Solving Negative APYs for LPs in P2Pool

Prerequisite propositions

1. For derivatives trading in Defi, P2Pool model is how liquidity is decentralized and communitized, and is the de facto best solution for insufficient trading depth and liquidity (which CEXs have often had to provide themselves)
2. In the P2Pool model, LPs’ presence is paramount since they provide the liquidity. Therefore, the usability of the platform depends on how incentivized LPs are to provide liquidity.
3. In the P2Pool model, traders bet against LPs (pool) and LPs set orders against traders passively. The passive nature of LPs’ orders carries with it risks for LPs, especially during times of market volatility.
4. In a model in which the role of LPs is essentially paramount, a project cannot be sustainable in the long term if the incentive structure for LPs gives positive yields in the long run.

Problem Statement

In many derivatives trading platforms in the Defi space, because LPs sometimes have negative APYs, the only (and short-term) incentive for their continued liquidity provision is the platform token rewards that compensate their loss in addition to the premiums they get paid from trades.

But at the moment, the tokenomics of many of these platform tokens is still in development, and in the fast-moving space of Defi, LPs cannot anticipate certainties on the sustainability of these token models. The incentive is therefore short-term.

Solution proposals are needed.

Solution Proposals

Several solutions are plausible in the current P2Pool setting. They come from different angles and involve different actions. We’ll start with the basic ones and move to the more innovative ones (open for discussion).

1. LP-side risk hedging: risk is an inherent part of Defi — smart contract risk, IL, & APY instabilities just to name a few. Risk is probably also the reason why Defi can be exciting, but it means that Defi-ers need to be relatively more educated in risk-hedging compared to centralized finance. IL and negative APYs, over the past few months, have made traders & LPs realize that hedging is a must for sustainable Defi participation. Many have started to offset in one platform when they have provided liquidity in another. One downside of this Defi-specific phenomenon is it raises the entry bar for the mainstream to get in. So protocol or product-level solutions will be inevitable for Defi to become mainstream.
2. Tokenomic solution: token rewards such as UNI and HEGIC have been one way to (further) compensate LPs, especially important during times of negative APYs in certain derivatives trading platforms. However, as AC once pointed out, this state of retail farming of platform (sometimes governance) tokens is unsustainable/unhealthy for the Defi space. Overall, the role of tokenomics in Defi is to complement the existing incentive mechanisms, not to replace it. So far, tokenomic solutions such as burn/lock claims have proven to be yield moderate results. But still, the primary solution should come from the product design side.
3. Pool-side risk hedging: this has been proposed and discussed in certain discord groups so it is briefly mentioned here. But it is only tangentially related to the APY problem, though much more meaningful in the larger Defi context. It primarily aims to prevent pool meltdown during times of extreme market volatility and liquidity drainage. The solution will come from the product/protocol level.
4. Instrument solution: this is probably the most interesting, and the least explored solution in the Defi space so far — solving the problem with the product type for market fit. I’ll elaborate below.

The fundamentals of the current stage of Defi is as followed:

1. The risk profile is recognized and being taken seriously by all participants, so risk-hedging will be the norm.
2. Risk-aware users are still profiting despite the risk bc of their risk knowledge
3. The Defi space is laying the groundwork of infrastructure and service diversity parallel to centralized finance. AMM-spot trading; and rising stars are perps, swaps, and options. The newcomers carry more risks, as in traditional finance.
4. Conclusion: the downside doesn’t inhibit Defi growth and trader/LP participation as long as risk awareness of the community continues to grow. Upsides will remain to be the feature of attraction for new products coming up, as in traditional finance, bc risk-hedging is assumed.
5. The next step: the next step for Defi therefore is to build up its diversity in instruments and services to match up and exceed the centralized finance world, to develop further mechanisms that involve new types of users (traders, LPs, liquidators, keepers, etc.), and at the same type developing risk-hedging solutions.

Having recognized these realities, what constitutes a plausible instrument solution becomes clear. To increase LP upsides, higher leverage for possible higher returns (given risk-hedging) is one essential element. Lowering the entry bar for more users from CEX to come into Defi is also important. This is an important product-market fit issue that Defi is still grappling with in terms of attracting mainstream crypto users. Options are good, but they are relatively more complicated than e.g. futures, which Synthetix is still developing but FTX has had much success with. So for the instrument-side solutions, perpetual futures and Contracts for Difference trading would be the next step for Defi — they both fill the gap in instrument diversity in Defi and the user-friendliness that Defi currently lacks. And by solving the user-side considerations, LP upsides are also made possible.

(More people are familiar with perp futures than with CFDs. You can basically understand CFDs as futures on steroids. For more details, see here.)

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