Potential effects of Protocol Incentivised Liquidity on $LQTY

Introduction

Stablecoins have proven to be one of the most impactful and practical use cases in the cryptocurrency landscape, addressing the volatility concerns often associated with digital assets. As a result, they have quickly gained popularity and are now a cornerstone of the crypto economy, offering a stable medium of exchange and a reliable store of value.

Given our focus on stablecoin strategies, we are always on the lookout for new and promising stable protocols. As a firm with specialized stablecoin strategies, we understand the critical role these protocols play in maintaining liquidity and stability in the market.

One protocol that has captured our attention is Liquity. The upcoming V2 upgrade has generated significant buzz online, with anticipation building as the launch date approaches in just a few months. Liquity has already established itself as a unique player in the decentralized finance (DeFi) space, and this new version promises to bring even more innovation to the table.

In a previous article, we delved into the fundamental mechanics of Liquity's core protocol, detailing its unique approach to maintaining decentralized and stable borrowing. The original model, while innovative, had its limitations, especially regarding the incentive structure for its native token, LQTY.

The old and new LQTY tokenomics

Recently, Liquity released more details about the changes to its token economic model for its native token, LQTY, as part of the upcoming V2 upgrade. This article will explore how these changes might impact the growth trajectory of the Liquity V2 model and the potential effects on the price of the LQTY token.

In the initial version, LQTY had a straightforward mechanism. Whenever users borrowed Liquity's stablecoin, LUSD, from their trove, a one-time borrowing fee ranging from 0.5% to 5% was charged and added to their debt. This fee was then paid out to LQTY stakers when the borrower repaid their debt.

However, a significant issue with this model was the lack of ongoing incentives for debt repayment. Since there was no annual interest charge, borrowers had little motivation to repay their debt promptly. This problem, coupled with recent high collateral ratios (often exceeding 410%), resulted in low revenue and annual percentage rates (APRs) for LQTY stakers.

The V2 upgrade introduces several new features for LQTY stakers. While they will continue to earn fees from the original model, they will also gain new benefits, including voting power and additional rewards. But what exactly does this voting power entail?

Liquity V2 maintains a "governance light" philosophy, meaning that while the protocol introduces governance features, it stays true to its ethos of being an "unstoppable DeFi" protocol. The smart contracts will remain immutable, and even the core parameters will not be adjustable once they go live.

However, the upgrade aims to create more consistent revenue for the protocol. Users will now select their desired yearly interest rates, allowing for more predictable revenue flows. This income can then be allocated more efficiently across the protocol.

Under the V2 model, Liquity will distribute 75% of its revenue to the Stability Pools for each collateral asset, with the remaining 25% going into an initiative pool. This revenue split is hard-coded into the protocol's smart contracts, reflecting Liquity's commitment to maintaining an "unstoppable" and decentralized DeFi ethos.

While LQTY stakers will no longer receive direct revenue from the protocol, they will gain the ability to influence how the initiative pool's revenue is allocated. In the DeFi space, this is typically achieved by providing incentives to liquidity providers and sometimes traders on third-party platforms. This process is referred to as Protocol Incentivized Liquidity, or PIL. Moreover, the implementation of this module is agnostic, allowing for any on-chain address to serve as the target for a given initiative.

By having the power to direct where these incentives are allocated, LQTY stakers will play a crucial role in driving the growth and adoption of Liquity V2, potentially enhancing both the utility and value of the LQTY token in the market.

Incentives in DeFi

While it's widely understood that offering incentives on DEXs can significantly boost TVL, the exact magnitude of this effect is often unclear. To shed light on this, we set out to explore just how much TVL DeFi protocols could potentially acquire for every dollar spent on incentives.

To quantify the relationship between incentives and TVL, we adopted a targeted methodology:

Data Collection: We gathered data on stablecoin yield vaults, lending pools, and DEX pairs with limited-time incentive programs.
TVL Threshold: Only pools with over $500,000 TVL before incentives were included to ensure significant data.
Measurement Period: TVL changes were measured from one week before to one month after the incentive program.
Incentive Cost Calculation: Incentives distributed were calculated in USD based on average token price, then annualized by multiplying by 12.
Data Sources: TVL data was from DeFiLlama, and incentive tracking was from Arkham Intelligence.

We analyzed data from 30 pools and plotted the distribution of the boost factor, which represents how much TVL can be gained per dollar of incentive. Additionally, we examined the relationship between the boost factor and the total amount of incentives spent. This analysis revealed several insights into the effectiveness of different incentive strategies.

It is important to note that the incentive costs considered in this study are only for a one-month period. Historical data suggests that once an incentive program ends, TVL tends to decline. For example, during the Yearn V3 program on Arbitrum, TVL rose from $533,000 to $1.4 million while ARB incentives were active but fell back to $650,000 once the incentives ceased.

We believe the trend observed in the right subplot above is as a result of 2 factors:

Lower incentive amounts often stem from very new pools, where TVL is very low and any additional incentive program, combined with any hype generated by the launch leads to pretty high boost factors.
The slump in the middle is often due to semi-new stable pools, where some TVL has already been attracted but because of the protocol the pool is on or the underlying stablecoin, markets see these positions as riskier, which leads to an APR “premium”

For the purposes of this article, we will use a conservative and generalized boost factor of 7x for our subsequent calculations. We believe this is justified as Liquity V2 is a new set of smart contracts, but the reputation of its approach to security and custody makes it less likely to fall into the Boost Factor slump shown above. This means that, on average, we estimate that for every dollar spent on incentives, protocols can expect to see an increase in TVL by a factor of 7.

PIL effects on Liquity’s TVL and revenue

If Liquity were to allocate some of its Protocol Incentivized Liquidity to a DEX pool containing $BOLD and another stablecoin, it would naturally attract yield-seeking farmers, causing the TVL of the DEX to rise. The increased yield would create a strong incentive for liquidity providers to add capital to the pool.

Although the initial TVL increase happens within the DEX, this would also have a significant effect on $BOLD’s overall TVL. If a DEX pool becomes overly imbalanced due to an excess of one asset, users can swap the stablecoin against $BOLD, exploiting the opportunity for arbitrage profits. As this trading happens, the necessary $BOLD must be sourced, drawing more of the token into circulation.

As the amount of $BOLD in circulation increases, the protocol generates more revenue through fees. These additional fees result in a larger allocation to PIL, reinforcing the liquidity incentives and further growing the TVL. This creates a positive feedback loop, where increased $BOLD circulation perpetuates more revenue, driving protocol growth indefinitely.

However, this would of course not happen in practice since the effects of PIL diminish each time. To prevent this, we propose a specific formula to calculate the true economic value of PIL.

PIL: Represents the actual amount of $BOLD allocated to the Protocol Incentivized Liquidity pool. This is the capital available for deploying incentives to DEX pools or liquidity providers.

BoostFactor: The 7x boost factor mentioned earlier represents the expected TVL increase for every dollar of PIL invested in the pool. This reflects the degree to which liquidity incentives can multiply TVL growth.
PoolShare: Denotes the proportion of $BOLD in a particular DEX pool. Since not all TVL is held in $BOLD, we assume a PoolShare of 0.6 for our example, as newer stablecoins tend to be overweight in imbalanced pools like those found on Curve or Balancer.
APY: The annual percentage yield is an important factor in our calculations. For this analysis, we use the average market rate for borrowing stablecoins. Based on historical data from large platform stablecoin lending market, we use a rate of 6.3%. This rate is slightly above the recent quarterly median but aligns with longer-term trends.

When we plug all these factors into our formula, we arrive at a true PIL value of 1.0708. This means that for every dollar of $BOLD in the PIL, its actual economic value is worth approximately 7.1% more. However, it’s important to note that this value is highly dependent on both the boost factor and the prevailing market interest rates, meaning it can fluctuate significantly under different conditions. The graph below shows how the TrueValuePIL reacts to changes in the input.

Effects on the value of LQTY

As mentioned already, the PIL represents 25% of the protocol's interest revenues, distributed as incentives to DeFi LP positions across platforms. LQTY stakers control how these incentives are allocated by voting on gauge percentages.

This dynamic gives LQTY stakers rights to direct cashflows, making the value of LQTY tied to the power to influence these "dividends" to third parties. Valuing LQTY becomes simpler, as traditional financial tools can assess the cashflow value, combined with Liquity's Tokenomics to determine each LQTY token's worth.

The key question is whether a third party seeking these cashflows should buy LQTY for minimal governance boost or pay an optimal "bribe" to current stakers to control the flows.

To calculate the optimal bribe for LQTY stakers, we look at their seniority (time locked) and voting power. A rational liquidity provider (LP) would pay a bribe just under the economics value of the total PIL (i.e., PIL - 0.000000000001) to ensure they still make a profit. This sets a theoretical maximum value for the bribe.

Each LQTY stakers’ cashflow is based on their share of the PIL, factoring in their seniority and voting power:

Long-term stakers with higher voting power receive a larger portion. The present value (PV) of these cashflows can be calculated using a perpetuity formula:

This gives a clear view of the optimal bribe, effective cashflows, and how LQTY stakers can maximize profits through PIL.

LQTY Value with multiple stakers

Since seniority plays a critical role in determining the value of LQTY, we aimed to illustrate how that value changes when multiple participants are staking. To clarify the dynamics, we will simplify the scenario by considering just two actors: A and B.

Actor A stakes their LQTY tokens from day one, while actor B waits 300 days before staking an equal amount of LQTY. The graph below depicts the evolution of their respective voting power over time.

Initially, A has a clear advantage in voting power due to their early stake. However, as time progresses, B’s voting power starts to catch up. While the voting power tends to converge toward an equal 50/50 distribution, the longer B delays staking, the slower this equilibrium is reached. This demonstrates how the timing of a stake directly influences the stakers’ voting influence within the protocol, rewarding early participants with a higher initial share of governance power.

As shown in the graph above, the voting power of A and B tends to approach a 50/50 balance over time. However, the longer B waits to start staking, the more slowly they approach this equilibrium. The delay in B’s stake means that A retains a larger share of voting power for a longer period, making it harder for B to catch up quickly.

To better illustrate this effect, we took the current TVL in Liquity V1, which stands at $66.5 million at the time of writing. Using a market rate of 6.3%, we calculated the Protocol Incentivized Liquidity. We also assumed a growth rate of 5% of TVL and PIL per year. We then plotted the value of tokenstakers A and B, taking into account when B begins staking. The graph shows how B’s delayed entry impacts their eventual share of governance power and overall value in the system, highlighting the benefits of early participation in staking.

There becomes a significant issue in the value of the token, as shown between these lines. As an existing stakers who is staking LQTY token will have value over time developing in effective price by the cashflow values of the economically optimal bribes to LQTY token stakers in perpetuity by the orange line while other agents buy and sell at varied time points. Generally if other agents exit the eco-system and sell their tokens, the party that is holding the tokens that have been staking longest get an enhanced value per token as relatively their tokens would then command much higher voting power per token over time.

The problem with this is, for this initial user, the value an external party would be willing and able to pay depending on the time since the launch is only denoted by the blue line, decreasing over time, given the assumption that there is any party holding LQTY with a higher boost weight, as the voting powers per token never truly converge.

We also want to mention that this is not designed to be a model for predicting the future price of LQTY, but rather using the existing data to showcase the influence of the token economics on the development of the value of the token for new market participants.

Implications for LQTY and its stakers

Economically, the longer new stakers wait to buy LQTY and enter the market, the less incentivized they are, as they would need a greater discount to compensate for the lost voting power and seniority. As time passes, the value of newly staked LQTY decreases, making it less attractive for late entrants.

However, this is counterbalanced by existing stakers having fewer reasons to sell their LQTY tokens. Selling would require them to offer a higher discount due to their accrued voting power and seniority. This creates a scenario where both new and existing participants are reluctant to engage in trading, leading to a highly illiquid token model.

This illiquidity makes liquid wrapper platforms, such as Convex or StakeDAO, particularly appealing. These platforms can buy up LQTY, stake it permanently, and offer liquidity via their own tokens, which don’t depend on infinite scaling boosts. Essentially, they allow participants to access voting power without requiring direct LQTY ownership or extensive lock-up periods.

Conclusion

In conclusion, the mechanics of LQTY staking and governance in Liquity create a unique dynamic where timing, seniority, and liquidity all play crucial roles in determining the value and influence of token stakers. Early stakers gain a significant advantage, as their voting power grows proportionally faster than those who enter the market later. As time progresses, new entrants must offer larger discounts to justify their participation, while existing stakers are incentivized to hold onto their tokens, creating a highly illiquid market.

The overall tokenomics design promotes long-term staking, enhances governance stability, and reinforces the value of early participation, but it also highlights the potential for third-party liquid staking services to play a significant role in the ecosystem. This structure provides opportunities for innovation in how governance and liquidity are managed, ensuring that LQTY remains a central asset in the DeFi space while allowing for more accessible participation through liquid staking platforms.