Authors: Henryctus, Kryptonite
Since inception in 2020, Curve Protocol has grown itself an important reputation and played a key role in providing DeFi ecosystem with precious liquidity. We will dig deeper into the core mechanisms of Curve later on, but first let’s depict the story of one of the most insidious war in Defi: the Curve Wars.
Like many kingdoms, Curve has lands in which people can trade without too much harassment, but unlike many kingdoms, Curve has no King. Instead, of centralizing all the power in one hand to decide the policy of each land, the crown has been divided into thousands and thousands of pieces and distributed in proportion to the braves who dare to provide liquidity to guarantee the trades. By accumulating those pieces of the crown over time, some of the braves can progressively stand out and decide on the policy within their lands and especially how rewards are distributed, incentivizing them to provide more.
Eventually, some of the braves quickly understood that true power can only be obtained by joining forces through alliances. They organized themselves in houses and quickly convinced people to funnel their pieces of the crown through them, promising even more rewards to their new affiliates.
Did the kingdom’s founders expect that? Probably. Is it immoral or unethical? There is no such thing in DeFi, the holy grail only being decentralization and nothing else. But how is it that a few organizations do centralize power to take advantage and get more benefits? That is what we are going to explain further through this article.
Curve is an automatic market-maker (AMM) whose main purpose is to allow low fees (0.04%) and low slippage trades of stablecoins. I am sure you already know what fees are, but if you’re not familiar with slippage, just imagine that you give a $10 bill to your favorite bakery to get 10 croissants, and, by the time the cashier hands in your order, price has changed so you end up with 8 croissants. Pretty annoying right? That is why Curve does not rely on book orders where demand meets offer at a specific price and volume. Instead, it relies on liquidity pools where tokens that trade within the same price range are paired according to a given ratio, ratio that changes over time depending on the trades.
Now you might wonder what are those liquidity pools and how do they work? That’s fair, let’s imagine that someone wants to create a pool with DAI and USDC in it to allow for trades between those two tokens. The pool starts with 1,000 DAI and 1,000 USDC, which means the price of 1 DAI is 1 USDC and vice-versa (1:1 ratio). Someone on the market is craving for 100 USDC but only has 100 DAI in its portfolio, guess what? He is going to exchange its 100 DAI from its portfolio against 100 USDC from the pool and be very grateful for this low fee and low slippage trade.
Now the pool has 1,100 DAI (initial 1,000 DAI + 100 DAI from Mr.Trader’s portfolio) and 900 USDC (initial 1,000 USDC – 100 USDC sent to Mr.Trader’s portfolio), so the new ratio is 1 USDC for 1.22 DAI or 1 DAI for 0.82 USDC. No worries, someone else will take advantage of this and re-equilibrate the pool by injecting cheap USDC in exchange of DAI and average back the whole pool. Don’t be fooled by our example, arbitrage trading does not offer that kind of opportunity. In reality, prices are closer to 1.00 as liquidity pools involves much larger volumes and a bit more complicated formula that rather looks like this:
Alright, but who provides the liquidity in the pools and why would they do such a thing? The liquidity providers (LPs) are the stars in this ecosystem, the ones we need, the ones without whom nothing would be possible. Joking, they are greedy persons just like me and you, attracted by the yields offered on their deposits in the pools. It is not a surprise that LPs get benefits from depositing their tokens, right? First, they have their share of the fees incurred by the traders depending on their share in the pool. Then, Curve grants extra yields to the LPs by lending out the liquidity to other protocols. But finally, and probably most importantly, LPs are offered the possibility to boost their rewards.
Remember the pieces of the crown from my introductory story above? That is what CRV tokens are, pieces of the crown. LPs obtain CRV tokens in exchange for providing liquidity in the pools. Pools’ liquidity and how LPs contribute to it is measured with “Liquidity Gauges”. These liquidity gauges directly dictate how many CRV tokens are distributed to each LP, and this is exactly where things are getting interesting.
Do you know this legendary snake called Ouroboros? It’s an ancient symbol depicting a serpent or a dragon eating its own tail (see below).
Well, the previous one is a bit old and murky, but if you reshape it a bit you can get something more interesting like this:
