Why is Karma Bond needed?
For decentralized finance (DeFi) protocols to operate effectively, it is essential to have large amounts of liquidity in token pairs, commonly known as liquidity pools, to allow users to carry out token swaps with low slippage.
To bootstrap liquidity, protocols incentivise liquidity providers (LPs) to deposit liquidity in token pairs, usually the protocol governance token paired with a stable coin. As a reward for providing liquidity, LPs are rewarded with the protocol’s governance token, usually at an attractive annual percentage yield (APY). This is commonly known as liquidity mining or yield farming.
Protocols essentially pay out high incentives to rent liquidity from LPs. As DeFi matures, it is becoming increasingly clear that incentives are not a viable long-term strategy for protocols. The goal should always be to bootstrap and accrue long-term defensible value, rather than perpetually pay high interest on rented liquidity.
Additionally there are other negative side effects of liquidity mining such as impermanent loss for the liquidity provider and a constant sell pressure of the governance token due to high pay-outs to LPs who subsequently sell the governance token to offset their impermanent loss.
Starting with liquidity incentives at launch is a short-lived bootstrapping mechanism to attract new users and capital via LP incentives. These incentives build up large liquidity pools quickly, but they are not a long term strategy.
Bonds are a mechanism by which the protocol itself can trade its native governance token in exchange for liquidity. Instead of renting liquidity from LPs, it purchases the liquidity outright and owns it.
Additionally, some of the liquidity contains productive assets such as tokens that capture trading fees within liquidity pools for example. Instead of giving away those productive tokens to LPs, they are bought by the protocol which in turn can generate income for the protocol’s treasury.