This article mainly explains Protocol-Owned Liquidity (POL). Could not found a better entry to this article. So I will directly dive into it.

This idea came to me while drafting my latest article on yield-bearing stablecoins. During my research, I came across a project called Aera. When I wanted to learn more about it, I thought it would be much better to talk about protocol-owned liquidity first. The thing is, almost e-v-e-r-y single article I read was ALMOST the same. Even their headings were identical. This one will not be one of t-h-a-t ones. First, this article will explain on-chain liquidity, liquidity mining, and lastly, POL.

On-chain Liquidity and Protocol Growth

What is On-chain Liquidity?

On-chain liquidity allows users to transact directly on the blockchain without needing a centralized intermediary. This liquidity model offers a mechanism operating through DEXs, facilitating the buying and selling of tokens. As liquidity depth on DEXs increases, transaction costs decrease, and slippage is minimized. This enables investors to enter and exit positions more efficiently, leading to a rise in overall protocol activity and trading volume.

Why Should a Protocol Prioritize On-chain Liquidity?

The main issue is the lack of enough DEX liquidity, which makes it hard for a protocol's native token to gain wide acceptance in the DeFi ecosystem. This problem is even bigger for systems like lending or perpetual protocols that depend on highly liquid markets.

Liquidity depth also plays a crucial role in expanding the token ecosystem. Low liquidity makes it challenging for large investors to take positions due to high slippage, deterring potential investors. However, as liquidity on DEXs increases, it becomes easier for new market participants to enter the ecosystem, supporting the protocol's organic growth—a win-win.

Additionally, liquidity is a core determinant of token price stability. Insufficient liquidity leads to significant slippage during large transactions, increasing price volatility. Robust liquidity pools absorb such unexpected sales, maintaining price stability. This dynamic often creates a self-reinforcing cycle: increased liquidity drives higher trading volumes, resulting in higher fees for LPs and attracting more liquidity providers. This positive cycle lays a solid foundation for the protocol's long-term growth and value creation.

One Last Step Before POL: Liquidity Mining

Liquidity mining is a strategy often used during the initial phase of on-chain liquidity. LPs are incentivized to deposit their crypto assets into liquidity pools, supporting decentralized trading, lending, and other financial activities. LPs are typically rewarded with additional tokens, significantly boosting capital flow. How effective are these incentives? Research shows that, depending on market conditions and token profiles, each dollar of incentive can significantly increase daily liquidity.

The key advantage of liquidity mining lies in its high leverage effect on expenses. A small incentive expenditure can generate thousands of dollars of liquidity in DEX pools. However, this strategy also has notable drawbacks. Primarily, the liquidity generated is often temporary. When the program ends and rates normalize, so-called "mercenary" LPs withdraw liquidity to pursue other mining programs, potentially destabilizing the protocol.

Moreover, during periods of market turbulence, LPs may withdraw liquidity despite incentives, leading to critical losses in DEX liquidity when it is most needed. Finally, liquidity mining incentives are costly as they are unrecoverable payments from the protocol treasury. LPs often sell these native tokens, exerting downward pressure on token prices and shrinking the protocol treasury over time.

What is Protocol-Owned Liquidity (POL)?

As the DeFi ecosystem grows, a fundamental question arises about liquidity: Is there a more effective way to control it? The answer lies in a model often overlooked yet in plain sight: Protocol-Owned Liquidity (POL).

To understand POL, let's first define the problem. In traditional liquidity models, protocols depend on external liquidity. This means playing in a field where others set the rules—a risky and costly approach. POL flips this equation. Instead of relying on external sources, protocols create and control their own liquidity. In this model, the reins are in their hands.

Why is POL so significant?

For instance, with POL, protocols can respond swiftly to market movements. This is not just a competitive advantage but also a strategic gain. Additionally, POL transforms liquidity from a cost center into a revenue stream. Thus, protocols can use their treasuries not merely as reserves but as active strategic tools.

Liquidity management now becomes more than answering whether liquidity is available.

Quick Look at POL’s Working Mechanism

POL's success lies in protocols directly owning and managing liquidity. For example, Olympus DAO holds liquidity in pairs like OHM/wETH and OHM/DAI within its treasury. By governing liquidity through community management, the protocol becomes resilient to external factors.

Mechanisms like Reserve-Balanced Swaps (RBS) establish a dynamic balance between liquidity and reserves, protecting against market fluctuations. This system ensures liquidity is not only maintained but also optimized.

The Cooler Loans mechanism allows users access to reserves, deepening liquidity and enhancing user flexibility regardless of market conditions.

In conclusion, POL is not just a liquidity management tool; it is a growth engine for protocols.

A Tangible Example of POL

Consider a user holding 800,000 DAI planning to buy 50 ETH and 1 BTC in two months. Traditional methods to meet this need include:

1. Immediate Purchase: The user acquires assets immediately to avoid price changes. However, these assets remain idle for two months, missing potential gains.

2. Deferred Purchase: The user waits two months to purchase, risking price increases that may exceed their budget.

3. Using Derivatives: The user buys derivatives tied to ETH and BTC prices, which may provide capital efficiency but come with extra costs and limited availability.

A POL-backed model offers more flexibility:

• Reserve and Liquidity Management: The user deposits DAI into a POL-backed pool. The protocol manages these reserves to meet the user's ETH and BTC needs under favorable market conditions.

• Dynamic Market Alignment: POL uses algorithmic mechanisms to stabilize ETH and BTC price fluctuations, protecting the user from market volatility.

• Maximizing Idle Assets: DAI generates additional value through transaction fees or other liquidity mechanisms, providing income without selling assets.

A More Complex Scenario:

Imagine a protocol anticipating a liquidity need of 150–200 ETH over three months, contingent on market conditions. POL balances reserves and liquidity, minimizing uncertainties. Excess reserves are leveraged for transaction fees or incentives, ensuring optimal use of resources.

>> bonus: abracadabra.money

Maximizing Liquidity with Innovative Approaches

great example of pushing liquidity efficiency further is Abracadabra.Money. This protocol allows users to borrow stablecoins, specifically MIM (Magic Internet Money), by collateralizing interest-bearing tokens such as yvUSDT and xSUSHI.

Unlike traditional collateralized loan systems like MakerDAO, which use assets such as Ethereum, USDC, and USDT as collateral, Abracadabra introduces a novel approach. By using interest-bearing tokens (e.g., yvUSDT, which represents staked USDT in Yearn Finance, or xSUSHI, earned from staking SUSHI on SushiSwap), users can continue earning yield on their collateral while borrowing against it.

This mechanism optimizes both liquidity and capital efficiency, allowing users to unlock the value of their staked tokens without sacrificing the rewards they generate. It’s a prime example of how DeFi protocols are innovating to improve asset utilization and enhance user experiences.