UST Provides Cautionary Tale: Protocol Liquidity Is a Fundamental Operational Imperative

In a crypto landscape, there are fewer markers for measuring investment risk and opportunity than in traditional finance. Recently, I discussed why liquidity is one important indicator for decentralized finance (DeFi) investors as they evaluate DeFi protocols for investment.

Unfortunately for many, the recent fall of Terra USD ($UST) is an example of why liquidity is important. In this (what is almost certain to be historic) case of UST, there were not enough liquid assets to back the amount of UST that was minted by the protocol. When people started to redeem their UST en masse, its value collapsed with nothing underlying the UST asset.

The Terra UST protocol is now inoperable, with all related assets trading near zero. This was a large-scale project with a large-scale (and highly visible) failure. Similar—albeit smaller—failures could await other projects that do not learn the importance of liquidity for their survival. For investors or potential investors, it’s important to understand how projects are leveraging, managing, and monitoring liquidity to avoid the pitfalls that befell UST’s investors.

Funding Operations with Liquidity
In addition to liquidity being needed for a protocol to operate, liquidity also allows the project to use its own native token to pay the operational costs of building the protocol until a viable revenue model is built and enough revenue is brought in to cover costs. Often, when a project first gets off the ground, it has no other assets in the treasury besides the native token.

Liquid markets assign a value to the token so that workers and contributors are more likely to accept the token as payment for services.

They also allow the token to be directly sold, indirectly sold, or used as collateral to acquire ETH or stablecoins—a requirement for many workers who will use the token as payments for their personal monthly expenses.

With enough liquidity, a project can use its native token to fund itself, rather than rely on outside investors such as venture capitalists.

Creating Liquidity Through Tokenomics
There are various methods that can be used to create liquid markets for a new token. How the new project utilizes these methods, and the tools they use in doing so, are generally referred to as the “tokenomics” of the project.

Tokenomic Initiatives
Following are some example tokenomic initiatives a protocol may undertake:

DEX Liquidity Pool:	Anyone can start a market for a token by creating a new liquidity pool on a DEX, such as Uniswap or Sushiswap. This is frequently the initial public assignment of value for a new token.
Token Airdrop:	Many projects spread the word and involvement by allowing certain wallets to claim free tokens based on previous actions, such as using the protocol in its early stages.
Liquidity Provider (LP) Staking & Rewards:	Encourage people to provide additional liquidity (usually to a DEX Liquidity Pool), by rewarding them with additional native tokens for doing so.
Bonds:	Protocols like Olympus and Hedgey allow projects to sell tokens through mechanisms that do not cause tokens to be immediately sold on the open market.
Liquidity Direction:	Protocols such as Tokemak provide mechanisms for additional liquidity to be directed to a protocol’s liquidity pools.
Token Swaps:	Protocols will engage in token swaps with each other to assist each other in diversifying their treasuries. It is also a signal that the projects support one another.
Borrowing with Token Collateral:	Open loan protocols like Rari Fuse Pools allow protocols to create markets where the native token can be used as collateral for loans.

In addition to the objectives laid out above, each of these mechanisms indirectly provides value to the project, which in turn may increase the value of the token (and provides more data for a prospective investor on the prospects of the project). With increased value of the token, it becomes easier to execute on additional tokenomics initiatives to increase liquidity and value flow between the emerging protocol and other DeFi protocols.

As with most growth cycles in markets, the flywheel effect comes into play once the wheel is kicked and momentum is gained.

Tokenomics Risks

The protocol’s team and community need to be careful, monitoring for the following risks when building out their tokenomics strategy:

Token Devaluation: Initiatives like providing rewards and selling bonds result in token “emissions,” which increase the circulating supply of the token. Increased supply results in lower prices. Initiatives that create emissions require careful monitoring to maintain balance.

Proper Collateralization: As vividly seen during the UST debacle, protocols should set the parameters of their initiatives so they do not lead to under-collateralized positions, which in turn could negatively impact users of the protocol and its initiatives. Rari appropriately informs users to check the parameters of any loan pool (see here).

Conclusion
With a handle on the different options to build liquidity and value for a token and an eye on the risks, protocols can build a strong tokenomics position to fuel their development. The space is moving fast, and new instruments and methods are constantly being developed. How tomorrow’s DeFi projects create value to build protocols could be as different as how DeFi projects compare to traditional VC-backed startups today.

Discerning investors can review that protocols are following fundamentals for more in-depth information before wading into a DeFi position.

Disclaimer: The contents of this article are not to be construed as investment advice. Investing in any vehicle can carry risks; consult with an investment advisor to understand risks of specific investment opportunities.