Karma University

A series of educational posts around decentralized finance, the use cases for Karma Finance and the ICON blockchain.

Liquidity pools

For decentralized finance (DeFi) protocols to operate effectively, it is essential to have large amounts of liquidity in token pairs, commonly known as liquidity pools, to allow users to carry out token swaps with low slippage.

An excellent explanatory video by Finematics can be found here

To bootstrap liquidity, protocols incentivise liquidity providers (LPs) to deposit liquidity in token pairs. As a reward for providing liquidity, LPs are rewarded with the protocol’s governance token and a portion of the trading fees.

Protocols essentially pay out high incentives to rent liquidity from LPs. As DeFi matures, it is becoming increasingly clear that incentives are not a viable long-term strategy for protocols. The goal should always be to bootstrap and accrue long-term defensible value.

Additionally there are other negative side effects of liquidity mining such as impermanent loss for the LPs and a constant sell pressure of the governance token due to high pay-outs to LPs who subsequently sell the governance token to offset their impermanent loss.

Another great explanatory video by Finematics here:

Introducing bonds! Bonds are a mechanism by which the protocol can trade its native governance token at a market discount in exchange for liquidity. Instead of renting liquidity from LPs, it purchases the liquidity outright and owns it.

Additionally, some of the liquidity can contain productive assets. Instead of giving away those productive tokens to LPs, they are bought by the protocol which in turn can generate income for the protocol.

Bonds

Bonding is a mechanism where a user can sell liquidity pool tokens such as $BALN / $bnUSD to a protocol such as @BalancedDAO in exchange for its native token $BALN through what we call a bond.

To incentivize users to sell liquidity pool tokens to the protocol, rather than the open market, bonds are offered at a market discount, typically 5–10%. Bonds have a vesting period of 5–7 days to prevent users from selling the discounted tokens for a quick profit.

If you’re a fan of the protocol token and you’re currently farming it via liquidity pools, then bonding is an excellent alternative to get your precious tokens at a discount without suffering from impermanent loss!

Protocol Owned Liquidity (POL)

POL is an essential part of DeFi as it guarantees users that there will be sufficient and sustainable liquidity in token pools. Rather than relying on liquidity providers, the protocol owns the majority of the liquidity for their governance token.

POL transforms liquidity from a liability to a revenue source. Token swaps using liquidity pools generate fees. If the protocol is the largest liquidity provider, they will receive the most trading fees. Protocols would have an additional source of passive income!

If @ommfinance owned the majority of the liquidity for $OMM for example, they would own the majority of the OMM/stablecoin pools. This would stabilise the $OMM price since the protocol would capture the majority of the $OMM emissions and allow for large trades with low slippage.

So to summarise, POL benefits protocols by creating:

• Deep liquidity
• Low slippage
• Lower volatility
• Income generation