Contents
Introduction
In a recent group discussion held by Mint Ventures, our Researcher Lawrence and Investment Manager Scarlett offered their insights in response to my questions. This Clip predominantly features a synthesis of their perspectives, further enriched by my own thoughts and the topic.
The two questions I asked were:
1. Should trading platforms offer token incentives for boosting liquidity or trading volume and Why? 2. Assuming there is a token-backed incentive program, the consequent wash trading for incentives can be regarded as either a boon or a bane for the protocol , and why?
*It should be noted that the “trading platforms” we referred to are a general term that includes spot DEXs (such as Uniswap, Curve), decentralized derivative protocols (GMX, Gains), and NFT marketplaces like Blur, and even centralized exchanges (although most of them currently do not have direct yield farming or trans-fee mining models)
Origin
Unraveling the Reasons Behind Trading Platforms Issuing Equity Tokens and Offering Incentives
In my opinion, there are three primary motives for trading platforms, including spot DEXs, NFT marketplaces, and derivative protocols, to issue equity tokens:
1. Token-based fundraising. 2. Decentralized governance. The creation and distribution of equity tokens serve as the prerequisite for community-driven governance. 3. Tools for growth and economic system regulation.
Nonetheless, within the context of Web3 business practices, the first two reasons are not necessarily obligatory because:
1. Projects can get funding through equity financing. 2. Centralized governance is still being widely adopted by business and project management, and even in some relatively decentralized projects, governance and voting rights are still centralized under the control of the core team or institutions. 3. Potentially, the most fundamental reason is the third one: a project utilizing token incentives possesses more resources for growth, as well as the capacity to regulate their economic systems, as opposed to projects without tokens.
In the world of trading platforms, token incentives—designed to either encourage liquidity or stimulate trading behaviors—generally serve two essential goals:
1. Facilitating a cold start for new projects by deploying token incentives to captivate the initial user base of the product bilaterally (Uniswap also employed token incentives during the early stages of the DEXs War). 2. Expanding the bilateral market and leveraging token subsidies to expedite the growth of cross-side network effect, thereby creating a competitive barrier.
For the majority of trading platforms, the word “bilateral” refers to liquidity providers and traders. This relationship is characterized by interdependence and mutual benefit; without liquidity providers, trading would be impossible, and without trading, fee returns would be nonexistent, thereby discouraging liquidity provision. Conversely, within the same product framework, higher liquidity results in lower slippage, which in turn attracts more traders and generates higher fees. As fees increase, liquidity yields grow, ultimately leading to more sufficient liquidity.
The scenario where “user growth on one side delivers increased value to users on the other side” represents a type of network effect, known as the “cross-side network effect”. Network effects are among the most critical competitive advantages for business projects, particularly for new projects.
Upon its inception, Uniswap experienced an accelerated growth trajectory, fueled by the curiosity of early enthusiasts and natural demand due to the lack of competition in the nascent DeFi landscape. However, in today’s highly competitive and fast-evolving trading platform ecosystem, bilateral and multilateral models face big challenges in kickstarting their operations without offering incentives, such as anticipated airdrops.
Consequently, the initial goal of overcoming the cold start phase paves the way for fostering cross-side network effects, with the ultimate goal of striving to establish a competitive edge (monopoly position) as a foundation for achieving and expanding profitability (protocol revenue > token subsidy expenditure).
Considering that trading platforms provide indirect incentives to users on the other side due to cross-edge network effects, whether they incentivize liquidity providers or traders, does this imply that:
“Incentive LP” is equivalent to “Incentive Trader?”
Practice
Liquidity Incentives VS Trading Incentives
The Early Practices of CEXs
In fact, incentives for liquidity and trading behaviors have existed long before the DeFi Summer. For example, most centralized exchanges implement incentive programs for their affiliated market makers, designed to bolster trading depth on their platforms and provide other traders with a low-slippage trading experience, akin to liquidity incentives. However, most of these incentives manifest as fee reductions or refunds with little connection to the platform’s equity tokens.
The earliest experimentation with trading incentives, or trans-fee mining, can be traced back to a centralized exchange, Dragonex (Dragonet), in 2018. Dragonex implemented a “trans-fee mining” mechanism that granted equity tokens (DT) in proportion to transaction volume, while also sharing trading fees based on the number of tokens held.
Fcoin later refined this mechanism. Following the launch of trans-fee mining, the two exchanges witnessed remarkable business expansion. Fcoin, despite a latecomer joining the “exchange wars”, reached its peak with daily trading volumes exceeding the total volumes of all other leading centralized exchanges.
However, the triumphs of both Dragonex and Fcoin were short-lived. Dragonex collapsed due to insolvency resulting from being hacked, while Fcoin faced a massive deficit due to an alleged “terrible internal financial strategy.” Although the reasons for each platform’s downfall are slightly different—external attacks for Dragonex and internal issues for Fcoin—a shared factor in their collapse was the financial shortfall.
This raises an intriguing question: if hacking incidents and internal financial troubles had been avoided, might the trans-fee mining model have helped these platforms in solidifying their market share in terms of trading volume and in building a competitive advantage?
Emerging Trends in DeFi Protocols
The emergence of Uniswap further popularized the AMM mechanism in the market, a method that significantly reduced the entry barrier for liquidity market makers and offered inherent incentives for liquidity mining. Sushiswap’s token-based subsidies to LPs rapidly siphoned off a considerable portion of Uniswap’s liquidity, prompting Uniswap to temporarily introduce its own liquidity mining program as a countermeasure.
Besides DEXs, NFT marketplaces like Looksrare, X2Y2, and Blur have also implemented liquidity incentive strategies, extending the subsidy competition from fungible tokens (FTs) to the NFT space. With Blur coming to the stage, even Opensea experienced a palpable challenge and decided to adopt a zero-fee model in response.
On the other hand, perhaps due to the Fcoin’s catastrophic failure, the trans-fee mining model in the DeFi space only gained widespread adoption after DYDX issued its utility tokens. Subsequent adopters include Cherry, an DEX on OKChain, Dinosauregg on Binance Smart Chain, and others. More recent projects embracing transaction incentives include Level, Gridex, Kwenta, and more. However, overall, projects utilizing the trans-fee mining model as their primary incentive strategy remain in the minority.
Incentives for Liquidity or Trading Behavior
As previously mentioned, token incentives for trading platforms aim to swiftly establish a lead in cross-side network effects and forge a monopoly advantage. A prerequisite for monopolies is that users find it difficult or unwilling to leave their frequently-used platform, reflected in the internet product operation metric known as 【retention rate】.
When determining whether a trading platform should incentivize liquidity or trading behaviors, a crucial factor to consider is which strategy or target audience is more inclined to demonstrate long-term retention following incentive reduction. Users and behaviors with a higher likelihood of long-term retention will contribute greater lifetime value (LTV) to the platform, making them the primary focus of platform token incentives.
The question arises: who is more firmly rooted in their behavioral patterns, the liquidity provider or the trader? Our current understanding points to liquidity providers due to several reasons:
- LPs generally have a stronger connection to the platform compared to traders
projects like Curve encourage LPs to optimize their market-making returns by staking CRV tokens through vote-escrowed mechanisms, which increases the migration costs for LPs and aligns their interests with the platform.
- LPs have a greater concern for and reluctance to switch products
Traders’ interactions with platforms are transient and do not require fund escrow within the protocol, resulting in minimal funding risk. Conversely, LPs’ funds are authorized within the platform’s smart contracts, facing higher risks. As a result, they tend to choose platforms they are familiar with, which have a robust safety reputation and a long-standing history. LPs often view trying new platforms as carrying greater psychological risk, making them hesitant to migrate even when offered a higher APR.
- Aggregators lead to rational trading behavior and take minimal losses as the only principle
While there are aggregators for providing liquidity (by depositing funds into automated market maker pools or yield aggregators), people generally prefer to engage in market-making directly, especially for larger funds. This preference stems from concerns over the risk of authorizing funds in smart contracts via aggregators, as well as higher revenue-sharing proportion charged by aggregators (despite the fact that they do not charge usual fees). Furthermore, large funds tend to make a market directly because they usually have little concern for the gas friction caused by reinvestment.
- Incentives for trading behaviors are diluted by transaction frictions
The frequency of trading behavior significantly exceeds that of market making, and the frictions generated during trading, such as gas (including MEV) and NFT trading royalties, are captured by third parties outside the protocol and users, which results in a portion of incentive loss.
- Incentives for transactions will inflate transaction demand
While such behavior may seem to contribute to transaction fees and protocol revenue, it might not be very beneficial for the project’s incentive goal—namely, achieving cross-edge network effects advantage through token subsidies.” This is because these “inflated transactions” will vanish as soon as the incentive stops, failing to help the protocol achieve its aim of “capturing a larger market share.”
In summary, LPs maintain a closer and more long-term relationship with the trading platform compared to regular traders. Therefore, allocating incentives to LPs may yield a higher total user value in the long term. This could explain why the majority of trading platforms continue to concentrate on liquidity incentives, with relatively limited exploration of trading incentives.
Outlook
How to Better Incentivize Trading Behaviors
While liquidity and trading are the two primary options for incentives, and it’s often safer to incentivize liquidity, exploring incentives for trading behavior still holds significant value. This is because the ultimate revenue of a trading platform comes from trading volume, and offering incentives for liquidity providers aims to create a better trading environment, which in turn leads to increased trading volumes and transaction fees.
When designing trading incentives, better outcomes may be achieved by considering the following points:
Do Not Offer Direct Incentives for Trading Behavior or Volume; Instead, Concentrate on Liquidity Pools or Pairs with Higher Trading Volumes
A notable example is the concept introduced by AC when designing the ve(3,3) project Solidly. In this case, veToken holders would only receive transaction fees from the pools they voted for, rather than getting the entire protocol revenues regardless of which pool they voted for. This approach encourages veToken holders to cast more votes for pools (trading pairs) with high trading volumes and significant contributions to protocol revenues. As a result, these pools receive more liquidity (increasing the token incentives to the pool), better trading depth, and potentially gain more transaction volume and fees. This is equivalent to a “disguised trading incentive.” Besides Fork by Solidly, some other projects have begun experimenting with similar incentives, such as Pendle, which has adopted the method of “allocating 80% of pool revenues to veToken holders who vote for pools.” Consequently, veToken holders are more inclined to vote for pools with high volume, increasing token incentives for LPs.
Control the Value of Incentives to Prevent “Inflated” Transaction Volumes
By ensuring that the incentive value of trading subsidies is lower than the frictional cost of trading, people will be less likely to engage in “incentive-driven trading”. Instead, they will rationally choose platforms with trading subsidies when they have a need to trade and participate in necessary trading behaviors.In the long term, under similar conditions, users may be more inclined to trade on platforms with incentives. Once these behaviors form a habit, the purpose of the subsidy will be achieved.
Trading Behavior Incentives Can Be in the Form of “Operational Activity” Instead of “Token Distribution Mechanism”
Token allocation mechanisms are long-term and require careful adjustments, while operational activities are short-term and can be flexibly modified. Trading platforms can design short-term trading campaigns to encourage the activation of essential new user behaviors (e.g., defining an activation as a user completing their first transaction on the platform) or develop trading contests to achieve specific short-term business goals (e.g.,fundraisings or competing with rivals). For instance, Vela, a copycat of Gains on Arbitrum, uses short-term trading incentives with continuously adjusted incentives and amounts to attract users from platforms such as Gains and GMX.
These design ideas for trading incentives align with the 【retention rate】 concept previously discussed, which emphasizes focusing on real user behaviors that can bring long-term retention for more refined incentive design.
Conclusion
In the Highly Accessible Web3 Business World, Operational Efficiency is Crucial for Long-term Growth
In observing the development of the Web3 industry so far, I have concluded that forming a monopoly in Web3 is challenging. The nature of the Web3 ecosystem, with its unique account system, permissionless capital liquidity, open-source code and composability, makes it difficult to construct a competitive edge. This is because users become increasingly resistant to being “captured and monopolized”.
For any project to survive and grow in a highly-accessible environment, the focus must be on continuously improving operational efficiency. “Operation” is a general term that includes product innovation, marketing activities, team management, and many other metrics, with precise and efficient incentive design being one of the critical tasks. It is expected that token distribution and incentive models will need to be continuously iterated to keep up with competition and evolving user needs, making it a long-term effort. A “one-size-fits-all economic model” based on a divine perspective will likely be an illusion for most projects.
When selecting long-term investment targets, investors should consider whether the project’s core team have the key qualities such as “long-term operational ability,” “ongoing business commitment” and “eagerness to proactively adapt to market changes”.
In the future of Web3, the “easy wins” that come from ingenious ideas will become increasingly rare.
