The emergence of Liquidity Restaking Tokens (LRTs) has profoundly impacted the DeFi landscape, ushering in both impressive returns and sudden price volatility. As Decentralized Finance (DeFi) continues to evolve, there are valuable lessons and opportunities to be explored. This blog delves into one of the foundational pillars of DeFi: Liquidity, examining its pivotal role and profound implications across the ecosystem.

Liquidity & Liquidity Incentives

In the dynamic landscape of DeFi, liquidity is the lifeblood that enables the swift exchange of assets. Sophisticated liquidity provisioning strategies are essential for maintaining market stability and enabling seamless trades.

Liquidity, in the context of crypto markets, refers to the ability to buy or sell assets with minimal impact on price stability. High liquidity indicates a healthy market where transactions can occur promptly and efficiently, while low liquidity suggests a lack of available buyers or sellers, often leading to larger price fluctuations and a more volatile market environment.

Why does liquidity even matter in the first place?

• Market Depth and order Execution: Liquidity ensures that there are sufficient buy and sell orders in a market. Deep liquidity allows traders to execute large orders without significantly impacting prices.

• Reducing Slippage: Slippage occurs when the execution price deviates from the expected price due to insufficient liquidity. Liquidity incentives help mitigate slippage.

• Stability and Confidence: Liquid markets are less prone to extreme price fluctuations, fostering investor confidence.

How is liquidity measured?

Measuring liquidity typically involves observing both the trading volume and the spread between bid and ask prices. Trading volume reflects the total amount of an asset that changes hands over a specified period, showcasing the market's activity level. A narrower spread, the difference between the highest price buyers are willing to pay and the lowest price sellers will accept, often signals higher liquidity as it denotes a market with more synchronous pricing among market participants.

Factors affecting liquidity?

Various factors impact liquidity in the crypto markets. The presence and activity of market makers, entities committed to buying and selling at advertised prices, significantly enhance liquidity by ensuring there are always counterparties for trades. Increased participation from both buyers and sellers can lead to a more liquid market. Conversely, external events or regulatory changes can create uncertainty, often resulting in reduced participation and lower liquidity.

What are Liquidity Pools?

Before we dive into incentivizing liquidity, let’s first understand what liquidity pools are. A liquidity pool is a smart contract that holds funds for a specific trading pair. Liquidity providers deposit their funds into the pool and receive liquidity pool tokens in return, which represent their share of the pool. These tokens can then be used to trade or withdraw their share of the funds in the pool. When a user wants to trade a specific asset in the pool, they can do so by trading against the liquidity pool, instead of needing to find a counterparty on a centralized exchange. The liquidity providers earn a fee on each trade where their liquidity is active, which is related to their share of the pool.

Liquidity incentives play a pivotal role in financial markets, decentralized networks, and blockchain ecosystems. At their core, these incentives aim to encourage participants to provide liquidity by staking their assets, thereby enhancing market efficiency and stability. Let's explore this multifaceted topic:

For liquidity providers who want to bootstrap their pools, incentivization can provide an easy and effective way to attract initial liquidity. By offering additional rewards on top of the normal fees earned from trading, new pools can quickly gain traction and attract more liquidity providers. This can lead to a virtuous cycle of increasing liquidity, trading volume, and rewards, which can ultimately benefit the protocol and its community.

Terminologies:

• Yield: Rewards gathered from participation in liquidity pools.

• Liquidity Provider (LP): Contributors of assets to the pool.

• Farming Rewards: Incentives earned from yield farming activities

Various Liquidity incentivisation techniques:

1.      Market Maker Programs: Market makers are essential for maintaining liquidity in financial markets. They provide continuous buy and sell orders, bridging the gap between buyers and sellers. Market maker programs incentivize these players to participate actively. Market makers receive rewards (often in the form of fees or tokens) for providing liquidity. These incentives encourage them to quote competitive bid-ask spreads, reducing slippage for other traders. Example: Uniswap's liquidity provider program rewards LPs (liquidity providers) with a share of trading fees. By staking assets in Uniswap pools, LPs earn tokens and contribute to the platform's liquidity.

2.      Airdrops and Token Distribution:  Projects distribute tokens to specific addresses (e.g., existing users, early adopters, or community members) as an incentive. Airdrops create a sense of ownership and community involvement. They can also introduce new users to a project. Example: Uniswap's retroactive airdrop rewarded users who had interacted with the protocol before the official token launch.

3.      Staking Rewards: Staking involves locking up tokens in a smart contract to support network security and consensus. In return, stakers receive rewards. Staking incentivizes long-term commitment to a network. It aligns the interests of token holders with the network's success. Ethereum 2.0's proof-of-stake (PoS) mechanism rewards validators for securing the network. Validators stake their ETH and participate in block validation.

4.      Liquidity Mining: introduced by IDEX in 2017, liquidity mining combines yield farming with liquidity provision. Users stake tokens in decentralized finance (DeFi) protocols and earn additional tokens as rewards. Liquidity mining attracts capital to DeFi platforms, bootstrapping liquidity. However, it can also be volatile and speculative. Example: Compound's COMP token distribution initially incentivized users to supply assets to the Compound protocol. Participants earned COMP tokens alongside interest.

5.      Network Participation Rewards: Some networks reward users for participating in governance, security, or other activities. These incentives foster community engagement and decentralization. Example: Tezos rewards bakers (validators) for securing the network and participating in governance decisions.

6.      Collateralization and Borrowing Incentives: In decentralized lending platforms, users can borrow against their collateral. Incentives encourage both borrowing and collateralization. Borrowers benefit from low interest rates, while lenders earn fees. Overcollateralization ensures system stability. Example: MakerDAO's DAI stablecoin incentivizes users to lock up ETH as collateral to mint DAI. Stability fees paid by borrowers reward MKR token holders

7. Concentrated Liquidity Provision is a novel approach introduced by Uniswap v3 that allows LPs to allocate their capital within specific price ranges. This strategy enhances capital efficiency by maximizing yield within the designated range. LPs can earn higher transaction fees compared to a traditional liquidity pool due to the increased liquidity density if the market price stays within their chosen range.

Some really advanced techniques exist as well :

One of them is Graviton’s interchain swaps and wrapped tokens liquidity incentivisation solution .

The essence of the Graviton protocol solution is to create incentives for both cross-chain transfer providers and shareholders of wrapped tokens’ liquidity pools for the most popular and liquid tokens of the destination chain.

A schematic indicating the same is as shown below:

You can read more on it here .

Balancing liquidity incentives is akin to walking a tightrope; offering excessive rewards may lure in short-term speculators, yet inadequate incentives risk dampening participation. With the ever-evolving crypto and DeFi terrain, anticipate novel strategies emerging, finely tuned to accommodate a variety of stakeholders.

DeFi Summer

Compound catalyzed the DeFi farming frenzy during the summer of 2020, marking the inception of what became known as DeFi summer. This period witnessed a surge in token farming, lending, and borrowing activities, signaling the nascent stages of the DeFi revolution.

Yearn Finance is among the first yield aggregators in the now mature DeFi ecosystem. Yearn Finance is a suite of Decentralized Finance (DeFi) products that provides yield generation, lending aggregation, and more on the blockchain. Yearn is maintained by various independent developers and is governed by $YFI holders. At it’s core there is the yVault(yearn vault) and this is what a vault really means:

yVault provides automated yield generation to many different crypto assets, each driven by one or more Strategies. The yVault design is open-ended, which means other protocols can build and innovate on top of Yearn, like the Abracadabra + Yearn case.

Last year in January, Yearn Finance announced that it will now allow anyone on the protocol to create curve reward farms.

Before this move, users have been limited to vaults created by Yearn’s contributors and developers. With the introduction of the “permissionless vault factory,” anyone can create their own strategies and offer them on Yearn, where other interested users can deposit their own tokens and earn yields.

I am leaving a link here for a proposal at the forum of Yearn Finance that would be really interesting for you to read.

Renzo Depeg

So, now after learning through these concepts let’s get to one of the most catastrophic event that shocked the world of LRTs. Let’s learn a bit about Renzo & ezETH too now :

Renzo is a Liquid Restaking Token (LRT) provider and Strategy Manager, seamlessly interfacing with EigenLayer to simplify the complex dynamics between users and EigenLayer node operators. With its beta mainnet launched on December 18, 2023, Renzo's platform offers a user-friendly liquid restaking solution. Users have the flexibility to deposit any amount of ETH or select quantities of LSDs (WBETH and stETH for the time being), with ambitions to broaden support for additional LSDs in the near future. Currently, the platform does not facilitate withdrawals, and a lack of public source code or deployed contract functions for these actions implies that exiting an ezETH position is presently confined to DEX liquidity or OTC transactions.

Source : rootdata

Depositing native ETH to Renzo triggers a process where the ETH is earmarked for staking through a validator node on the Ethereum Beacon chain. This ETH is temporarily stored in the DepositQueue contract until reaching the 32 ETH threshold required for direct transfer to the Beacon Chain Deposit Contract. At this juncture, withdrawal credentials are aligned with the EigenPod in EigenLayer, ensuring the staked ETH not only garners Ethereum validator rewards but also secures AVSs within EigenLayer. In the event of a validator node shutdown, the EigenPod reserves the right to retain a portion of the ETH as a safeguard against potential slashing incidents.

For LSD deposits, Renzo facilitates immediate restaking within EigenLayer, assigning them to the designated node operator. Renzo claims that the direct transfer of all restaked points accrued in EigenLayer to the users is guaranteed, foregoing any fees. Furthermore, should Renzo users qualify for airdrops from other projects, they are assured receipt of the full airdrop benefits. To foster community engagement and protocol growth, Renzo introduces Renzo Points as rewards for user contributions, be it through DEX liquidity provision or restaking efforts. Additionally, a referral program enhances user rewards with additional Renzo Points for every new participant they successfully introduce to the platform who engages in restaking ETH.

ezETH is the yieldbearing receipt token of Renzo, mirroring the conceptual framework of Compound’s cTokens. It maintains a soft peg to ETH, with its foundation firmly rooted in collateral comprising staked ETH and select LSDs. Currently, Renzo accepts WBETH and stETH within its supported LSDs, with an ambitious roadmap to extend coverage to a broader spectrum of LSDs in due time.

On 24th of April starting at 2:25 UTC, the ezETH price started facing a liquidity crunch that ultimately resulted in a price drop.

The ezETH/WETH/0.86 LLTV market accrued 10.96 WETH in insolvencies, of which, 7.12 WETH was socialized  to the Gauntlet LRT Core Vault. (Source : Morpho Forum Post by Gauntlet)

ezETH Price Volatility Timeline

On April 24, 2024:

• 02:25 UTC: The ezETH/WETH oracle first dipped below 1.0

• 02:29:47 UTC: The first liquidation occurred at block 19722269

• 02:52:35 UTC: 145 of the 146 total ezETH liquidations occurred

• 13:00:47 UTC: Final liquidation

The WETH Liquidity in the ezETH/WETH Balancer pool  decreased from 4K WETH down to as low as 500 WETH before rebounding to 1300 WETH between 2024-24-4 00:00 UTC and 2024-24-04 08:00 UTC. A combination of factors led to liquidity decreasing:

• ezETH holders swapping out of their position

• Liquidators liquidating ezETH positions swapping out of the ezETH they claimed

The underlying price oracle used in this market relies on a few liquidity pools:

• ezETH/WETH Balancer pool

• ezETH/weETH/rswETH Balancer pool

• ezETH/WETH Curve Pool

• ezETH/WETH Uniswap V3 pool

Decreasing liquidity in all of the pools put downward pressure on the underlying price oracle used in the ezETH/WETH/0.86 LLTV Morpho Blue market, triggering further liquidations, which in turn led to even lower liquidity in these pools as liquidators swapped out of ezETH to realize their profits.

ezETH Liquidations

• 138 liquidations in the ezETH/WETH/0.86 LLTV market 8

  • Net debt repaid: 5035 WETH

  • Net collateral liquidated: 6236.72 ezETH

  • Net socialized  insolvencies: 10.96 WETH

• 8 liquidations in the ezETH/WETH/0.77 LLTV market 1

  • Net debt repaid: 804 WETH

  • Net collateral liquidated: 1000.25 ezETH

  • Net socialized  insolvencies: 0

Source : Morpho Forum Post by Gauntlet

The following chart shows ezETH daily volume on the balancer pool

But what in the world did really happen?

Soon after, Renzo launched tokenomics and information related to the REZ token. The project information released has encountered a lot of controversy from the community.

After tokenomics was launched, the project received a wave of criticism from the community for the following reasons:

1. The 2 illustration parts of 2.5% are exaggerated to be equal to the 20% of Core Contributors, the 62% parts of Fundraising and Community only take up half of the image, creating a feeling of deceiving the community

2. Token Allocation is unreasonable when the project team is said to be able to hold up to 95% of the total supply. Only 5% from Lauchpool and Liquidity is reserved for the community.

3. Users who participate in staking on Renzo early will only receive a 5% airdrop. Previously, the project mentioned that the airdrop portion was only 5% of 30% (ie 1.5%), this airdrop number is much smaller than expected from the community, In fact, it is less than the share for Binance Launchpool and has to be shared with other NFT projects (Milady & SchizoPosters) that are not really related to the project.

4. Users can only claim REZ on May 2, 2024, 2 days after TGE, this is considered an unusual point for the project to be ahead of users.

5. The project does not allow reverse redemption from ezETH to ETH, users can only swap ETH back through pools on DEX.

Leveraged restaked ETH farmers using Renzo protocol got a taste of what can happen when too many token holders head for the exits all at once. Evidently, the release of the protocol’s REZ token distribution plan led ezETH to take the "easy" route back to ETH by swapping in onchain liquidity pools.

The frustration after receiving information about tokenomics caused a group of users to no longer want to hold ezETH and sell ezETH on a large scale. This immediately caused ezETH to lose peg relative to ETH.

Users who used the ezETH lending strategy as collateral to borrow out restaking ETH to create a loop were immediately affected. This strategy is theoretically quite safe as ezETH and ETH fluctuate in the same direction.

However, the above event caused the peg ezETH to decrease compared to ETH, increasing the Loan to Value of the loan and causing a group of users to be liquidated on Lending platforms.

At the most stressful time, the price of ezETH dropped 20% to 2700 USD compared to ETH, causing users using leverage lending strategies on some platforms Gearbox, Morpho... to liquidate their assets. There was about 340 million USD of ezETH liquidated in the recent depeg, this is a group of users using 4-5x leverage or more.

Although this also creates opportunities for ezETH arbitrage traders on different blockchains, Blast's Thruster is a project with stable ezETH-ETH liquidity and users are already using this pool and a few DEXs on other chains for arbitrage. This also contributed to the price of ezETH returning to the correct peg.

So this was it for now! The next blog in this series will dive into concepts of the properties of liquidity according to market cycles, the effect of amount of liquidity on leverage rates & demands of leverage, effect on pools like Pendle are affected & how change in amount of liquidity affects demands for credit/leverage.