Financial liquidity incentive options

A number of decentralised finance (DeFi) protocols already exist within 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 an incentive option 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.

Liquidity incentive objectives

Some relevant objectives that could help with improving the effectiveness of a liquidity incentive 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 its utility such as improving the efficiency of financial protocols. All of the approaches below could help with increasing the utility of network money. However it is more a case of whether each of these use cases is essential or not as a responsibility for network money. 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 those 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. The incentives below should ideally make network money more available for people to use rather than less available.

Token exchange

Token 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.

An efficient token exchange protocol will be a vital part of creating a competitive digital asset network. An incentive for using network money for token exchange should help with improving the effectiveness and efficiency of the token exchange market. Liquidity could also be locked-up using an incentive to create longer term demand for network money, this could then help with improving the overall network effects.

The problem with this incentive on its own is people could exploit the incentive by creating their own token and adding their own liquidity that no one uses. If the incentive required transaction volume or a certain amount of wallets this could also be easily faked and exploited. There is already an incentive to add liquidity to the exchange pairings that generate the most fee income. However this incentive also forces users to take on a level of risk as they must hold another token as well which might collapse and lose its value. The holder might end up with less network money and more token money that now might be worthless. Some users would prefer to not risk their network money. Creating their own token and owning the supply and exchange liquidity would solve that problem however now network money is not being used productively. Single asset lending and borrowing incentives should help to provide an alternative and complementary solution to this forced risk taking problem.

Single asset lending and borrowing

A single asset lending and borrowing protocol could help with enabling users to lend out their network money to earn interest or with borrowing against their own network money. This helps users to generate passive income or gives them access to leveraged liquidity.

This liquidity incentive should encourage people to lend network money to other people. This is useful as it provides people a way to leverage their network money and use it more productively. Users could swap the network money for another token if they wanted exposure to the price change of the other asset but also wanted to retain exposure to network money. If a user thought network money was over priced at that moment, but they didn’t want to sell out of their position, they could borrow against it and exchange the borrowed network money for another token and then exchange it back in the future. This liquidity incentive could also adopt a lock-up incentive to help with generating longer term demand.

The benefit of a single asset lending protocol is it doesn’t require a pricing oracle for liquidations. If the price of network money goes down relative to other assets this doesn’t matter as both the lending and borrowing assets are the same. Liquidations can still occur with single asset lending due to interest accrual however this can all be handled on-chain and without the introduction of any systemic risks from integrating pricing oracles.

Another benefit of a single asset lending and borrowing protocol is it solves the risk problem that exists with a token exchange incentive. If someone doesn’t want to risk the loss of their network money due to token failure they can lend their network money in a lending and borrowing protocol instead. They would have no risk in this protocol of loss and they would have the potential to earn fee income from lending their assets. If someone paired their network money with a randomly created token they could avoid the risk problem but they wouldn’t receive any fee income and would also pay for any associated costs of creating and maintaining a token. So if the incentive is the same to deposit to either protocol there is no reason to create fake token exchange pairing over the alternative of just lending it to the networks single asset lending and borrowing protocol.

One concern with this incentive is how it could dilute the amount of network money that is used for token exchange liquidity. Creating stronger incentives for people to use it within a token exchange protocol would likely result in the issue of people creating fake tokens and exchange volume just to benefit from the better incentive without taking any risk. So the incentive amount likely needs to be the same for depositing network money into a token exchange protocol or a single asset borrowing and lending protocol to minimise this behaviour.

A potential improvement of this protocol incentive idea is if it accepted token exchange liquidity pairings as collateral. The collateral would be valued based on the total network money that can be extracted out of the pairing. The token paired with network money could be sold in the exchange to get back network money in the event of a liquidation event. This means that someone could leverage their existing token exchange liquidity to get more exposure to a similar exchange pairing or for another use case. This is useful for someone who wants to receive the benefit of cheaper transactions for depositing liquidity but also wants to use that collateral to leverage further financial activity. Stop losses within the exchange token liquidity pairings would likely play an important role in preventing liquidations. Using token exchange pairings as collateral would mean you wouldn’t be able to leverage the full value of the collateral, as if you did it could mean that any price movements could cause liquidations depending on the liquidity and depth of the order book.

Overall this liquidity incentive is a compelling one as it provides a risk free way for people to productively lend their network money to other people which is a problem that exists with the token exchange liquidity incentive.

Multiple asset lending and borrowing

A multiple asset lending and borrowing protocol would help users with lending out their network money or tokens to earn interest or to borrow against their own network money or tokens.

The benefit of a multiple asset lending and borrowing protocol is people can keep their collateral without selling it and then borrow other tokens against that collateral. This gives them exposure to other tokens without losing exposure to their collateral.

The problem with token based lending and borrowing protocols is that tokens can be available in different places within the network as well as across multiple external networks. So the pricing of that token could be different due to this availability in multiple places. Pricing oracles help to resolve this issue by aggregating the pricing information across multiple sources to generate more accurate pricing information. This pricing information can then be used for determining and acting on liquidation levels that ensure that lender assets aren’t at risk. At the network level, implementing pricing oracles would introduce a systemic risk for network money as if the pricing oracle fails the deposited network money could be extracted from the protocol. Pricing oracles would mean incorporating off-chain data into the network design. The added complexity and risk is highly undesirable at the network level as a global population of users could be depending on the network for daily usage.

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 could be one that uses network money as the collateral to mint the stablecoin.

The network would likely need to maintain a list of stablecoins that people can use when depositing network money as liquidity to mint those stablecoins. Otherwise people could create a new stablecoin by depositing their network money as liquidity and then could just hold the stablecoin supply themselves to just get the incentive benefit. This outcome would mean unproductive usage of network money and one where it would pose little risk to the holder of the network money. Maintaining a list of valid stablecoins for the incentive to function would add a meaningful amount of governance complexity due to the global scale of the network. 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 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 need to be maintained as otherwise people could deposit liquidity to mint and then hold a new type of token that they only intend to 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 network 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 does not seem compelling for ensuring the network money is used productively.

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 the more compelling incentives like a token 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 these synthetic assets.

Collateral for creating synthetic assets would mean the network money would not easily be accessible for other 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 however nothing is preventing people from using network money for creating synthetic assets. This particular use case doesn’t have a compelling enough reason for it to be actively incentivised when compared to the more compelling incentives like a token exchange liquidity incentive.

Summary

The most compelling liquidity incentives mentioned above are a token exchange liquidity incentive and a single asset lending and borrowing liquidity incentive. These two incentives are complementary and help to encourage people to use their network money productively, whether that's taking risk themselves to generate yield in a token exchange or from enabling others to borrow their network money and use it productively themselves. The token exchange incentive will be particularly important for making the network's token exchange market more efficient by reducing slippage and increasing the amount of available liquidity being used to facilitate exchange.

The problem with incentivising people to deposit liquidity across many of the other financial protocols is the increased risk of unproductive network money as there is often less opportunity for it to be used productively. The other problem is it dilutes the impact of the other incentives as now the network money would end up being spread across a large number of protocols. So each financial protocol needs to be highly compelling to justify the introduction of a network based incentive. Stablecoins, collateral debt positions, derivatives and synthetic assets don’t appear to have a use case that is as compelling as a token exchange incentive or a single asset lending and borrowing incentive.

The token exchange incentive is likely one of the most important use cases for network money beyond its use for transaction fees. This incentive can directly contribute towards the long term success of a digital asset network. Other tokens could be widely used for the other protocol liquidity use cases. Nothing is preventing network money from being used for these other use cases. A network should focus on incentivising the most important financial use cases for network money.

Overall, a token exchange liquidity incentive and a single asset borrowing and lending liquidity incentive appear to be the two most compelling liquidity incentives for a digital asset network. As these new technologies improve and continue to mature the other options should be reconsidered again.