyone will depend on its availability to pay for any network fees.

Token asset exchange

Token asset exchange protocols let users swap various digital tokens with one another.

A primary use case for digital asset networks is to facilitate the creation and usage of different tokens. Tokens could represent any physical or digital asset. A Web3 digital asset network will greatly benefit from incentivising exchange liquidity to make it as easy as possible to exchange tokens for other tokens. This should make the exchange market more efficient and also make it easier for people to access network money as they would now be able to more easily exchange any existing token for network money.

There aren’t any obvious reasons why a token exchange protocol wouldn’t be a vital part of creating a more competitive digital asset network. An incentive for using network money for token asset exchange can help with improving the effectiveness and efficiency of the token exchange market. Liquidity could also be locked-up using an incentive, this could create longer term demand for network money and help with improving overall network effects.

Lending and borrowing

Lending and borrowing protocols enable users to lend out their tokens to earn interest or to borrow against their own assets. This helps users generate passive income or gives them access to immediate liquidity.

The liquidity incentive could focus on encouraging people to lend network money for other people to borrow. This is useful as it provides people a way to access network money more easily without having to exchange their existing tokens for network money. If a user thought network money was over priced at that moment they could borrow it and exchange it for something else due to the belief that the cost to purchase it again in the future will be lower. This liquidity incentive could also use a lock-up period to help with generating longer term demand.

Although useful, a lending and borrowing liquidity incentive is not an essential use case for network money. One concern for this incentive is around the importance of oracles for lending and borrowing protocols as these enable a broader and more accurate reflection of a tokens price when the token is available on more than one network. This is important for determining accurate collateral liquidations when the prices fall. If a token was available in multiple places it could create a risk for the network if it was only using the local network's price for liquidations. Users could consolidate an amount of tokens they need on the network to try and force liquidations more easily if the protocol wasn’t looking at the broader price changes across multiple networks. The other concern is that this incentive could dilute the amount of network money that is used for token exchange liquidity. One way this problem could be reduced is by making a stronger incentive for token asset exchange liquidity when compared to the incentive that is applied to lending and borrowing protocols. It is not immediately compelling that this incentive is as important and impactful for the network long term as the token asset exchange liquidity incentive.

Stablecoins

Stablecoins aim to maintain a more consistent value, often tied to a major currency. The type of stablecoin that would be relevant for a network money liquidity incentive is one that uses network money as the collateral to mint the stablecoin.

The network may likely need to maintain a list of stablecoins that people can use when depositing network money as liquidity to mint those stablecoins. If this wasn’t the case people could create a new stablecoin by depositing their network money as liquidity and then could just hold the stablecoin supply themselves. This outcome would mean an unproductive use of the network money and would pose little risk to the holder of network money. Maintaining a list of valid stablecoins for the incentive to function would add governance complexity. This incentive would also reduce the availability of network money as it would be locked up as collateral which prevents other people from using it. Although there might be some value in a stablecoin collateral incentive, it is not as compelling as a token asset exchange liquidity incentive.

Collateralised debt positions (CDP)

Collateral debt position protocols allow users to lock up collateral in exchange for newly created tokens or credit. By maintaining a sufficient amount of collateral, users can leverage their assets to access additional liquidity.

A list of viable tokens would likely need to be maintained as otherwise people could deposit liquidity and mint and then hold a new type of token that they intend to just hold to get the benefit from the incentive. This would not pose the holder any risk of loss and would also be an unproductive use of money. The network money could also be locked up meaning other people wouldn’t be able to use it. There is little guarantee that the minted tokens would be used productively. So this incentive could lead to an unproductive use of the network money.

Derivatives

Derivative protocols give users the ability to gain or hedge exposure to an asset’s price movements without directly owning it. Common derivative contracts include futures, options and perpetual swaps. This can be useful for speculating on market changes or mitigating risks.

Derivative contracts will be an important use case for digital asset networks, however they aren’t an essential use case and responsibility for network money. There are many other token based assets that people could use as liquidity in derivative contracts. Nothing would stop people from using network money in derivative contracts, however this particular use case doesn’t have a compelling enough reason for it to be actively incentivised when compared to more compelling incentives like a token asset exchange liquidity incentive.

Synthetic assets

Synthetic protocols replicate the value of other assets, letting users tap into different markets. This gives users a way to hold or trade assets, like stocks or commodities. Network money could be used as collateral to create synthetic assets.

Collateral for creating synthetic assets would mean the network money would not easily be accessible for users to pay for transaction fees. This use case is also not essential for a digital asset network to compete effectively against other networks. Many other forms of collateral could be used instead of network money. Nothing is preventing people from using network money for creating synthetic assets, however this particular use case doesn’t have a compelling enough reason for it to be actively incentivised when compared to more compelling incentives like a token asset exchange liquidity incentive.

Summary

The most compelling liquidity incentive for network money is to encourage people to deposit it along with another token in a token asset exchange. This would help with making the network's token exchange market more efficient by reducing slippage and increasing the amount of liquidity that is available and used for facilitating token exchange.

Due to how important token asset exchange will be for the success of a digital asset network it is hard to say that a lending and borrowing liquidity incentive is compelling enough to also introduce that incentive as well. A lending and borrowing incentive would face risks around having accurate pricing information from all external sources, adding in an unnecessary systemic risk to be concerned about.

The problem with incentivising people to deposit liquidity across multiple financial protocols is it spreads the usage of network money across many areas. This dilutes its impact in areas that might be more impactful. So each area needs to be highly compelling to justify the incentive. Stablecoins, collateral debt positions, derivatives and synthetic assets don’t have a use case that is as compelling as a token asset exchange incentive. The token asset exchange incentive is likely one of the most important additional use cases for network money. This incentive can directly contribute towards long term success of a digital asset network. Other token assets could be widely used for the other protocol liquidity use cases. Nothing is preventing network money from being used for these other use cases. Although the network should focus on incentivising the most compelling use cases, such as a token asset exchange liquidity incentive.

Overall, a token asset exchange liquidity incentive is the most compelling incentive for a digital asset network. As new technologies improve and mature the other options can be reconsidered in the future. For instance, if the accuracy of oracle pricing information stops being a risk over the long term a network could consider the benefits of a lending and borrowing liquidity incentive in more detail. For now a great starting point for any digital asset network will be to focus on a token asset exchange liquidity incentive.