Protocol owned liquidity (POL) is a new approach pioneered by Olympus DAO to provide liquidity to tokens on decentralized exchanges.
Protocol owned liquidity is an innovative solution to the mercenary capital problem, whereby protocols engage in a so-called “race to the bottom” to provide higher and higher incentives to attract liquidity providers, in-turn diluting the value of the protocols through the high issuance of tokens. ^[1][4][5]

Overview

Protocol owned liquidity (POL) is one of a few key innovations of the DeFi 2.0 narrative. Protocol-owned liquidity seeks to solve the mercenary capital problem of DeFi 1.0.^[3]

Decentralized finance, known as DeFi, has seen explosive growth since 2020, bringing with it the potential to disrupt traditional finance.
In particular, the rise of decentralized exchanges (DEXs) — most notably Uniswap — introduced key innovations that allowed trading to be facilitated without a centralized intermediary, utilizing an Automated Market Maker (AMM), liquidity pools and liquidity providers.
However, these innovations are not without their drawbacks. Namely, the mercenary liquidity problem plagues protocols, who often need to incentivize liquidity providers with substantial rewards to provide liquidity to enable trading of their token.

The mercenary capital problem that plagues DeFi 1.0 protocols, especially automated market makers (AMMs), is caused by protocols seeking to incentivize users through LP tokens and trading fees. Incentivizing users to add value to a protocol sounds like a meaningful addition to an ecosystem. But users can easily switch to the protocol offering the best incentives, creating a race to the bottom scenario for protocols as they increase the supply of their governance token and, in doing so, decrease its value. ^[3]

In this backdrop, a new form of providing liquidity to tokens on DEXs emerged in the form of protocol owned liquidity. This model developed by Olympus DAO, promises not only to resolve the mercenary liquidity problem, but also to create a reserve currency in the process.
Instead of relying on providing incentives to the market to provide liquidity to liquidity pools, the protocol owned liquidity model instead utilizes a “bonding” mechanism.

As examples, Frax Finance, ^[12]Fei Protocol, and Olympus DAO are all powered by PCV, and as such their tokens have extremely high liquidity per unit of TVL.^[9]

In the future of DeFi, protocol-owned liquidity (POL) is a very important concept. POL is a popular provisioning tactic amongst some major revenue-generating initiatives in the market. It is indeed an interesting formula to diversify a protocol treasury and, if architected correctly, a sustainable market for the native asset. Low liquidity induces volatility.
Arguably, Ethereum (ETH) is the prevalent pair for all decentralized markets on its network. While this asset has its benefits, it also inherits price exposure, which either is a magnitude greater or less than that of any token.
Protocol-owned liquidity (POL) is one of a few key innovations of the DeFi 2.0 narrative. The protocol behind this invention is Olympus DAO. Protocol-owned liquidity seeks to solve the mercenary capital problem of DeFi 1.0.^[6][7][8]

Bonding process

The bonding process involves the protocol itself selling their own token (e.g. OHM) in exchange for another token (e.g., ETH or DAI) or a liquidity pool token (e.g. OHM/ETH) from a buyer. The buyer is incentivized to bond (instead of buying tokens on-market) by the protocol selling their token at a discount (usually 5–10%) to the current market price, which is vested over a period (typically under a week) to prevent an immediate arbitrage opportunity.
The net result of the bonding process is that the protocols end up holding a large number of valuable tokens in their treasury. This process can be thought of analogously to how a reserve bank (i.e., the protocol) would sell their country’s currency (which they control) to buy a foreign currency from the market, and thus store this foreign currency in their treasury.

Bonding essentially involves the protocol selling their tokens at a discount to buyers, who in exchange will provide another token, which forms part of the protocol’s treasury. The treasury can then be deployed to provide liquidity directly to DEXs (earning trading fees) and can be invested to generate returns.

With the tokens received from the bonding process, the protocol utilizes these tokens providing liquidity to liquidity pools on DEXs for their own token in the process collecting the transaction fees, or investing the tokens to earn a return.

Protocol owned liquidity is likely to be an ongoing feature of the DeFi landscape, with protocols utilizing a mix of the protocol owned liquidity model and traditional liquidity pools for trading on DEXs.

Protocol-owned liquidity is a natural evolution that will strengthen protocols and DAOs staying as a mechanic to strengthen liquidity and reward the community.^[2]

Protocols providing POL

Frax Finance

Fraxswap is specifically designed for use in the Frax Protocol’s critical system functions through TWAMM orders. The motivation for building Fraxswap was to create a unique AMM with specialized features for algorithmic stablecoin monetary policy, forward guidance, and large sustained market orders to stabilize the price of one asset by contracting its supply or acquiring a specific collateral over a prolonged period. Specifically, Frax Protocol will use Fraxswap for:

• buying back and burning FXS with AMO profits,
• minting new FXS to buy back and burn FRAX stablecoins to stabilize the price peg,
• minting FRAX to purchase hard assets through seigniorage, and

Fraxswap is a fully permissionless AMM which means other protocols can create their own LP pairs in any token and use Fraxswap for the same (or other novel) use cases. [12]

Ideal Fraxswap use cases by other protocols, stablecoin issuers, & DAOs include:

• Accumulation of treasury assets (such as stablecoins) over time by slowly selling governance tokens.

• Buying back governance tokens slowly over time with DAO revenues & reserves.

• Acquire another protocol's governance tokens slowly over time with the DAO's own governance tokens (similar to a corporate acquisition/merger but in a permissionless manner).

• Defending "risk free value" (RFV) for treasury based DAOs such as Olympus, Temple, and various projects where the backing of the governance token is socially or programmatically guaranteed.

Olympus DAO

Olympus Pro is offering projects a chance to get their own Protocol Owned Liquidity by leveraging the OlympusDAO bond mechanism. Projects can exchange their token for any kind of LP token or underlying asset they wish, at a discounted price. This is a huge improvement over traditional liquidity mining programs where the project does not get to keep any of the mercenary liquidity. The underlying token in Olympus Pro bonds does not need to have any relation to the OHM token, but projects can pair with OHM or sOHM to gain exposure to the OlympusDAO ecosystem. Olympus Pro upends liquidity mining reward costs and shifts the burden on protocols toward more sustainable Protocol Owned Liquidity. Here, protocols can spend native tokens to acquire liquidity in perpetuity without fear of loss. Traditionally, liquidity mining represents the same high upfront cost with no benefit in return.[9]

Liquidity-as-a-service (LaaS)

Another approach is to rent it from protocols that can offer the cheapest and highest quality liquidity which is called "Liquidity as a Service (LaaS).

This concept enables protocols to easily utilize the protocol owned liquidity model. The protocol platform serves as a bond marketplace, whereby users can purchase a bond from protocols listed paying a transaction fee. Marketplaces such as these should reduce friction in issuing bonds, providing a valuable matching service between protocols and capital providers that should continue to drive the adoption of this model in DeFi.

LaaS can be highly efficient when offered by protocols that specialize in this service such as Fei and Tokemak.^[9]

Protocols providing LaaS

Fei Protocol

Fei Protocol supports FEI, a fully decentralized and scalable stablecoin backed by on-chain reserves. Fei can use its Protocol Controlled Value (PCV) to back liquidity provision denominated with FEI as a base pair.
Fei Protocol is partnering with Ondo Finance to offer a cost effective and flexible term liquidity as a service offering. Essentially, projects can deposit their project token into an Ondo liquidity vault with a flexible duration, and Fei Protocol will match their deposit with an equivalent amount of newly minted FEI to form a liquidity pair. The tokens get paired in an AMM such as Uniswap or SushiSwap.
Fei Protocol essentially doubles any liquidity the project provides and removes all upfront capital costs. At the end of the vault window, the vault returns the FEI to Fei Protocol plus a small fixed fee, and returns all remaining tokens to the project.
The Ondo Vault takes care of all of the accounting behind the scenes, and the project is left with all trading fees AND all impermanent loss.^[9]

FEI is an ERC20 stablecoin native to the Fei protocol. It’s a decentralized stablecoin that uses various mechanisms in order to (in theory) sustain a more efficient and fairer capital distribution than other projects. The purpose of the Fei protocol is to create a liquid market where FEI/ETH can be traded closely to the ETH/USD pair.
Unlike most other tokens, FEI’s token supply is essentially unlimited. It’s governed by the minter and burner contracts that control the token release through bonding curves and trade incentives. The FEI token demonstrates certain nonstandard functions of the ERC20, but only for a subset of transactions. 
The ETH bonding curve will have a target supply of 250 million FEI set as a bootstrap target. This target, also known as “Scale,” will be the mark when FEI will stabilize its price at $1. FEI’s peg is managed by two core elements of the Fei protocol, namely:

• Protocol Controlled Value (PCV), and
• Direct incentives

While the project will launch with only one bonding curve denominated in ETH, it will allow for other curves to be created as time passes. ^[11]

Tokemak

Tokemak allows projects to provide a single token to a reactor, which is then paired with a base asset such as ETH, USDC, or (possibly in the future) FEI in liquidity pools. TOKE holders direct this liquidity towards the venues that need it most, and cover any impermanent loss that projects incur.
This impermanent loss coverage presents a great benefit to depositors. Tokemak accumulates assets for itself through trading fees. This ultimately reinforces its ability to provide sustainable liquidity. Initially, TOKE is emitted as a reward for users, and TOKE holders ultimately have a claim over the Tokemak Protocol Controlled Assets (PCA).
TOKE tokenomics encourages long-term value-aligned participation in the network. By acquiring a stake in TOKE, projects can direct their liquidity to whatever venues they need. This represents an upfront investment, but far better than traditional liquidity mining.^[9]

Tokemak's native protocol token, TOKE ("toe-kuh") can be thought of as a homogeneous form of tokenized liquidity. It is representative of the ability to direct any of the deposited LP assets in the form of liquidity to various exchange venues. TOKE serves several purposes:

• Its primary use case is for it to be utilized by Liquidity Directors who stake $TOKE in order to receive votes that are used to direct liquidity and collateralize Token Reactors.

• It is the systems incentivization / reward token that is distributed to participants for performing various actions on the platform such as directing liquidity or providing assets.

• Protocol risk mitigation - It acts as a backstop for potential losses incurred during liquidity deployment.^[10]

Pros and cons of Protocol Owned Liquidity (POL) Model

Pros

• In part addresses the mercenary capital problem, with protocols in theory paying a lower cost (in the form of a discounted tokens) to retain liquidity
• Protocol keeps the trading fees from their own trading pair in DEXs
• Treasury assets can generate revenue for the protocol
• Assuming sufficient scale in the treasury, the trading pair should be able to absorb higher trades with less price impact

Cons

• Reliant on incentivizing users to bond through a discount to the market price. More competition in this space may result in higher discounts being offered, which would dilute existing holders further
• Systemic risk of protocols using this model to create a reserve currency, with the chance of sustained selling eroding the “price floor” and creating a negative feedback loo