Maximizing LP Token Incentives
The liquidity providers (LPs) in a pool can generally receive basic token incentives in two parts:
- Trading fee from users who wish to perform swaps; and/or
- Additional reward from the third-party interest-earning protocols (such as Compound/AAVE).
However, the drawback of supporting the rewards from the third-party interest-earning protocol is that significant gas is incurred by moving the tokens to/from the protocols. To address such concerns, Curve.fi offers the pools for liquidity providers (LPs) with and without participation in third-party interest-earning protocols at the cost of lower liquidity.
Smoothy addresses the concerns by using a dynamic cash reserve (DCR) algorithm. The basic idea is that Smoothy will reserve about 10% of the token as cash in the pool and deposit the rest 90% into the third-party interest-earning protocols. If a swap results in
- The cash reserve is greater than 20%; or
- There is insufficient cash reserve to complete the swap
Smoothy will perform a rebalance so that
- If the cash reserve is greater than 20% of the token, 10% will be retained as cash, and the rest of the cash reserve is deposited into the underlying protocol to earn interest; or
- If the cash reserve is insufficient to complete the swap, extra tokens are withdrawn from the underlying protocol so that 10% of the token becomes reserved cash after the swap.
As a result, if as long as the swap does not trigger a rebalance event, the gas cost of the swap can be extremely low by moving reserved cash owned by Smoothy and bypassing gas costly withdrawal/deposit operations of underlying protocols.
By putting 90% (expected) of the tokens into the third-party interest-earning protocol, the LPs of Smoothy can maximize their token incentives by
- Trading fee (including swap fee/penalty fee); and
- Interest earned from the third-party protocols; and
- Penalty fee incurred by slippage.