The Importance of POL
“POL” stands for “Protocol owned Liquidity”
What is Liquidity and why is it important?
In the off chain world most trades are matched through an orderbook system. Market orders move the price and the amount and the size of limit orders, set in the order book, decide how far the price is moved. In the DeFi world, things are a bit different. Here, so-called AMMs (Automated Market Makers) are used. Decentralized exchanges like Uniswap or Sushiswap created on-chain Liquidity Pools (LPs), which are smart contracts with two paired assets in them, for example KLIMA and USDC (to learn more about AMMs, here is a good video about it). The bigger the pool, the better, trades can be facilitated: this reduces the volatility in the price; reduces the possible slippage (difference between requested and actual trade price) and makes large trades feasible. This is why protocols will want to have a large liquidity pool for their tokens. In the case of KlimaDAO, that would mainly be the KLIMA token and all the other carbon tokens held in KlimaDAO’s treasury. KlimaDAO aims to create a liquid on-chain market for carbon assets, so large LP’s are needed for KLIMA and the Carbon Tokens which are used to back it.
Who owns the liquidity?
In “DeFi 1.0” providing liquidity was mainly incentivised by rewards of the native tokens of the protocol so you would get extra tokens X when you would provide liquidity in the X/USDC Pool. Liquidity was therefore owned by individual users who were looking to “farm” the incentive rewards. This brought a few problems with it:
- 1.Temporary liquidity: The liquidity is mercenary, once the rewards leave, so does the liquidity. You've provided liquidity for the short term.
- 2.Lack of security: The liquidity is owned by users and not by the protocol, they are free to exit at any time. This means during times of turmoil, liquidity providers will leave in order not to suffer impermanent loss, when the protocol needs it the most.
- 3.Constant selling pressure: Since rewards are paid to the LP, they sell these rewards either to LP more, causing more emissions, or to another asset, causing constant selling pressure to the token.
In “DeFi 2.0” protocols introduced new techniques by which the liquidity is owned by the protocol instead of individual users. This means that the protocol has a guaranteed amount of liquidity available at all times. This also reduces the cost for the protocol of the long term availability of liquidity. In “DeFi 1.0” rewards have to be constantly paid out to Liquidity Providers just to hold the liquidity. In “DeFi 2.0” the protocol purchases the Liquidity only once via bonding and is able to hold on to it forever from then on. KlimaDAO owns the vast majority of its liquidity and can guarantee a stable trading experience for the users.