The power of incentives
Understanding the broader impact and control incentives have on potential users
Incentives are commonly used to drive TVL and attention to platforms. Over time, these incentives have evolved from yield farming to point systems. At the crux, though, each incentive system within crypto offers the same concept: the platform will eventually pay you for using its platform.
Yield Farming
Yield Farming was the standard form of incentives during the speculative mania of 2021.
The simplest way to understand why yield farming mattered is through liquidity pools:
Liquidity Pool Created (5% APY from trading fees) → Liquidity Pool Seeded with native tokens (5% APY from trading fees + ? APY from native tokens)
Typically, these liquidity pools had APYs ranging from 40% to 5000%. The bulk of these APYs almost always originated from a non-major token, whether that be from the DEX or from the actual token being used in the liquidity pool.
(Incentives drive Narratives) <> (Narratives drive Price) <> (Price drives Incentives)
The sequence is the following:
XYZ dAPP offers liquidity incentives in the form of their native token, $XYZ
Liquidity farmers see XYZ/ETH pool offering 500% APY
Liquidity farmers buy XYZ and ETH to provide liquidity
XYZ price goes up
XYZ liquidity incentives are now worth more than $
Repeat
The issue with the above is that farmers will move to the next pair offering higher APYs when the incentives dry out. This means that the losers (crypto is a zero-sum game) are the protocol believers who did not sell during the liquidity rise and subsequent price fall (from token dilution) and the farmers who were late to farming. Yield farming is mainly comprised of mercenary farmers, so the liquidity is not sticky.
Yield Farming → Points
Points are a version of yield farming that provides users with less information about their expected yields (that is if the points even translate to tokens). In many ways, point systems are anti-crypto. But much of what goes on in the crypto world today is against the original crypto ethos.
With yield farming, farmers knew the expected APY they were receiving and could typically sell tokens as soon as they farmed them. With point systems, all farmers know is the amount of points they receive.
From a dAPP perspective, point systems are superior to yield farming for the following reasons:
The mystery surrounding airdrop details creates hype; people are naturally optimistic, and TVL will be higher. This is similar to the idea that in terms of price appreciation, the optimal fee switch is the switch that always exists but is never turned on.
With higher TVL and better metrics, raising at a higher valuation is plausible.
Ability to do tiered release to allow smaller players a fair chance at receiving tokens
Don't have to initially allocate a significant amount of tokens to yield farming to garner TVL1
Real data supports these ideas. In Solana lending dAPPs, projects like MarginFI and Kamino with points programs attracted more TVL than their competition, Solend, who has an established token and an arguably better set of contracts and features.
Points are a gamified version of incentives.
When the eigenlayer caps were hit, the only way to restake was through native restaking pods. This wasn't viable for the majority of people, so what happened? Protocols started releasing LRTs, a form of an LST that restakes through Eigenlayer. These skyrocketed in TVL: the ability to farm native ETH yield, LRT points, and Eigenlayer points was incredibly valuable. At the time of writing, 2.70M ETH is staked through LRTs.
The growth is parabolic:
Source: Hashed Official Dune
It's important to understand that Ethereum staking was not built to be a black hole for raw ether. This is why core researchers and developers are moving the validator size to 320E and proposing issuance changes to dissuade stakers.
However, aside from that, the influx of ETH staked to farm Eigenlayer poses a series of issues related to liquidity, pegs, and leverage.
LRTs do not have optimal liquidity relative to the number of ETH staked.
Because there is no optimal liquidity, LRT pegs are in danger. I wrote about this danger in 2022 with stETH here. Liquidity is essential here because what goes up must eventually go down. People will sell eventually, and the time restrictions on withdrawing native ETH from eigenlayer pods + beacon queue could take weeks up to months to withdraw, taking into account the limits on withdrawals from the beacon queue. These LRTs can and will trade severely below peg for sustained periods once the EigenLayer point system is over. LRT pricing is capped at a 1:1 peg because the ability to mint new LRTs always exists. For the peg to remain stable (.999 and up), the demand must always equal the supply willing to sell. With proper incentives set up, this is not an issue. However, with the incentives gone, the supply > demand and price trends lower than the peg.
There is a lot of leverage within the Eigenlayer and restaking ecosystem. Services like Gearbox offer relatively cheap borrow rates for ETH and the usage of LRTs as collateral. This creates a looping effect that, when unwound, either intentionally or through liquidations, can have a massive impact on the stability of LRT pricing.
The point? Users know the risks. The incentives to take on the risks to farm these points (which should turn into monetary value) outweigh the potential loss or time they will need to wait to regain their principal value.
Incentives alleviating fees
The upside from point systems is that they can counteract incredibly high platform fees. A golden example of this is the socialfi platform Friendtech.
Friendtech charges a 10% tax on each sell and buy, with half going to the creator (incentivizing them to promote FT) and half to the platform developers.
In traditional markets, this would never be accepted because a roundtrip 20% total fee on a position makes it very difficult to turn a profit. However, FT offered a point system to people who traded shares to create a cloud around their fee system.
People are generally willing to pay higher interest rates on borrowed assets, accept lower rates on deposited assets, and pay higher fees on trades because they believe the points generated will return a higher rate than the fee itself.
In a bull market, this typically works well because of inflated valuations.
Incentives as a trap tool
From a user perspective, staying wary of the protocols interacted with is essential, regardless of their incentive systems. Not all points are worth more than the fees users pay to earn them, and many protocols actively' farm' users with point systems to continue generating substantial rake fees.
From a protocol perspective, doing this is essentially 'free' money because point systems will allow them to generate high TVL while charging high fees.
A protocol that has been accused of this is MarginFI.
Stay cautious and understand the risks associated with utilizing incentives to counteract high fees and take on additional contract risk.
Sustainability
Incentives can be a tool for protocols that foster rapid, high-scale adoption. For users, they can generate substantial returns from farming. However, the concept is mainly unsustainable, as trading is a zero-sum game.
Point program attract high TVL, but eventually the points need to transition into something material. This is usually in the form of the native token, but native tokens have a fixed supply.
The point is that incentives need to continue turning into $$$ (which is impractical), or the TVL will flow into other protocols with higher incentives.
With plenty of protocols launching tokens this cycle, we haven't seen harmful TVL migration. The protocols that do launch mostly run multiple seasons of token incentives to bribe TVL to remain.
Eventually, this will stop, and it will be interesting to see, in a land of few incentives, the team and protocols that have built the best protocols to attract TVL.
Conclusion
In today's cycle, incentives are a must to garner attention.
In reality, point systems are antithetical to the original crypto ethos. Alas, they are still, for the most part, 'free' money (outside of contract risk and assuming due diligence).
Does everyone wish point systems were more transparent? Yes. However, some of the fun in farming point systems is not knowing how much they will be worth. Crypto was supposed to be fun, after all.
While there is no system bounding a project to reward people with points, narrative drives price, and the narrative can only be created by giving people tokens. Projects that screw over early participants rarely see high valuations.