The high-octane 50% APR yield farms that originally fueled decentralized finance’s (DeFi) meteoric rise are finally dissipating. It took an entire blockchain and DeFi ecosystem collapsing but it looks like DeFi is maturing from the unsustainable designs that led to the issues we're seeing now and towards safer, more resilient and more user-friendly models.
Decentralized token liquidity lies at the core of the current woes – and the path forward. DeFi projects need liquidity in their native tokens to be successful. If your token doesn’t have liquidity it’s less desirable to hold, largely because the price is unstable and can dump the moment a whale takes profits.
Automated market makers (AMMs) open liquidity provision to a broader set of market participants, and have proven they can create deeper, more robust liquidity for DeFi projects compared to centralized exchanges. However, DeFi projects of all sizes still face a major issue in generating liquidity in their tokens: It’s highly risky for token holders to act as liquidity providers because if the token goes up in value, the person who's providing liquidity in that pool would have been better off just holding the token outside of the pool in their wallet. They suffer what’s called impermanent loss, which disincentivizes them from providing liquidity in a pool.
To incentivize liquidity in these AMM pools, many projects have resorted to liquidity mining or spending money on rewards. This poses a whole other set of issues. By giving out free tokens, projects are attracting mercenary yield farmers who will come in, provide liquidity, suck up all the rewards and then, once the rewards are done, they sell and move on to the next project running a rewards program. Meanwhile, the initial project is left high and dry.
Bancor has been addressing these systemic issues head-on since its launch in 2017 as the first DeFi protocol. Indeed, Bancor invented the concepts of liquidity pools and automated market makers, which are the basis of most decentralized exchange volume around the globe.
In 2020, Bancor released its first version of impermanent loss protection, and to this day it's the only protocol that protects liquidity providers from these losses. Alongside this, Bancor natively supports single-sided staking of tokens in a liquidity pool.
This is one of the main benefits to liquidity providers that distinguishes Bancor from other DeFi staking protocols. Typical AMM liquidity pools require a liquidity provider to provide two assets by selling 50% of the token that is staked and combining the tokens in a pair. When providing liquidity, therefore, the token deposit is often composed of two tokens in the pool.
Bancor’s single-sided staking changes this completely. It allows liquidity providers to only provide the token they hold. Depositors can maintain full price exposure to that token while also collecting yield from trading fees and liquidity mining rewards.
DeFi’s problem is not so much one of liquidity but sustainable liquidity. Decentralized autonomous organizations (DAO) and token projects have had trouble retaining the liquidity in their tokens. By offering a way for token holders to mitigate the risk of impermanent loss, Bancor allows these projects to drop rewards into their pools and incentivize liquidity in a way that makes the rewards less likely to be farmed and dumped. Further, this means the rewards can be auto-compounded and exist as liquidity in the pool from day one, which is different than the traditional yield farming rewards programs.
The truth behind APRs
By protecting against impermanent loss and not just brushing it under the carpet, as many protocols seem to do, Bancor is further helping to 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 a hard lesson that the APR figures they see do not include impermanent loss. Rather, they just see fees over liquidity. But that assumes that liquidity stays the same over time. To get true APR you must take fees, minus impermanent loss over liquidity. This is what Bancor can show because its liquidity providers are fully protected from impermanent loss.
As more token holders have started to realize the APR they see going in is not what they eventually get out, they have started to pull back from staking inside liquidity pools. This is bad for trust, it’s bad for liquidity and it’s bad for the development of DeFi.
Bancor solves many of the liquidity issues that have plagued DeFi, and which have made it difficult for everyday users and for token projects to build liquidity. With its latest version 3 iteration, Bancor expects a fresh wave of interest in DeFi, just like the summer of 2020. But this time, the liquidity will be sustainable because the incentive structures and loss protection will encourage liquidity to stay.