Let me start by saying that I think that Aqua is a great idea. However, when I watched the launch video I was immediately concerned with the sell side pressure that is bound to occur when LP providers receive Aqua tokens for their contribution to the liquidity pool. The question is, how do we incentivize LP providers to hold Aqua instead of instantly converting to a different token? And how do we ensure that the Aqua token has a measurable value?
My proposal would be to create a price floor by introducing a Fee Pool Native Asset Value (FP-NAV).
For the remainder of this post LP will refer to the liquidity pool and FP too the Fee Pool, which contains all generated fees in the Aqua protocol from liquidity mining.
Native Asset Value
The NAV of Aqua is simple, it is defined as (Total Fee Pool Value)/(Aqua circulating supply). Total Fee Pool Value is simply the dollar equivalent of all assets in the FP (Oracles might be required here).
In the following example lets assume the following:
- There is a circulating supply of 1000 Aqua
- The FP contains 1 Eth worth 1000$, the value of Eth is fixed for simplicity
- This would naturally result in a NAV of $1
So how does this translate to a price floor?
The trick is to add a smart contract to the protocol that allows Aqua holders to immediately liquidate a proportional amount of the FP.
- Abby wants to liquidate 100 Aqua using the smart contract
- 0.1 Eth (minus fees) is transferred to Abby and 100 Aqua is burned
- The remaining FP value is $900 and there are 900 aqua in circulation
- The NAV remains at $1
- There is a substantial amount of assets in the Aqua LP that are generating fees for the FP
- No new liquidity is added and no aqua is burned through the smart contract.
- Over time more $100 worth of fees are collected and the FP is now worth $1000 again.
- The circulating supply of Aqua is still 900 so the NAV becomes 1000$/900 = 1.11$
Naturally, the price of the Aqua token appreciates due to the increased value of the FP.
- Carol provides additional liquidity to Aqua which over time generates another $100 worth of fees without impermanent loss.
- 100/1.1111 = 90 Aqua is minted and distributed to carol. The total circulating supply is now 990 Aqua and the FP contains $1100 worth of assets.
- The NAV remains at $1.1111
- Dave provides additional liquidity to Aqua which over time generates another $100 worth of fees with an impermanent loss at a value of $25.
- To ensure dave’s impermanent loss is covered he still recieves 100/1.111 = 90 Aqua however the impermanent loss has to be covered by the FP.
- The new NAV decreases due to the impermanent loss coverage and is now $1080/1175 = $1.0879
The crux to this model is that the generated fees have to be greater than the reimbursed impermanent loss of course.
Spot market premium
Due to the promise of future increasing NAV, the price of the aqua token could be higher than the NAV, this is called the premium. However, if the price decreases below the NAV, arbitrage traders can use the smart contract to even out the NAV price. The liquidation smart contract should only work one way so that the premium is a bonus for Aqua holders should they want to sell.
- If the covered impermanent loss is greater than the generated fees for a sustained time period the protocol will fail. Other defi protocols have different solutions to impermanent loss (e.g. Bancor V2 adjust their weights automatically based on the external prices coming from price oracles), these solutions could be used for Aqua as well. The protocol can also implement a cap to the amount of impermanent loss that is covered to ensure that the Aqua FP never is drained.
- There has to be a decently sized starting capital in the FP otherwise the NAV could go below zero.
By holding Aqua, investors are essentially getting the benefits of providing liquidity without actually locking up funds. So what is the incentive for liquidity providers if they can simply hold Aqua? The answer is obviously a higher ROI since they don’t suffer impermanent loss.
Hopefully some of you like this idea, I literally haven’t been able to sleep the last two nights because I was thinking about Aqua , let me know what you think.