What is Protocol Owned Liquidity? Solving the Mercenary Capital Problem

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By Kate
Estimated reading: 6mins
Protocol owned liquidity

Protocol owned liquidity (POL) is the new method of providing liquidity aimed at reducing risks inherent to traditional staking pools.

Initially invented by Olympus Pro, it enables protocols to stay in control of their liquidity and helps them to hold back significant price movements in the case of massive sell-off.

Read on to find out how the POL works, what benefits it offers, and what limitations it comes with.

Key Takeaways

  • DeFi protocols offer different reward programs to improve the liquidity of their tokens.
  • Users can still freely withdraw their tokens in case they find a more profitable option.
  • Protocol owned liquidity enables projects to create their own liquidity pools and to gain control over token prices. 
  • With POL, protocols sell their tokens to users with a discount but vest them gradually to prevent massive sell-offs.
  • Such an approach helps to reduce the risks inherent to traditional staking mechanisms and makes the whole blockchain environment healthier.

The Source of the Mercenary Capital Problem

Launching a new DeFi protocol is not an easy task to accomplish. In order for a project to be successful, it needs not only to build a viable product but also to acquire the first users. 

Yet, there’s nothing new to these tasks as they are relevant for traditional IT startups as well.

What makes things more complicated in web3 is liquidity.

Blockchain-based solutions often feature their own tokens that users have to obtain in order to use their products. These tokens may be based on existing popular solutions like Ethereum or Polygon, or they may reside on some brand-new blockchains.

Regardless of the case, the financial liquidity of these tokens comes hand in hand with the scale of interest among investors and the project’s community.

To reward their supporters, protocols often initiate various programs. They grant LP tokens to their users and incentivize automated market makers (AMMs) with rewards collected from the trading fees. 

While such an approach helps to improve token liquidity, it also comes with significant drawbacks:

  1. Transaction fees alone are not always sufficient to reward decentralized market makers. To keep the liquidity, protocols have to offer additional rewards int he form on their own tokens.
  2. The more tokens a protocol dumps into the market, the lower their price.
  3. If another liquidity pool offers higher rewards, AMMs eagerly relocate their assets.

The so-called mercenary capital problem is particularly inherent to DeFi 1.0 solutions. Protocol owned liquidity can help projects to resolve it.

What is Protocol Owned Liquidity?

Initially introduced by Olympus DAO, protocol owned liquidity eliminates the need for external liquidity providers (LPs). Instead, it enables protocols to provide liquidity for their own tokens to be traded on DEXes.

For that, it implements the key innovation known as the “bonding process”. It implies that the protocol exchanges its tokens (namely OHM daily tokens in the case of Olympus DAO) for other assets that users want to sell. 

To eliminate the negative effect on the token price, the protocol makes it difficult for token holders to sell these assets. Here’s how it works.

How Does Protocol Owned Liquidity Work?

To incentivize users to buy its tokens, the protocol sells these tokens at a discounted price. 

But instead of sending these tokens to users’ wallets straightaway, it vests them during a predefined period of time (one week on average). This prevents immediate cashout for the sake of the arbitrage.

As a result, the protocol ends up holding a large portion of its own tokens in the treasury. At this, it can decrease the sell pressure on the tokens by providing liquidity independently. Also, it controls the floor price, i.e. doesn’t let the token value drop below a predefined limit.

Sound like a perfect solution, doesn’t it? 

Indeed, it does, but it comes with another risk, though.

As token holders start to sell tokens, the treasury has to perform massive buybacks to hold back the price. This may result in the so-called negative feedback loop and make users sell tokens further. 

Staking with high interest rates can help to prevent token holders from creating negative feedback and incentivize them to hold tokens instead of selling them.

Benefits of Protocol Owned Liquidity

POL is capable of solving many issues that the early DeFi solutions came across. At this, it can be truly considered a part of DeFi 2.0.

Here are just some of the advantages that it offers.

1. Improved liquidity and higher stability

Thanks to the new solution, protocols gain access to a stable source of liquidity. They no longer have to depend on third-party liquidity providers as they can control this liquidity themselves.

Thus, they no longer bear the risk of sudden price slippage if their users massively cash out their tokens. Users, in turn, can concentrate on long-term profits instead of pursuing quick and unreliable results.

2. Lower risk of impermanent loss

One of the key problems that liquidity providers come across is the so-called impermanent loss. It happens when one of the two assets they stake in a pool decreases in price with respect to the other.

Since the protocol holds a large portion of its tokens, it can buy or sell these tokens on the open market according to the demand and thus reduce their volatility. As a result, the risk of impermanent loss decreases.

3. Reduced fees

In order to attract liquidity providers, protocols reward them with a portion of the fees that users pay for transactions. 

Protocol owned liquidity eliminates the need for LPs. Therefore, projects can offer lower fees to their users.

4. Higher sustainability

Finally, POL contributes to projects’ sustainability. With its help, they can control the liquidity of their own tokens and adjust their circulating supply according to the current situation.

POL reduces protocols’ dependence on external LPs and helps them gain greater success in the long-term scenario.

Are There Any Limitations?

Alas, the new approach is not perfect either as it comes with a set of its own drawbacks.

One of the key challenges that protocols may come across is finding the right balance of the tokens in the reserves

If the amount of tokens they keep is too small, they won’t be able to provide sufficient liquidity. The opposite scenario may lead to centralization with all the attendant problems. LPs, too, will lack the incentives as the rewards they may earn will not be enough.

Still, the technology looks promising. At this, it represents the next stage of blockchain development by solving its key issues.

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Disclaimer:Please note that nothing on this website constitutes financial advice. Whilst every effort has been made to ensure that the information provided on this website is accurate, individuals must not rely on this information to make a financial or investment decision. Before making any decision, we strongly recommend you consult a qualified professional who should take into account your specific investment objectives, financial situation and individual needs.

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Kate is a blockchain specialist, enthusiast, and adopter, who loves writing about complex technologies and explaining them in simple words. Kate features regularly for Liquid Loans, plus Cointelegraph, Nomics, Cryptopay, ByBit and more.

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