Understanding Method Finance

The first in a series of educational articles about how the Method NFT vault solves many of today’s issues with liquidity mining.

As we democratize access to financial systems, we believe a core component of that is sharing our knowledge with anyone willing to learn. Our passion is not just about building great technology, but educating the current and prospective members of our community about how it can be leveraged and its impact. The start of our educational series will be to publish a post breaking down the fundamentals behind our project.

We’ll start by breaking down some of the foundational pieces that Method Finance is built upon (along with some helpful links) and then finish by directly diving into how Method Finance is implemented. By sharing this article you can help continue our mission to build for the next wave of DeFi and ensure the entire crypto ecosystem has safer, more secure assets.

The Foundations

If you’re reading this article our assumption is that you have a solid understanding of core topics such as Crypto, Ethereum, DeFi, etc. These topics are prerequisites before diving into Method Finance.

Let’s start to outline some of the more specific topics related to Method Finance. There are a few in particular that will be important to understand, these include: Non-Fungible Tokens (NFTs), Liquidity Pools and Liquidity Mining.

Non-fungible tokens (NFTs)

Chances are you’ve probably heard the phrase Non-fungible tokens or “NFTs” tossed around. What’s been one of the more interesting aspects of this trend, is that many of the people talking about NFTs have limited working knowledge of Ethereum. As a result, most people have overlooked the technicalities of NFTs and focused instead on the high-level concept of rare digital art. We’re going to take a deeper look under the hood for NFTs.

If you look at popular tokens on Ethereum (DAI, UNI, etc) most are built using the ERC-20 standard. This standard supports the creation of tokens that are fungible (i.e. indistinguishable from others). For the majority of use-cases, this standard works just fine.

However, there is also a standard for creating non-fungible tokens known as the ERC-721 standard (there’s also a standard called ERC-1155 which supports both token types). So what are some of the benefits that could come with having an ERC-721 or Non-fungible token?

• Unique: Each NFT has a different set of properties which can be stored in the token’s metadata.
• Verifiable: Every NFT has historical ownership data which is stored on the blockchain. This allows for quick and easy authentication and for building a reputation profile
• Easily transferable: If an NFT owner wants to transfer ownership, they can easily do that while still retaining all of the unique properties and historical data associated with it.

Keep these benefits in mind as they will be valuable for later on when we discuss the different use cases these features of NFTs unlock for Method Finance.

Liquidity Pools

The next key topic is that of liquidity pools. Before defining what these are, it’s important to understand why they exist in DeFi. If you look at most centralized exchanges (including Coinbase and Binance) you’ll see that they all operate on the order book model.

In an order book model, buyers (bidders) and sellers come together to place their orders. For these trades to actually happen, the buyers and sellers need to meet on price. But what would happen if there was no one willing to meet at their price?

This problem is typically handled by market makers. Market makers facilitate trading by always being willing to buy or sell an asset, which helps provide liquidity to the market so that users can trade and don’t have to wait for another counter-party.

In DeFi, the order book model does not make sense because it would be slow, expensive and a poor user experience. To be more specific, the implementation of market makers isn’t feasible on Ethereum since market makers track the current price of an asset by constantly changing prices, which results in a huge number of orders and cancelations. This would add up to exorbitant gas fees and limited transaction volume.

To fix this problem in DeFi, liquidity pools were created. Liquidity pools work by holding 2 (or sometimes more) tokens to create a new market for those tokens. When a new pool is created, the 1st Liquidity Provider (LP) sets the initial price for the assets in the pool, and the LP is incentivized to supply an equal value of both tokens, so they don’t risk losing capital via arbitrage.

Each time the liquidity pool facilitates a token swap, it results in a price adjustment amongst the tokens. This price adjustment is facilitated via a deterministic algorithm that goes by the name of an Automated Market Maker (AMM). Each protocol can use their own version of an AMM, but we’ll take Uniswap as an example. Uniswap uses the following constant product market maker algorithm:

x * y = k

Where x is the quantity of one token in the liquidity pool, y is the quantity of the other token and k is a constant. Since k is a fixed constant, the pool’s total liquidity always has to remain the same. This means that the liquidity pool can always provide liquidity no matter how large a trade is. A big reason for this is that the algorithm will asymptotically increase the price of a given token as the desired quantity increases.

Lastly, it’s important to realize that the ratio of the tokens is what ultimately dictates the price. For instance, if you have a liquidity pool with an equal supply of DAI and ETH, then taking ETH out of the pool will naturally increase the price of ETH and decrease the price of DAI. The bigger the pool, the lesser the price impact (and resulting slippage) from each trade. This is why many protocols seek to create larger pools via incentives to liquidity providers.

Liquidity Mining

We now understand what liquidity pools are and why they are valuable in DeFi, however there is still one open question we haven’t answered, which is why would someone want to be a Liquidity Provider for a pool in the first place?

The short answer to this question is Liquidity Provider Tokens or simply LP Tokens. When a liquidity provider deposits tokens into a liquidity pool, the platform generates new ERC-20 tokens that represent the share of the liquidity pool that the depositor owns.

LP tokens unlock a variety of different functions, including dictating the % of transaction fees that should be allocated to each user depending on the amount of LP tokens they hold. However, these transaction fees alone are usually not enough to incentivize LPs. To provide further incentives, many protocols offer their own native token as a reward.

This brings us to the activity of liquidity mining. Liquidity mining is the activity of taking LP tokens generated from depositing a pair of assets in a liquidity pool, and then depositing those LP tokens into a protocol’s staking contract to earn the rewards, often computed in terms of an APY.

The activity of liquidity mining speaks to one of the core value props of LP tokens, which is that they provide greater liquidity to the overall ecosystem. Without them, all assets that a liquidity provider staked would be inaccessible for other DeFi activities during their period of use. But with LP tokens, Liquidity Providers can continue to leverage their assets through activities like liquidity mining.

How Method Finance Works

So now that we have a solid foundation, let’s break down how all of these topics are brought together into an elegant solution by Method Finance. But first, we need to walk through how liquidity mining normally works.

Normal Liquidity Mining

with Vitalik Buterin and SushiSwap

Step 1: Vitalik becomes a liquidity provider by depositing (locking) Token A and Token B into a SushiSwap liquidity pool.

Step 2: Vitalik is then allocated LP tokens from the SushiSwap pool, which represent his share of liquidity provided to the pool.

Step 3: Vitalik then takes his LP tokens and deposits them into a SushiSwap staking contract.

Step 4* : Vitalik is then rewarded in the form of SUSHI tokens, based on the amount of LP tokens he deposited to the staking contract.

*The Risk:

While on the surface this may seem like a perfectly reasonable solution, it is actually fraught with peril. Let’s say the SushiSwap staking contract were to be hacked by a bad actor or SushiSwap initiated a rug pull (reminder just an example, not saying they would).

As a result, Vitalik would lose all of his LP tokens in the process, which would also mean losing the rights to the assets he initially provided to the liquidity pool. This would be a disaster, and highlights the key risk with the current Liquidity Mining process, which is that Liquidity Providers are required to give up custody of their LP tokens.

But what if there was another way…

Liquidity Mining with the Method NFT Vault

with Vitalik Buterin, SushiSwap and the Method NFT Vault

Step 1: Vitalik becomes a liquidity provider by depositing (locking) Token A and Token B into a SushiSwap liquidity pool.

Step 2: Vitalik is then allocated LP tokens from the SushiSwap pool, which represent his share of liquidity provided to the pool.

Step 3: Vitalik then takes his LP tokens and deposits them into his Method NFT Vault.

Step 4: Method Finance has established a partnership with SushiSwap which accepts the ‘UniversalVault Standard’ used by Method. Because of this partnership, Vitalik still receives his SUSHI tokens from SushiSwap.

Why Method Finance is the future of liquidity mining:

As you can see from the above examples, there are clear and obvious benefits to the Method NFT vault. Our solution leverages all of the benefits of NFTs to unlock a liquidity mining flow that allows for self-custody of assets and unlocks a myriad of other opportunities as well.

For the Method Finance team, this problem we are solving is deeply personal. Multiple members of our team have been burned by a loss of LP tokens from either a rug pull or contract vulnerability.

We hope to build a community that sees the power in our solution and that we can push forward together to unlock the future of liquidity mining.

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Image sources:

1. Ledger.com
2. Finematics
3. Cryptoadventure.org