Governor Note: Objective-Based Liquidity Design for stETH

Key Insights

• Steakhouse has suggested that the Lido DAO should replace LDO incentives for stETH with an objective-based liquidity design focusing on Layer-2 pools. The approach would result in more on-chain liquidity and sustainability.
• Balancing incentives with genuine utility and core product-market fit is crucial for Lido DAO's long-term success.
• Steakhouse's investigation found that most recipients of LDO incentives sold them immediately, indicating a need for long-term investment interest in the token.
• Alternative incentive management strategies, such as a PID-regulated liquidity controller, are necessary to synchronize tokenholders' interests with the protocol's goals.

Introduction

Steakhouse Financial is the Lido DAO Finance Workstream that oversees its financial operations and promotes sustainability, transparency, and long-term financial planning. It has proposed that Lido stops using LDO for liquidity incentives. As it stands, LDO incentives don't substantially affect stETH/ETH exchange rates and place the burden of risk on the DAO. Instead, Steakhouse recommends that Lido DAO focus on incentivizing early pools on Layer-2 networks to better promote the protocol’s on-chain liquidity and sustainability.

Liquidity Incentives in DeFi Adoption

Liquidity mining incentives have been crucial in developing and promoting decentralized finance (DeFi) protocol adoption. DeFi protocols incentivize liquidity mining by offering rewards, typically native governance tokens, for users’ contributions to the protocol’s liquidity pools. These tokens can be used to vote on proposals, staked for additional rewards, or trade on exchanges. Liquidity mining incentives help ensure sufficient liquidity, making the protocol more attractive and functional for other users and creating a virtuous cycle of growth and adoption.

However, the DeFi landscape has evolved, and new incentive models have emerged. Airdrops, for instance, distribute tokens to users for meeting certain requirements. Retroactive airdrops reward early adopters who have contributed to a protocol's growth, even if they did not initially receive any incentives. These reward mechanisms aim to create a loyal user base and foster network effects that drive further adoption.

Lido allows users to simultaneously secure the Ethereum network and participate in DeFi investments by staking their ETH tokens through its liquid staking protocol. This process mints stETH tokens, a rebasing asset that accumulates staking rewards as ETH. With Lido, users avoid the opportunity cost of locking up their assets until the Ethereum Shanghai Upgrade. This setup enables staking ETH on the Beacon Chain and engaging in DeFi activities using their stETH tokens.

stETH is an Ethereum (ETH) derivative intended to maintain a floating 1:1 price ratio with ETH. When the stETH/ETH exchange rate falls below this ratio, it becomes more attractive for new users to purchase existing stETH from current holders rather than minting new stETH. This situation must also take into account the fair liquidity yield discount, which is essentially a market discount. To encourage growth in ETH deposits, Lido must ensure that the stETH/ETH exchange rate stays above the adjusted ratio.

Source: @LidoAnalytical Dune Dashboard

Lido needed to subsidize the selling pressure of stETH and ensure ample on-chain liquidity before the approval of ETH withdrawals through its incentives. Adequate stETH liquidity is essential for price discovery, reducing transaction slippage and volatility, and enhancing security. These factors contribute to a robust DeFi ecosystem, benefiting stETH holders and the overall market.

Liquidity is vital for stETH utility on lending platforms like Aave as it improves platform utility and attractiveness and stabilizes prices. Additionally, robust stETH liquidity plays a critical role in managing liquidations. When the collateral value for borrowed assets falls below a specific threshold, liquidations are triggered to protect the protocol from insolvency. Maintaining adequate liquidity ensures efficient and quick execution of liquidations, minimizing losses for borrowers and lenders. Sufficient stETH liquidity allows liquidators to easily purchase stETH to repay the debt, maintaining the platform's overall health and stability.

Incentives have played a pivotal role in the growth of DeFi and crypto more broadly, so much so that the sector has come to rely heavily on these mechanisms to drive adoption. Some argue that these incentives are a temporary solution, pointing instead toward utility as the primary driver for long-term success.

Lido has established itself as the market leader in liquid staking protocols, which is contributed to by its attractive incentives. However, new entrants like RocketPool are gaining traction by adopting similar incentivization strategies, such as using their native RPL token to increase market share and liquidity. The competition between established and emerging players will shape the future landscape of liquid staking protocols as incentivization and platform offerings evolve.

Lido DAO and Liquidity Mining Incentives

Lido DAO has distributed LDO token rewards to its liquid staking protocol users across multiple networks, including Ethereum, Polygon, Solana, Polkadot, Kusama, Arbitrum, and Optimism. However, the DAO and its staking partner MixBytes, which supports Lido on Polkadot and Kusama, recently decided to discontinue the service. Factors like market conditions, protocol growth, limited capacity, and priority alignment influenced this decision, removing LDO rewards for Polkadot and Kusama networks from the DAO's rewards budget.

The argument against incentives promoting utility in DeFi and crypto maintains that they can result in short-term focus and incentive dependency from its users. The argument also points to increased token price volatility, inefficient resource allocation, and unsustainable growth. Critics stress the need for projects to develop genuine utility and long-term sustainability rather than depending solely on rewards for adoption.

Lido DAO's Approach to Incentive Management

In response to these concerns, Lido DAO established the reWARDS committee to optimize incentive allocation. Previously, Lido DAO had allocated up to $15 million in LDO tokens monthly to incentivize protocol usage. The reWARDS committee, now a sub-governing body within Lido DAO, is tasked with managing and reporting incentives for Lido assets. With the autonomy to deploy allocated rewards budgets, the committee submits monthly reports detailing their decisions, outcomes, and community feedback. By focusing on initiatives like maintaining liquidity, increasing DeFi usage, and facilitating trading volume, the reWARDS committee also streamlines Lido DAO's governance process. This leads to a more manageable expense towards liquidity incentives.

The reWARDS committee works alongside the Lido Ecosystem Grants Organization (LEGO) committee, part of Lido DAO's Financial Operations Team. LEGO encourages protocol growth by rewarding early contributors with incentives and support, while the reWARDS committee ensures the ongoing utility and adoption of staked Assets (stAssets, e.g., stETH, stSOL, etc.) in DeFi through effective rewards distribution.

In August 2022, Lido integrated Steakhouse Financial, the third component of the Finance Operations Team. The team’s responsibilities include creating financial statements and reports and, ensuring transparency, analyzing Lido's finances for sustainable planning.

The Steakhouse team has recognized problems with the existing approach to using LDO incentives for staked assets. They have proposed potential solutions to maintain sustainable on-chain liquidity for Lido's long-term success. Sustainable liquidity is crucial for stable trading without significant price fluctuations or slippage. It could attract more users and projects to the ecosystem if implemented correctly.

However, as the Ethereum network moves closer to enabling withdrawals from the Beacon Chain, it will become more beneficial for Lido DAO to direct incentives towards new liquidity pools, such as Layer-2 solutions. This shift in focus will help support increased protocol utility instead of subsidizing liquidity providers (LPs) and delta-neutral staking farming strategies.

The current reWARDS program has several goals. It aims to create positive feedback loops of liquidity and attractiveness, subsidize liquidity pool emergence, and protect stETH holders from sudden market movements. It also seeks to increase LDO token decentralization, attract new governance participants, and incentivize large pool creation. Regarding all these goals, the Steakhouse team has found the reWARDS program to be ineffective for these purposes.

Analyzing the Effectiveness of LDO Incentives

Reward Distribution and Impact on Tokenholders

From Jan. 1, 2022, to Feb. 23, 2023, approximately 80 million LDO tokens were transferred to Lido’s Curve incentives pool, a staggering 98% of which were claimed. However, an investigation by the Steakhouse team unveiled that only 5% of the claimed tokens were still being held by the recipients. In contrast, 85% of the tokens were sold immediately, and 10% were sold within six months of transfer.

Moreover, Steakhouse's examination of LDO token sales disclosed that 55% of the sold tokens were converted into ETH, and 35% were converted to USD. The distribution might be due to ETH and USD being the most liquid pairs with LDO, but it also highlights the preferred incentive asset for the liquidity providers. This data implies a lack of long-term investment interest in LDO tokens among the largest holders.

Governance Participation and Long-Term Investment Interest

Of all the addresses that claimed LDO tokens as incentives, only 80 claimed more than 100,000 tokens each. However, four of these addresses participated in fewer than three Snapshot polls, while only one participated in more than five. This indicates a low level of governance engagement among these addresses. Distributing LDO tokens as incentives have had a limited impact on governance participation and could have negative implications for the DAO. The data suggests that many large LDO tokenholders are not actively contributing to the protocol's long-term success.

These findings highlight the need for alternative incentive strategies that encourage greater active participation and align tokenholders' interests with the protocol's objectives. The Steakhouse Finance Workstream suggests initiating a natural mechanism for stETH liquidity. Employing the most advantageous incentive currency for the DAO would narrow exchange rate disparities in smaller pools and only reward pools that offer marginal benefits for stETH users.

Previously, the team proposed a Proportional-Integral-Derivative (PID)-regulated liquidity controller as a scientific approach to managing liquidity more effectively. Without human involvement, the PID controller could automate and minimize the DAO's liquidity expenses. It could also adjust the liquidity incentives given to liquidity providers (LPs) based on the stETH/ETH exchange rate. If the exchange rate deviates from the desired level, the PID controller can adjust the liquidity incentive to stabilize the rate. This method would enable Lido to respond proportionately to rapid fluctuations in the exchange rate over time.

This approach would encourage a more systematic discussion about parameter setting and increase the potential impact of each dollar invested. However, PID would require some time for implementation, not to mention that, ideally, liquidity pools should implement similar mechanisms on their end.

Steakhouse's analysis revealed that the primary stETH/ETH pool on Curve has more liquidity than necessary. They attributed this excess liquidity to the incentives allocated to the pool, resulting in an oversupply of liquidity.

The analysis also showed that if the market discount for stETH exceeds 1.5%, there is a high probability that less than 20% of stETH would come from the new stake. In this scenario, market participants would be more likely to purchase stETH than mint it.

Additionally, Steakhouse’s findings indicate that cutting incentives to zero would not necessarily lead to a significant drop in daily average exchange rates. In fact, the analysis shows no strong evidence to support this claim, as the 99% confidence interval of such a drop is less than 0.8% based on daily rates.

Key Considerations for Effective Liquidity Management and Incentives in the Lido DAO

The Lido DAO is the largest liquid staking derivatives protocol, with a significant stake in the liquid staking market at ~32%. As such, managing liquidity incentives and financial resources within the DAO is crucial for long-term sustainability and success. Here are some key points to consider for effective liquidity management within the Lido DAO.

1. Importance of Data-Driven Modeling and Quantitative Analysis: To effectively manage liquidity incentives, the Lido DAO must utilize data-driven modeling and quantitative analysis. An objective assessment of liquidity needs and the impact of incentives on LPs would help the DAO optimize liquidity management and save money.
2. Focusing on Core Product-Market Fit and Use Cases: To manage its liquidity more effectively, the Lido DAO must prioritize liquidity incentives for stETH/ETH pools and establish core product-market fit and use cases. Lido can allocate resources more efficiently and achieve better results by focusing on the essential use cases.
3. Establishing a Set of Principles for Lido DAO Responsibilities in Liquidity Management and Incentives: To ensure effective liquidity management, the Lido DAO must establish principles for its responsibilities. These include identifying liquidity management goals and objectives, developing clear roles and responsibilities for governance and decision-making, and ensuring transparency and accountability.
4. Cross-Chain Governance and Voting using stETH and LDO: The Lido DAO is exploring using stETH and LDO for voting. The DAO can also look into implementing cross-chain governance using LDO tokens, as Messari Analyst Ryan Holloway suggested. Doing so could enable more efficient and effective liquidity management and incentives decision-making. It could also increase the decentralization and governance capabilities of the Lido DAO from across its different service networks.
5. Why USD rather than LDO Should be Used to Measure Incentive Expense: While LDO rewards offer several benefits, measuring incentive expense in USD terms instead of LDO would more accurately assess the available resources and give a better understanding of the actual impact on liquidity. That said, there are advantages to using LDO, such as increasing its liquidity and decentralization, as well as benefiting stAsset holders. Alternatively, it is worth experimenting with using ETH, stETH, or stablecoins to incentivize liquidity, considering the LPs sell off their LDO incentive claims. Additionally, the approved Token Reward Plan (TRP) for Lido DAO contributors is a beneficial way to democratize governance participation. It would increase the number of independent actors who can enhance the resilience of the DAO's treasury to resist governance attacks, improve routine quorum, and reward long-time participation simultaneously.
6. Setting a Goals-Based Approach for Liquidity on New Domains: As Lido expands to new network domains, the team should seek to set a goals-based approach for liquidity management and incentives. This would entail explicitly identifying specific liquidity goals and tailoring incentives for each new network. By setting clear goals and objectives, Lido can optimize its liquidity management and incentives for each new domain and achieve better results.

Conclusion

The proposed objective-based liquidity design emphasizes the effective management of liquidity incentives and financial resources in a DAO like Lido. To achieve this, DAOs must evaluate the liquidity budget within overall operating expenses, ensure incentives align with long-term objectives, and address the core product-market fit. A quantitative analysis-based approach for incentive budgets, backed by historical analytics, would aid in determining total value locked and managing the DAO's largest expense. Paul Sengh, a Delta One contributor, emphasized that improving real use cases for stETH and addressing product-market fit concerns can increase trading volumes and fees for liquidity providers.

While scaling to new protocols and blockchains, teams must manage their reward systems properly to avoid costly liabilities and protect early liquidity providers. Lido DAO’s responsibilities should also be transparent, clarifying its role as a liquidity provider of last resort and managing user expectations, as Jacob Blish, Lido’s Head of Business Development, highlighted. The team must also establish publicly available principles in order to allocate resources appropriately. Ultimately, a data-driven, transparent, and strategic approach is vital for ensuring long-term sustainability and success in any DAO.