EDIT: As suggested I have added a 0.01% fee pool as well. Expected on chain date is 1.24.24
As has been demonstrated by the establishment of the lower fee variants of the “classic” pairs (ATOM, ETH, USDC), traders will vastly prefer the lower fee options and send most volume through them. It stands to reason that a pool with an even lower fee would attract even more volume. However, on the surface, it would appear that liquidity providers who supply to this pool would be guaranteed a loss.
Why would Osmosis want to provide incentives to a pool that will never be able to “sustain” itself through swap fees?
Consider the currently incentivized “high fee” 0.2% ATOM/OSMO LPs, pools 1 and 1135. Combined, their nominal swap fee return is usually somewhere around 2% - not enough to beat token inflation, by a long shot. Given the existence of a lower fee option to pull volume, there is no feasible way that this pool can become sustainable through swap fees. Yet, these pools continue to receive OSMO incentives. The nominal incentives returns are a bit higher than the swap fees, but even taking into account superfluid staking, the total theoretical return is only marginally higher than staking the assets separately. When considering losses that a liquidity provider will incur due to transaction fees, swap fees, taker fees, and impermanent loss, it is a reasonable assumption that many or most providers in these pools will break even or incur net losses.
What is the purpose of incentives?
The narrative around Osmosis incentives has historically revolved around bootstrapping or maintaining liquidity. The core of the idea as I understand it is that providing a certain level of incentivized return for a certain amount of time will create a base of liquidity that will allow for a high amount of swap volume and for the pool to remain sticky after the incentives are reduced or removed. I believe that this system has achieved partial success. A great deal of sticky liquidity has seemingly been achieved, however its quality and the stickiness of the volume itself leaves something to be desired. I would posit that the ongoing application of Osmosis incentives has exactly led to a situation as described above. The logical result is a large amount of inefficient passive liquidity being allocated appreciable incentives but offering practically no return. This situation is highly inefficient and likely to incur losses for both the LPs and for Osmosis.
How can we do it better?
0% swap fee LPs may be the way to fix this. But it’s not magic. This unexpected opportunity arises from Osmosis’s unique taker fee implementation The LP logic of the dex has been disrupted. Taken at face value, the taker fee could be considered hostile to LPs. Osmosis itself is beginning to derive much more return from trading than do the liquidity providers as volume inevitably moves to lower fee pools, redistributing an increased amount of revenue from LPs to the protocol. This is exacerbated by the shift to concentrated liquidity which necessitates that providers actively manage their position to maximize return, thus potentially incurring a large amount of taker fees themselves.
This is an environment that perpetuates the need for direct incentives in order for LPs to be sustainable. However, this doesn’t mean that incentive provision has to be unsustainable for the protocol. The final piece of the puzzle is volume splitting gauges. Because incentives can be distributed across multiple pools of the same asset pair strictly on “merit”, there is 0 upfront cost to the protocol to implement incentives to a 0% fee LP. Over time a balance can be struck between the incentives expenditure and incomes. Remember that currently 100% of incentives come from OSMO inflation, but as inflation decreases and taker fee revenue increases, this spending can be augmented or supplanted by taker fee return, eventually creating a self sustaining system. It is my view that the narrative around this system would essentially shift from bootstrapping liquidity to paying LPs to produce volume as efficiently as possible (by offering the best price with the lowest fees).
In tandem with my other pending proposal on taker fees, I think that we have a good start at reimagining the relationship between Osmosis and its liquidity providers, in a mutually beneficial way.
