Karma Finance is the name of a new decentralized finance (DeFi) protocol coming to the ICON blockchain. Its first service, Karma Bond, is aimed at helping other DeFi protocols more safely bootstrap liquidity. It puts liquidity ownership into the hands of the DeFi protocol instead of liquidity providers (LPs), which means that Karma is a pretty big deal and stands to potentially change how every other DeFi protocol out there on the ICON network operates — or at least gives them more options.
In order to understand what this all means, it’s important to know how liquidity pools actually work. Following is a short explainer for DeFi beginners — DeFi pros, feel free to skip to the next section!
Liquidity Pools 101
Most DeFi protocols allow users to swap funds, lend and borrow assets or otherwise transact funds in some capacity on their respective apps. These kinds of monetary exchanges are easy to perform at a centralized bank, as the bank maintains stockpiles of money — liquidity — that it can use to facilitate these transactions. However, it’s a bit more complicated for decentralized finance protocols, as they lack access to a centralized money vault.
To work around this problem, many DeFi protocols — including ICON’s Omm and Balanced — have bootstrapped liquidity by asking users to provide liquidity to various token pairs known as liquidity pools. As an incentive, LPs collect transaction fees and are rewarded with the protocol’s token at a variable APY (annual percentage yield). For example, one might put US$500 worth of BALN and bnUSD into a liquidity pool on Balanced, and in return Balanced will pay out BALN at a 36.78% APY (according to today’s rates — it changes regularly based on the value of BALN).
The Problem With Liquidity Pools
While the LP model serves its purpose — it is common across the majority of DeFi protocols thus far — it has a number of drawbacks, too.
One of its main disadvantages is that the protocol is essentially renting liquidity, but there isn’t anything stopping LPs from jumping ship whenever they like — and they’re a skittish bunch5, especially when markets are volatile. Liquidity providers are subject to a factor called ‘impermanent loss’, which happens when the LP’s tokens change in price compared to when they were deposited in the pool. The larger the change is, the bigger the loss. To avoid impermanent loss, LPs may decide to pull their assets out of liquidity pools or sell the governance token to offset the loss.
“LPs provide liquidity in these pools and can get heavily hit by impermanent loss, so they normally sell the protocol tokens to offset their losses,” explained @hyper_connect, a team member of Karma developer Protokol7. “An LP is an active participant in the market, but being an LP is very high risk. Impermanent loss is a thing that a lot of people overlook when they see these high APYs in token pools. Providing liquidity to a liquidity pool can be a profitable venture, but you’ll need to keep the concept of impermanent loss in mind.”
The other problem is that constantly offering high APYs may tend to result in a regular decline in value for protocol governance tokens, which could further disincentivize LPs from providing liquidity.
“The value of governance tokens is constantly being diluted due to the inflation mechanism — they end up in the hands of LPs and ultimately get sold on the market. I believe that this is the case for most governance tokens that incentivise LPs through token inflation,” @hyper_connect said.
The Karmic Solution
Karma Bond’s fix to this problem is simple, really: they help DeFi protocols sell their governance tokens in exchange for capital to be used as liquidity on their platform. To streamline this process, Karma is developing a “bond marketplace” where DeFi protocols can list their tokens at a discounted price. Anybody can buy these tokens, but with a short linear vesting period (that’s why it’s called a bond), and the users’ capital is used to add to the liquidity pools of the respective protocol, boosting the liquidity in those pools
Essentially, this lets the DeFi protocol become an LP themselves instead of relying on external LPs. It also means that the protocol can collect fees instead of paying them out to an LP, thereby creating a source of revenue for the protocol that can bolster its growth and (hopefully) drive its token price up.
This is great for investors who want to support the DeFi protocol without taking on any risk of impermanent loss. And because the bonds use smart contracts to lock the capital into the respective protocol treasury, the bond marketplace can be a trustworthy tool that benefits both parties.
The bond marketplace is also great for DeFi protocols to market themselves. And what better way for a business to make themselves known when entering a market than by having a ‘grand opening sale’? By listing their bonds on the Karma Bond Marketplace, newly joined DeFi protocols stand to gain a lot of exposure.
Also important to note is that investors can still provide liquidity as they did before, if the DeFi protocol offers that option. Karma just makes possible a new option that benefits both the DeFi protocols and LPs.
Coming Soon on the ICON Network
Karma Bond is being developed on ICON 2.0 through funding from ICON’s Contribution Proposal System (CPS), and is due to launch soon — by April at the latest. While only ICON DeFi bonds will be available at launch, the team hopes to open it up to other DeFi projects later on.
“We’re very excited for BTP,” @hyper_connect said. “We’re planning on taking part in the BTP fund to apply BTP to Karma, and hopefully attract other protocols onto Karma as well across the different partners such as Binance, Algorand or Harmony One. This could become a thriving marketplace across blockchains.”
Karma Bond is the first of three or four services that will be offered by Karma Finance, an up-and-coming decentralized platform that will provide infrastructure, expertise and exposure to other protocols. They will have a KARMA token powering all of Karma Finance — including Karma Bond — which is expected to have a lot of utility on the platform. The KARMA token will also give voting power for governance of the protocol.
In addition to Karma Bond, Protokol7 is also busy developing Convexus, another CPS-funded DeFi protocol launching this spring. And yes, there will be synergy between Convexus and Karma:
“Convexus will be integrated into Karma Bond and will most likely offer CXS token bonds in the bond marketplace. Also, when the KARMA token goes live, Convexus will be used as one of the decentralized exchanges to trade the KARMA token for other tokens,” @hyper_connect said.
He further stressed, “We’re also very keen to partner with all the other ICON protocols, too.”
For more information about Karma Bond, head on over to their documentation page. You can also get in touch with them on their Twitter or Discord channels.
