The rapid 50% APR return farms that originally fueled the meteoric rise of decentralized finance (DeFi) are finally unraveling. It took the collapse of an entire blockchain and DeFi ecosystem, but it looks like DeFi is maturing from the unsustainable designs that led to the problems we see now to more secure, resilient, and user-friendly models.
Decentralized token liquidity is at the heart of the current problems - and the way forward. DeFi projects need liquidity in their native tokens to be successful. If your token lacks liquidity, it's less desirable to hold, especially because the price is unstable and can collapse the moment a whale takes profits.
Automated market makers (AMMs) open up the provision of liquidity to a broader group of market participants and have proven that they can create deeper, more robust liquidity for DeFi projects compared to centralized exchanges. However, DeFi projects of all sizes still face the problem of generating liquidity for their tokens: It is very risky for token holders to act as liquidity providers because when the value of the token increases, the person providing liquidity in that pool would have been better off simply keeping the token outside the pool in their wallet. They suffer what is known as a volatile loss, which discourages them from providing liquidity in a pool.
To incentivize liquidity in these AMM pools, many projects have resorted to liquidity mining or spent money on rewards. This raises a whole host of other issues. By issuing free tokens, projects attract mercenaries who provide liquidity, suck up all the rewards, and then, once the rewards are depleted, sell them and move on to the next project with a rewards program. Meanwhile, the original project is left high and dry.
Bancor has tackled these systemic issues head-on since its launch in 2017 as the first DeFi protocol. In fact, Bancor invented the concepts of liquidity pools and automated market makers that are the foundation of most decentralized exchanges around the world.
In 2020, Bancor released its first version of protection against volatile losses, and to this day it remains the only protocol that protects liquidity providers from these losses. In addition, Bancor inherently supports one-way token stacking in a liquidity pool.
This is one of the key advantages for liquidity providers that differentiates Bancor from other DeFi staking protocols. Typical AMM liquidity pools require a liquidity provider to deploy two assets by selling 50% of the token that is deployed and combining the tokens into a pair. Therefore, when providing liquidity, the token deposit often consists of two tokens in the pool.
Bancor's one-sided staking changes this completely. It allows liquidity providers to provide only the token they hold. Depositors can retain full price risk on that token while earning revenue from trading fees and liquidity mining rewards.
DeFi's problem is not so much one of liquidity, but of sustainable liquidity. Decentralized autonomous organizations (DAOs) and token projects struggle to maintain liquidity in their tokens. By providing token holders with a way to mitigate the risk of volatile loss, Bancor allows these projects to throw rewards into their pools and promote liquidity in a way that makes it less likely that rewards will be hoarded and dumped. In addition, this means that rewards can be automatically compounded and exist as liquidity in the pool from day one, which is different from traditional yield-farming rewards programs.
The truth behind APRs
By protecting against unforeseen losses and not simply sweeping them under the rug, as many protocols seem to do, Bancor helps build sustainable liquidity in the DeFi market by bringing more transparency and accuracy to the inaccurate APR numbers that some protocols report.
Many token holders have learned the hard lesson that the APR numbers they see do not include a volatile loss. Rather, they are only seeing fees versus liquidity. But that assumes that liquidity remains the same over time. To get a true APR, you have to put fees minus volatile loss over liquidity. Bancor can show this because its liquidity providers are fully protected from volatile loss.
As more token holders have realized that the APR they see doesn't match what they end up getting out, they've started to withdraw from betting in liquidity pools. That's bad for confidence, bad for liquidity, and bad for DeFi's development.
Bancor solves many of the liquidity problems that have plagued DeFi and made it difficult for regular users and token projects to build liquidity. With its latest version 3 iteration, Bancor expects a new wave of interest in DeFi, just as it did in the summer of 2020. But this time, liquidity will be sustainable because the incentive structures and loss protection will encourage liquidity to stay.