Marketcap to liquidity ratio: DeFi’s path to sustainability
DeFi’s liquidity is being discussed again in the news, this time, by Polygon CEO.
Of course, this report I'll be quoting is mostly a promotion for Polygon as it supposedly plans to build DeFi solutions that fit for long-term stability, however, what's being highlighted is consistent with what I've personally talked about in recent times.
Decentralized finance has a liquidity problem, and whilst this is partly a fault of the lack of effective security solutions for DeFi protocols which pushed most trading activities onto centralized exchanges, the otherside of the problem is the flaws of DeFi’s biggest focus over the years — yield farming.
Yield farming, which generally involves staking a token or two tokens to earn rewards, have played a huge role in DeFi’s liquidity problems. This is because liquidity provision has been a significant part of this practice where users are incentivized to provide assets into liquidity pools in exchange for token rewards.
These token rewards are often native protocol tokens and yields associated with these incentive programs are often very high — a strategy which was designed to cause FOMO amongst crypto users and “quickly” attract sizable liquidity assets.
The weakness of this system is that it directly prioritizes short-term adoption at the expense of the valuation of the native token being given out as rewards.
With high yields, this often means high printing of native tokens to reward liquidity providers. These yields sometimes exceed 100%, making it wildly unsustainable.
The general logic, given its broad application by various DeFi protocols, has been that as user adoption increases, these high yields will be lowered. Consequently, if users exit and/or prices are down, yield can be increased to lure them back.
The reality? Most users don't necessarily wish to return after exiting a position because there's often some new shiny and more rewarding project that risking becoming exit-liquidity by chasing re-adjusted yields from old protocols isn't ideal.
As such, we have a situation where every new DeFi project effectively trends downward after initial hype captures some liquidity inflow. When the high yields that attracted this liquidity are removed, the liquidity follows, even when losses are guaranteed on withdrawable assets compared to initial deposits.
Protocol-owned liquidity
Most DeFi projects have poor marketcap to liquidity ratio because, well, they've followed the same blueprint as others before them and I've gotten the same results.
How much liquidity a project has measuring up to its token marketcap will be a metric highly watched to weigh risks associated with investing in these protocols.
The single best way to ensure liquidity grows as a the native token’s value grows is to have a protocol-owned liquidity. It's best of course, if this is a perma-liquidity solution, meaning that assets only flow in and can never be removed, this way, a deep liquidity is afforded for the long-term.
Polygon Labs CEO Marc Boiron called for a fundamental shift in how decentralized finance (DeFi) protocols manage liquidity, labeling the sector’s ongoing liquidity crisis as “self-inflicted.”
Boiron criticized DeFi protocols for fueling a cycle of “mercenary capital” by offering sky-high annual percentage yields (APYs) through token emissions. “It’s just renting liquidity; it’s not real loyalty,” he told Cointelegraph, noting that such strategies lead to fleeting liquidity that vanishes when yields drop or token prices falter. This reliance on short-term hype, he argued, undermines the sector’s stability and deters institutional adoption.
To break that cycle, Boiron urged protocols to prioritize fundamentals over flashy returns. “Sustainable DeFi needs models where liquidity sticks around for the right reasons,” he said, pointing to Polygon’s POL token as a blueprint for achieving this.
“Protocols can put their treasury to work, earning yield instead of diluting token value. Over time, this strengthens the treasury rather than just paying off temporary liquidity providers.” — Cointelegraph report
In recent times, I've discussed crypto developer's unhealthy focus on building investment products or services, one of which is LP incentive programs. By constantly trying to attract investors and trap them, the ecosystem neglects where the true value is.
Make no mistake, there's nothing wrong with building investment solutions, but without consumer-facing options, every thing built atop crypto is doomed and this is simply because this is where the revenue is.
Most DeFi projects focus on deploying a swap interface, then slapping LP incentives and that's it. Oh my bad, some introduce lending and borrowing, and that's about it. These things are bound to bring very limited revenue, especially when everyone is building it. There's just going to be the big guys getting all the volumes and thousands of small guys not making nearly enough to make their native tokens attractive assets.
The solution is to understand that DeFi isn't just about “swaps and loans.”
If we are onboarding the masses, it makes zero sense wanting them to become perpetual swappers or asset lenders.
This is why DeFi developers ought to focus on deploying various consumer-facing solutions that allow value to move around without hitting the swap interface. This ensures that whatever liquidity is there is not used up, and that consumer activities generate revenue which can be channeled into these liquidity pools to strengthen them.
When the system is set to earn most of its revenue from swaps and tries to attract liquidity by hyper-printing of native tokens, it's essentially running a flawed business that will collapse eventually.
For any DeFi protocol to have a perma-liquidity solution, it has to first figure out where that liquidity will come from that will not be a direct expense to itself.
This has to be mostly revenue, from regular user activities.