Protocol owned liquidity (POL) is one of a few key innovations of the DeFi 2.0 narrative. The protocol behind this invention is Olympus DAO. Protocol-owned liquidity seeks to solve the mercenary capital problem of DeFi 1.0.
Our past post regarding Olympus can be read here “What’s The Deal With The (3,3) Meme In Crypto?“.
The mercenary capital problem that plagues DeFi 1.0 protocols, especially automated market makers (AMMs), is caused by protocols seeking to incentivize users through LP tokens and trading fees.
Incentivizing users to add value to a protocol sounds like a meaningful addition to an ecosystem. But users can easily switch to the protocol offering the best incentives, creating a race to the bottom scenario for protocols as they increase the supply of their governance token and, in doing so, decrease its value.
Olympus DAO solves this issue primarily through protocol owned liquidity, which makes use of two popular DeFi mechanisms: bonding and staking.
Olympus enables its users to purchase their OHM using ETH, DAI, and other assets at a discounted rate. To mitigate the risk of traders turning around and taking advantage of this arbitrage opportunity, Olympus vests these tokens to bonders over a period of time, typically between 5 and 10 days (the vesting period is two days at the time of writing.)
Selling OHM as bonds has two benefits to the Olympus ecosystem; 1) the treasury now has a basket of assets backing the ecosystem, and 2) the protocol can now contribute to liquidity pools and earn fees on OHM trading pairs.
The treasury holding these assets now gives Olympus DAO a “floor price” as the market value should not go below the value of the Olympus treasury. Currently, Olympus owns over 99% of its OHM-DAI pair and has collected millions of dollars in trading fees.
Bonding creates a risk that as holders start selling OHM and the price decreases, the treasury will have to buy OHM to stabilize the price. OHM buybacks by the treasury decrease the value held in the treasury and create a negative feedback loop of value decline. A solution to prevent this negative feedback loop is staking OHM tokens.
The Olympus team implemented a staking mechanism into the protocol to prevent sell pressure on the OHM token. Not only did they add staking, but they also made staking a lucrative incentive. At the time of writing staking APY is over 800%. Olympus DAO employs a simple game-theoretic model to incentivize users to exhibit behavior beneficial to the community.
The matrix shows that any action that involves one user staking or bonding and the other doing the inverse results in a net positive outcome. Any action involving selling is at best a net neutral outcome, and both selling creates a net negative scenario for the ecosystem. This matrix is where the popular (3,3) crypto meme was born.
Olympus DAO’s addition of protocol-owned liquidity to the DeFi ecosystem will carry into the future. Some wonder if discounting bonds will cause similar issues as incentives in DeFi 1.0 or if Olympus DAO has too big a lead over competitors. Regardless we will likely see a combination of protocol owned liquidity and traditional liquidity pools in DeFi protocols in the future.