Liquidity Problems 101
Today, protocols set aside a large percentage of their token supply in order to incentivize liquidity providers (LPs). This negatively impacts the sustainability of the protocol in these ways:
1. Significant sell pressure: Inflationary token emission incentivizes short-term behavior that increases sell pressure on the farm tokens. Mercenary liquidity providers often sell their rewards to recoup their investments. Current solutions, such as time-locked staking, do not solve the core issue at hand and simply prolong the liquidity attrition.
2. Goal misalignment between Protocol and LPs: LPs are incentivized by high reward rates, rather than a strong belief in the success of the protocol. Hence, when the rewards are scaled back or exhausted, the LPs will remove their capital and move on to the next opportunity.
3. Impermanent Loss (IL): The success of a protocol causes price appreciation in its native token, causing a significant impermanent loss scenario for liquidity providers. This misalignment disincentivizes long-term LPs even if they are long-term believers in the protocol.
4. No buyer of last resort: During a market crash or in times of uncertainty, LPs tend to remove their liquidity from the pool as they run for safety. It is at these moments when liquidity is needed the most and if there is insufficient liquidity depth, it will lead to a downward death spiral of the protocol token's price.