The importance of Protocol-owned Liquidity for every community-owned Web3 project
Protocol-owned liquidity and bonding is a much better method to generate liquidity than yield farming because it benefits both the protocol and the community. In this article, we explain liquidity, yield farming and bonding. And we explain why bonding and Protocol-owned liquidity are so important for you, the DappRadar community.
While DappRadar is building the World’s Dapp Store, the future is in the hands of the community. Through the DappRadar DAO and by using RADAR, community members can build, add and adjust the direction of the number one discovery platform for decentralized applications.
RADAR is at the heart of it all, and for the community to use this token, it needs to have value. Again, value is determined by the free market. In the dapp industry, we have Automated Market Makers (AMMs), allowing users not only to swap one token for another, but also to provide liquidity in a liquidity pool.
A liquidity pool consists of two tokens, for example, RADAR and ETH. When someone wants to provide liquidity, they need to place an equal value of each token into the pool. Let’s say someone adds $100 of ETH and $100 of RADAR. They now provide $200 worth of liquidity to the RADAR-ETH liquidity pool.
In return, they receive LP tokens, a receipt for participating in the pool. This receipt represents the amount of tokens provided, and not the value. I will get back to these LP tokens in a bit, so don’t forget.
Why is liquidity important?
When a liquidity pool contains $100,000, a token swap of $1,000 can have quite some impact on the price of RADAR. Traders will need to pay a bigger fee for such a swap, while their trade can also impact the price. This is called slippage, and slippage is bad.
When you’re swapping crypto tokens, you want slippage to be low. Therefore the liquidity pool needs to be as deep as possible, ensuring that a $1,000 swap doesn’t impact the price too much.
Reduced slippage will make it easier to trade, resulting in higher trading volumes and more trading activity. It’s safe to say that deep liquidity is healthy for an entire ecosystem.
The risk of yield farming
Now, let’s get back to those LP tokens. As a strategy to attract more liquidity, many Web3 projects allow users to stake their LP tokens in return for some rewards, often presented in their native token. For example, you’d provide liquidity in the RADAR-ETH pool, and then stake your LP tokens. This will earn you rewards in RADAR tokens, expressed in an Annual Percentage Yield (APY). This phenomenon is called yield farming.
Getting rewards is amazing, and some yield farmers have made big bucks. But once the rewards become too little, these liquidity providers will put their money elsewhere, leaving the project and its community empty-handed . They will dump their rewards on the market and then remove their RADAR and ETH from the liquidity pool. Suddenly the pool needs to deal with higher slippage and lower liquidity again. This is not good.
Yield farming is only a short-term solution to reward investors or liquidity providers for their initial investment. The amount of rewards a protocol can hand out is somewhat limited, and therefore this model is not sustainable for long-term initiatives.
The advantage of bonding
We understand. Everybody is looking for juicy rewards. Therefore, we see bonding as the solution to align the community and a protocol for long-term gains and benefits. In July, DappRadar announced the launch of the RADAR Jungle Bill on ApeSwap. Instead of staking for rewards, RADAR community members now get to sell their LP tokens in exchange for a bonus.
So, someone buys RADAR and BNB and then provides liquidity in the RADAR-BNB pool. They will then receive LP tokens, but instead of staking them they can sell them in exchange for a bonus amount of RADAR. This requires 14 days of vesting before the total reward pool can be claimed.
Technically, what happens here is that DappRadar buys back the LP tokens and gives the provider some extra RADAR tokens as well. The user ends up with bonus RADAR tokens after the 14-day vesting period, while DappRadar and the DappRadar DAO take ownership over the market liquidity. We call this Protocol-owned Liquidity, or POL.
The more DappRadar and the DappRadar DAO purchases LP tokens from liquidity providers, the smaller the risk that big amounts of liquidity get removed from the liquidity pool. As a result, trading conditions remain positive without too much slippage and enough liquidity to facilitate big trades. Ultimately bonding is a solution with a long-term vision.
Yield farming is a nice reward mechanism for users, but a massive liquidity exit can destroy a project and its community. The better aligned the liquidity providers and the protocol are, the better resistant they become to volatile market conditions.
Protocol-owned liquidity – or POL – is good for DappRadar, DappRadar DAO, and the community.
- DappRadar DAO becomes a big stakeholder in the liquidity, aligning it with the future of the project and helping to stabilize the price of RADAR.
- DappRadar DAO also doesn’t need to throw incentivization rewards at liquidity providers, who can – and probably will – jump out once the rewards aren’t interesting enough.
- The RADAR community receives rewards paid in the native tokens for their participation.
Where liquidity providers and protocols only have short-term benefits when dealing with yield farming, bonding provides long-term benefits. Through Protocol-owned Liquidity, liquidity providers can earn rewards on their contributions, while the protocol generates a share in the liquidity pool. In the case of RADAR, this means that the DAO creates a revenue stream from the trading fees while gaining ownership over a portion of the liquidity pool. This in return brings more price stability, lower slippage, and more revenue to benefit both the DAO and the community itself.