Beyond Rewards: Incentives as Core Infrastructure in Modern DeFi

Transcript

1 2 Okay, perfect. Thank you. Um so yeah, my name is Pablo. I'm a co-founder of uh Merkle. Merkle, we are uh an incentive management and distribution platform. Um we work with uh chains, protocols, DAOs uh on their uh on-chain incentive program. Uh so if you are like uh if you have money deposited on Aave, on Morpho, Uniswap, you may have earned rewards uh distributed by uh Merkle. Um Oh sorry.

Um So today I want to uh explore the topic of uh incentives uh in DeFi, uh see uh where we've like where we're coming from and how this like the state of incentives and rewards have evolved over the last like few years. Um so why are incentives important? Uh imagine you're launching a a protocol, a chain uh in DeFi. Uh no one will use it unless other people use it. Uh and incentives uh are like traditionally here uh to uh kind of overcome this chicken and egg problem uh and bring like the critical mass of users.

Um So how did this all like started? Um Incentives uh started like around like 2019 and 2020 uh with Synthetix and Compound. This is what like the launch of Compound liquidity mining program is what made uh like is what kickstarted uh like the the DeFi summer in 2020. Um it showed that um back at the time like uh you know, you could really scale a protocol through like a well-calibrated incentive program. Uh at the time uh it was all about like staking uh in contract. Uh it was about uh building protocols with smart contracts specifically

for incentive distribution. There were some structural problem even though you know like it were clearly like Compound went in the matter of months from 1 billion in TVL to more than 15 billion just with its incentive program. And then everyone followed subsequently. You know, SushiSwap launching launching as well like doing the the vampire attack against Uniswap through the use of incentives. But at the time back in 2020 2021 you know, you had to stake in contract. So like the UX was not really good. You had to approve several time in order to like stake your tokens to be eligible to rewards.

The incentive infrastructure was also like not super composable. I don't know if like any of you have built integrations around Compound or Aave in 2020. You had to design your smart contract specifically around the fact that you could receive some Compound rewards or some Aave rewards. And there was also something where like the incentives were like kind of too general because everyone wanted to do fully on chain fully decentralized incentives. You could not account for some of the specificities of of some of some protocols. So typically if you were farming on Aave, it was easy to loop on the incentives like provide a collateral borrow another asset fold back again. So it was super

easy for advanced mercenary LPs to take advantage of it at the expense of the protocols which were spending tokens to acquire TVL. And there was a whole ecosystem like kind of there was a composability tax kind of with whole protocols billions in audits. I mean hundreds of millions in audits spent just to optimize the farming of of incentives. So the UX was kind of bloated at the time though it worked. Things move forward and there are several like um elements that helped shape the industry of rewards uh and incentives how it is today um in DeFi.

So, Uniswap V3 uh in 2021, um it broke the assumption that uh you had to stake your liquidity somewhere to be eligible to reward uh because Uniswap V3 positions are NFTs. There was no easy mechanism to reward Uniswap V3 holders, and this is what led to the emergence of the first like auction systems tracking the state of Uniswap positions to then distribute rewards to Merkle, and this is how we started by the way with a with Merkle. Um Aave launched uh in 2023 uh a system called uh Merit.

Uh it broke the assumption that incentive system had to be the same for all on-chain users. So, the Aave Merit system was like an auction system, and they regularly airdropped uh rewards. Um But, like the they had some stuff where they wanted to penalize users of this protocol, and they made something which was really like tailored to their needs. And this is how like through this system that they kind of killed the Morpho optimizers, which was like taking TVL from them. Uh and by having something super flexible and caliber to their needs, uh like it what like it I mean, I don't know if it's a a cause or a just a correlation, but at least uh when they launched this program, it's at this point where they really took

over on the on the lending space. Um Morpho showed that um Morpho is kind of a complex protocol. I mean, it's simple and complex. Uh and they were the first ones to do what we call forwarding. Uh and it broke uh the assumption that um you know, you had to hold the underlying token when you are farming something in DeFi to be eligible to reward. You know, on Morpho, there can be like a vault deposit depositing in a lending market, uh and the lending market is incentivized, and so you may earn rewards directly from a vault. Yeah, by depositing in a vault even though you're not directly interacting with the underlying lending market. And they were the first ones to do this. We did this as well with Merkle with liquidity management solutions on

top of Uniswap. Uh and this opened something like whole like new area of incentives that is today used by like the majority of of stablecoin protocols. Uh and stablecoin issuers. Um of course over the past few years we've seen the emergence of points uh Ethina um EigenLayer they showed that you didn't have if you wanted to achieve growth to distribute a liquid token. Uh I mean some people got wrecked farming points that ended up being worthless. Uh but these were really really good examples of yeah the liquid token the on-chain assumptions is not like really something you have to do uh if you want to be to be successful.

Um since 2021 we've seen the emergence of many new chains as well. Um L2s. Um and before like in the early days of these new chains there were there was like uh this trend of giving grants to protocol you know like the Optimism Foundation would give grants to protocol for the protocols to then use their incentives or for like projects to grow on the chain to kind of establish their ecosystem. Um It was not the most successful model turned out uh because many chains um like notably thanks to Merkle but also other tools uh I mean more and more chains are opting for were directly creating the incentive campaigns on top of the protocols.

Uh so rather than I give you money for you to give money to your users I directly give money to your users for them to use your product. Uh and most chains do this nowadays. Uh it's like it's a bit counterintuitive but there is like less uh coordination with the protocols uh and it enables you to be more much more opinionated as a chain in in of what you're uh incentivizing. So, like to link that far better thanks notably to this like five forcing functions, but there is one thing that didn't change is the fact that incentives rewards never replace the product market fit. Why were Ave Morpho earlier incentive programs super efficient? It's because it's protocols that had a true market

fit that had real users and that were able to reduce their incentives rate like they were able to overcome the chicken and egg problem and have a product that was truly sustainable to use at scale. And if you're a chain you're launching a chain, incentives they may help to buy time, but what really matters is differentiation and as it stands except for maybe hyper liquid there are very few chains which have this true like market fit and which have like big like a captive TVL within within the chain.

Um So, like things evolved and now you know like the incentives before it used to be chains protocols. Now the interesting thing that we're noticing is that DeFi is becoming institutional. So, there are many stablecoins that are launching Ripple, PayPal and even the old ones like the Circle, Tether. It becomes important for them to have a growth strategy on chain because it's a competitive market. Of course there is clarity, there is genius that prevents them from directly giving incentives to their users, but also like if if you're a neo bank you know you're a Robinhood you're launching an on chain activity, you want to be able to boost a kind of

your like user base at at some point. You want to attract more users towards your product. Coinbase, Revolut is I guess going to come on chain. So, all these players and so incentives are key for them. Now I want to walk you through kind of what the state of the art is at the moment in terms of incentives. First thing is like to link if you compare it from 2021 got far far more complex and advanced. But at the same time there is a like a tension between complexity and attracting real users. The more complex the incentive system you design like I only want to reward users who have like less than 10 million in TVL with some exponential behavior and some thresholds for them to acquire

more rewards and so on based on how long they've been in in my protocol in my in my fintech using my product. Like the more you are exposing yourself to mercenary LPs. Mercenary LPs are the ones that have the the time to max extract to max extract the rewards and it's kind of an adversarial behavior if you're if you're trying to grow something. And like so at the same time you want to have something that is customized and flexible adapted to your use case, but you also want to attract real users who don't have time to go everyday checking your dashboard and and know what to do if they want to optimize like their their their earnings from an incentive campaign.

So and this like this applies to chains, protocols stablecoins fintechs everyone that's washing incentives and the volume that is concerned by this is like several billions of a year in in money distributed to attract users, activity, LPs and so on. When you are doing an incentive campaign, your first goal is to like minimize the APR that you're paying to your users. You want to to attract as much liquidity as possible for the smallest amount of reward that that you spend.

How can you achieve this? Many people do capped APRs campaign in the sense that they're like I'm not going to pay you more than 5%, 3% like customizable threshold to attract liquidity. Incentives now are far more protocol aware. Like if you're going to farm on Ave, Ave has all these systems where okay, if you are folding on the incentives, if you are borrowing USDC to kind of increase your exposure to the asset that's being incentivized, you will be penalized. It was not the case back in 2022 and now with the advance of like more complex incentive systems, this is now possible.

Um we live in a question like in a multi-chain world. Users are not specifically bound to a chain. You are a stable coin, you do not care about the growth of your stable coin on I don't know linear or Ethereum, you care about the growth of your stable coin in general. And so people tend to do more and more and cross-chain protocols that are aware of all the chains on which activity can be tracked. When you know, before people had to do opinionated choices about okay, I want to focus specially on Arbitrum. Um now like should no longer be a be a be a problem.

And the goal to obviously once you've acquired TVL, once you you've managed to get some users for without paying for too much is to kind of retain them. Um the best retention aspect is do something simple. If you manage to attract real organic users and again like you need a market fit in the end like incentives will never replace a market fit. Um you you need to go and reward them where they are without having to assume that they'll they'll do like hundreds of different actions to to get the rewards.

So this forwarding feature is something that is like tapped into by the the most advanced incentives. So let me give you an example. You are like Circle, you want to reward like let's say this is not possible legally but technically this could be done. I mean legally technically Circle could reward all USDC lenders across all lending protocols because these are people that are taking risks and so on. So, this fits within the clarity framework in the US. And so, um Circle could do a campaign where, "Okay, I'm going to reward all USDC lenders on Aave, Morpho, Euler, and I'm not going to do to force them to do anything specific to move their liquidity to be

eligible to reward." This is what we call forwarding. This is what we call smart contract-aware incentives where Circle could do something where automatically they would detect every user that's on Aave, Morpho Euler anything. And this is the best because LPs like they can they can put themselves in a set and forget type of of mindset. Um For like retention maximization, we see many fintechs as well doing incentive programs specifically tailored to the type of product they want to promote. So, with Merkle, we work with Coinbase.

Coinbase, they are launching like they launched a Coinbase Earn product, and they want to promote this product within users of their wallet, so within their all the like niche of product. And they are doing campaigns to reward only like the users of Coinbase Earn that use a given like the Coinbase the Coinbase smart wallet. And we see these like ecosystem-specific activations as kind of the most efficient for for retention. Um So, and again, there is always this tension between over-optimizing over-optimizing like and over-complicating and attracting the real users in the end.

So, where is this all going? You know, I mentioned the fact that it's going to become even more prevalent with stablecoins, with fintechs all fighting, and we're going like incentives are evolving from the niche of DeFi protocols and chains all fighting for the same of liquidity to having this massive influx of liquidity driven like from money that was sleeping in people's bank account to like sleeping in in vaults on chain. Um what's interesting is that incentives so far have all been like top-down like from protocol chain stablecoin to users.

And we I see it becoming far far more like users kind of dictating how like they want their incentives and kind of it being as a notebook where users post their preferences for liquidity. I mean advanced users and protocols matching to these incentives. Um right now the user experience for incentives is always I claim and the UX is going to become I guess like the one of programmable payments for users. Users will be able to control more and more what to do with the incentives they're receiving.

So typically okay I want the rewards my the rewards I earned to be split between different wallets. I want to I want when I receive dividends from a tokenized stock I want it to be automatically streamed to this account. I want it to be split on the side. And so the rewards and payments primitive programmable payments primitive are slowly going to become the the main like the the same the same the same thing in a way in terms of money being distributed to users whether it is programmable payments or rewards it's it's kind of the same thing.

Um so DeFi goes institutional it's going to become a back-end for FinTechs. Um you'll see you know you often see in the in the in the in the train like these promotions earn 5% of your balances. But the thing is the DeFi experience is is still kind of complex you know when you lend in DeFi the rates are very often variable. A retail user doesn't have to understand that okay if he's pumping so everyone is borrowing USDC to to a leverage up on their ETH. And so the the the lending yield is increasing. Users do not need to be aware about this. And incentives and reward will be kind of the smoother to kind of you know elevate the like the UX constraints

UX frictions you have in a fully D5 world. So typically you could imagine a product built on top of Morpho with its variable rate that kind of offers a 5% rate for end users and we have this like with Fintex it's going to be the same with stable coins you know streaming their net interest margin to their users and for this you need incentives systems and incentives infrastructure to to exist. Many new things also emerging like everything I mentioned like I spoke about stable coins about Fintex this is more for the retail side but markets are also moving on chain and like the world of like with tokenized stocks there will be like dividend distribution

which is kind of will be the big new form of rewards distributed on chain. With markets moving on chain as well you'll see incentive campaigns driven for off hours liquidity and in general like more and more advanced players coming on chain will need more and more advanced tooling in terms of compliance reporting which is like completely diverse from the ethos you have here where like okay I stake liquidity I get rewards now it will no longer be possible in a in an institutional world.

So like incentives you know like everything about this talk was about okay how do we get better at solving the chicken and egg problem. Right now like the main players we have that are going to rely on incentives like we'll have already solved in fact this chicken and egg problem. If you're Revolut you don't need you already have the distribution it's just about using incentives and using rewards to propose a better and simpler UX for your users and this is where I see the market going over the next uh next few years. Um of course, if you can do it off-chain fully on-chain, it's better. There are new standards that are emerging like Tempo, the chain by Strap launched a tip 20 reward standard.

But these um remain still limited for me. So, I think that at least for a good time, uh incentives will like the the winning solution for incentives is really off-chain indexers tracking all the state that's going on chain and posting rewards on chain for users to claim them or for an off-chain system where users do not have to uh get uh their their liquidity because like if you want something flexible enough, you cannot do it with a monolithic uh on-chain system. Thank you uh for your attention. Uh yeah, if you've got any question, I don't know if you've got time for questions. Yeah.

What do you see as the differences between sort of the mercenary farmers who are always looking for the next incentive the person who comes along and sets up a farm and then doesn't go to the next incentive? Have you guys seen what the difference between those two could also be? So, like it's only because like there are some It's not like B2B or B2C, you know, you have retail users which are mercenary. There are companies that are doing this and on the opposite, there are like passive users and passive passive like companies. Uh and it all depends like the the the difference is how much time you have to put for this.

You know, like I tend to be more passive LP and I know that I'm missing out on some opportunities because I don't have the time to like move the money or I don't have the time to do the diligence for what's going on. So, essentially like the the main characteristics of mercenary LPs is that they are smart people who understand the risk mechanics. Uh they don't they don't understand the risk mechanics while like passive users who are not like shifting from one protocol to another, they tend to find more one program, one protocol, one chain that they like, they are comfortable with, and they just stay in there. Um, and the market fit, um, or like the anticipating market fit question is also important because if you are like a passive LP, you also want to have some guarantee on the fact that

yield is going to continue without having to check like every couple of months. And so you have to be like, "Okay, this is Aave, I can put my money here because I know that, you know, even if the incentives vanish, there will still be some yield for me to earn, and I don't have to check every day whether to see whether I'm not missing out on like some extra yield that I can find elsewhere." So is the is the percentage of say more active LPs increasing or decreasing? Uh, I'd say that the the percentage of passive LPs is definitely increasing. Uh, because because of the like FinTechs and so on bringing their big wave of users, uh, you see like, uh, a lot of uninformed players coming on chain through some like, uh,

apps, you know, that make their life easy like Coinbase typically. Uh, and I don't see this trend like, uh, changing. Like we'll see more and more passive users in DeFi. I mean, otherwise we wouldn't be doing what we're doing, right? If it's just about playing between us and doing some DeFi stuff, like what's the point?