Redefining Liquidity: Exploring Proof-of-Liquidity’s positive externalities
Revisiting PoL
Proof-of-Liquidity (PoL) has frequently been discussed on this blog from a purely technical level. It isn’t an easy task to simultaneously get acquainted with the Berachain eco, learn the ins-and-outs of the L1, and gather a firm understanding of PoL.
But it’s quite simple, and PoL functions quite similar to PoS with just a few key differences. There are validators that wish to uphold the security of a layer one blockchain, who post an initial token bond (in this case, BERA) to gain the rights to secure the network. Just like Ethereum, validators on Berachain are chosen to propose a new block - but there’s a catch.
Where PoS is only concerned with the security and functioning of the underlying network, PoL implements another layer of incentive alignment, effectively dictating the behaviors of users, dApps, and validators. With PoL, the subject of incentives and sustainable rewards gets thrown into the equation, turning this into an economic experiment that runs parallel to traditional cryptographic principles.
When a validator on Berachain is chosen to propose a block, they’re allotted some BGT, which is accompanied by the freedom to delegate this to any reward vault of their choice. Reward vaults are essentially smart contracts composed of various receipt tokens deposited by LPs.
If you were an LP in a BERA/HONEY pool, you might receive your receipt tokens and deposit them into a reward vault, gaining eligibility for BGT rewards distributed by validators. This BGT can then be delegated to validators of LPs’ own discretion, letting active validators become boosted validators, earning more BGT for their block proposals.
Descriptions of PoL’s benefits have usually targeted user behaviors more commonly associated with DeFi, and it’s time we change that. It isn’t just PoL descriptions that have been lacking, but liquidity as a whole.
We’ve always viewed liquidity in very binary terms. Yes, it’s capital deposited into a pool - but why can’t it extend beyond that? Instead of viewing liquidity as a necessary force that increases capital efficiency or improves the health of a financial application, why not take it a step further and view liquidity as a barometer for measuring these user behaviors?
Today, we’ll explore some of the less obvious positive externalities of PoL and how they could potentially redefine how we view liquidity entirely, beginning with a more holistic analysis of PoL.
Leveraging liquidity in net-new ways
Iterating on this, we enter a scenario where validators are now closely intertwined with the happenings of the underlying network they’re securing. Instead of blindly proposing blocks and collecting rewards, validators must adopt a more hands-on approach to ensure their reward share can increase and deliver greater returns over time.
This might come in the form of consistent collaboration with dApps, more user-centric reward structures, or just active involvement in the ecosystem. It’s often discussed how difficult it can be to incentivize on-chain users to participate in governance, but the easiest way to do this is simple: align the incentives.
Users are aware of this, with the addition of BGT incentives turning the average LP into a more consequential voice in the ecosystem they’re transacting within. BGT holders gain the rights to not only influence governance decisions, but the ability to dictate where future BGT emissions will flow - which is 99% of what makes PoL an enjoyable alternative to PoS.
If a BGT holder wants to see more rewards flow towards the reward vault their receipt tokens are deposited in, they must navigate through the list of validators and determine who to delegate their BGT to. Maybe there’s another BGT holder who wants to maximize their incentive intake, instead opting to delegate to validators that prioritize reward vault incentive earn rates, as opposed to validators that prioritize a user’s non-BGT earning rate.
On the other hand, dApps on Berachain can more easily bootstrap initial liquidity without needing to overspend on liquidity mining incentives. Prior to the introduction of PoL, dApps were forced to pay LPs with a sizable amount of native protocol tokens, leading to high CACs (customer acquisition costs) for these dApps and mercenary relationships with capital providers. On Berachain, dApps can instead work directly with validators and incentivize BGT rewards towards their reward vaults, aligning LPs across the ecosystem around a singular focus: BGT accumulation at all costs.
This is a very straightforward explanation of how PoL will function, though it’s a useful thought experiment for exploring the possibilities that might stem from a system like PoL. For far too long, liquidity has been viewed in an extremely binary point-of-view. Users deposit their funds into smart contracts, dApps see their TVL go up, and validators simply exist to ensure these interactions persist.
PoL will introduce new methods of interaction, differentiated strategies that vary user-by-user, and the possibility for on-chain liquidity dynamics to change entirely.
Transformative > Additive
While PoL might initially appear as an extension of PoS with a more opinionated view on participant alignment, the importance of it cannot be understated. Understanding how BGT flows between users, dApps, validators, and reward vaults is just the tip of the iceberg.
If we were to make an assumption that all three of Berachain’s core ecosystem participants are willing and able to fully participate in PoL as the system was designed, then we can agree that the day-to-day happenings on Berachain will not resemble anything we’ve seen before.
There’s a lot to be said about finally discovering a way to align incentives at the protocol layer, but this almost misses the point entirely. Incentives drive behavior, but there’s never been a way on any PoS chain to model what future behaviors might resemble given how differentiated dApps’ incentive approaches are.
Let’s illustrate this.
A new DeFi protocol decides to launch on a PoS chain, with a goal of delivering a unique, seamless, and valuable user experience for its depositors. On-chain users see this and begin to deposit assets, receiving the promise of a healthy yield in exchange for their tokens. On the dApp’s side, you’re paying out native tokens to gain a healthy TVL which can hopefully sustain itself and make your dApp stand out. However, this scenario doesn’t have a happy ending over the long-term.
As rewards dissipate and TVL grows, users inevitably flee to greener pastures. TVL bleeds until nothing is left, resulting in a situation far too familiar for any developers or DeFi power users reading this. This isn’t representative of dApp quality, but rather user interest and how fleeting attention tends to be in crypto.
PoL offers a solution to this.
A team of developers builds a novel dApp and decides to launch on Berachain exclusively. Liquidity is coming in, TVL is skyrocketing, and most importantly, users are happy. These devs may ask themselves how they can sustain this and compete with shiny new protocols.
Instead of only incentivizing LPs with native tokens, dApps can plug into PoL and begin interfacing with active or boosted validators to direct a greater share of BGT emissions to their reward vaults, offering them an edge over competitors. Instead of strictly running a liquidity mining program, dApps can reduce their reliance on unsustainable liquidity bootstrapping methods and prioritize long-term growth through sustained, predictable, and attractive BGT rewards. For users, this makes interacting on-chain less of a game of hot potato and more of an exercise in due diligence and strategic cooperation.
Obviously, it’s fair to assume dApps won’t maintain a lead in BGT incentives indefinitely. It might also be fair to say that not all users will want to only earn a greater share of BGT rewards - everyone has a different financial situation and the functioning of PoL might not be attractive for someone in the same way it could transform another user’s on-chain behavior.
But this line of thinking fails to highlight the reality: PoL exists, it’s there, and it isn’t something that will ever just disappear from Berachain. In fact, we can use PoL’s existence as a way of discovering previously obfuscated information about user behavior. This is a long way of saying PoL’s direct impact on participant interaction can be viewed as a tool for users, developers, validators, or even researchers to better understand why people do what they do on-chain.
The obvious retort to this might be that users only want to make money and it’s in their best interest to maximize their returns in whatever way they’re capable of. This is true, except users in a PoL system are better off going with the flow of BGT emissions than they are operating as a lone wolf. Additionally, users on Berachain might need to work harder to make money and navigate the flow of BGT, whereas LPs on other chains in the past have had fairly simple workflows on-chain.
It may sound like PoL introduces too many unnecessary steps for LPs, or sets lofty expectations for the average user, but this is a more pessimistic view of the system. In crypto’s very short history we’ve seen an almost uncountable number of on-chain metas, trends, and user behavioral shifts. PoL is just another tool for both the L1 and its developer community to more easily model this behavior and create sustainable on-chain economies.
Berachain’s economic activity will be underpinned by its ecosystem participants’ interactions with PoL and give rise to net-new behaviors on-chain. When liquidity is transformed from an economic tool to something more aligned with actual user activity.
Developers have been blind to the wants and needs of users, struggling to adapt after liquidity mining incentives dry up or people move on to greener pastures (other apps). Moving forward, developers can gain a more prescriptive understanding of users’ needs and accommodate for these varying incentive structures.
Through a mutual desire for more BGT and an increasingly larger share of it, dApps don’t have to worry about losing TVL or getting stabbed in the back by mercenary LPs. When incentives are aligned from day one, dApps gain considerable peace of mind knowing a non-negligible amount of capital will be more than happy to remain deposited. This has yet to be achieved at the application layer.
PoL makes it possible for not only the entire network’s economy to become more sustainable, but the numerous sub-economies of Berachain, too.
Measuring liquidity
With all of this in mind, we can begin to rewrite the definition of on-chain liquidity as we know it. Liquidity isn’t just something that separates one dApp’s position on the leaderboard from another, but a living, breathing entity on Berachain. With PoL, liquidity becomes more akin to the invisible hand of the market than just a bundle of assets that exist within a smart contract.
By stepping back and monitoring the flow of liquidity between users and dApps, we can begin to better understand what users want and how we can build both infrastructure and apps to support this.
For users that want more from their assets, PoL offers a native way to earn more and take advantage of Berachain-native opportunities. For developers that want to build novel experiences under a unique economic backdrop, PoL is their canvas.
It’s naive to assume that every user bridging to Berachain will understand PoL and consider it as a deciding factor for where they put their assets. Over time, the idea is that users become guided by PoL, treating it like you would any of the fundamental laws of physics. Developers might just want something new, and there isn't anything stopping them from building anything they can imagine with PoL.
Instead of obsessively tracking TVL and panicking over 5% moves, a fully aligned ecosystem can accept that users dictate the outcomes, choosing to adapt their strategies rather than roll over and die. All ecosystem participants will become acutely aware of how PoL guides their actions and choose whether or not to accept its terms and conditions.
PoL might appear as just another consensus mechanism, but it’s much more than that. For as much as PoL builds off of PoS’ strengths, it iterates and implements an entirely new economic system at the protocol layer. PoL is a response to the architecture of other chains, taking something as straightforward as a consensus mechanism and rewriting the rules entirely.
It’s cliche to say that crypto is constantly evolving, but it's the truth, and the time to begin more deeply examining our relationship with liquidity is now. No one knows what form PoL will take initially, but it’s interesting to think about some of these long term futures for Berachain under the guidance of PoL. As we begin to see increased exploration of app development on Berachain, PoL's game theory and the inter-participant dynamics will only accelerate from here, turning liquidity into a more integral aspect that dictates on-chain user behaviors.