5 min read

Liquidity Black Hole Theory

Liquidity Black Hole Theory

Andrew Kong of Mechanism Capital created the "Liquidity Black Hole Theory".  This article unpacks his theory, and shows you the tweet that started it all.  I wrote this for my pre-boomer friends who don't know that Twitter exists.  

What is the Liquidity Black Hole Theory?

It's an automated market maker (AMM) liquidity feedback loop that creates a black hole, sucking in liquidity from everywhere. As liquidity enters the hole it sucks in more and more at an accelerating rate. An example of one that could be forming soon can be found at THORChain.      

Liquidity Feedback Loop

To understand the theory, first recognize that liquidity can create feedback loops.

Higher Trading Volume > Higher Market Maker Profits > Increased Capital to Market Making > Increases Liquidity > Tightener Spreads > LOOP

Liquidity generates liquidity.  

Source: Andrew Kong

Liquidity feedback loops generally don't start themselves, which presents a problem for upstart exchanges. It raises the question, how do they generate liquidity when trading volume and liquidity are both low?  

Enter Liquidity Mining. Liquidity Mining (LM) is a network participation strategy that creates incentives for liquidity provisioning through token rewards. It's a novel way to bootstrap the network effect, which Andrew calls "Token Based Network Bootstrapping". It is one of the best ways to start a liquidity feedback loop, and you can read more about it if you are curious right below.

Supercharging Network Effects in Crypto - Deribit Insights
Building network effects is hard. In crypto, it’s especially hard because you’re either competing against strong incumbents (exchanges, payment systems) or working with a niche market (dApps). An upstart network faces the conundrum: a small network has limited utility to prospective users, but incre…

Central Asset Denomination

With the exception of Bancor and THORChain, Automated Market Makers such as Uniswap use $ETH as the central asset in market making.  But what if Uniswap, created their own token and it replaced $ETH as the central asset?  Examples include, Bancor denominating all their pools in $BNT and THORChain in $RUNE.  

Liquidity Pools, at their most basic, are collections of funds locked within a decentralized smart contract. When you Liquidity Mine a pool that is denominated in the Central Asset of the exchange, things get supercharged. Take THORChain for example. Liquidity Providers (LP) must buy and stake $RUNE token because all pools are denominated in $RUNE.  Liquidity Mining $RUNE increases liquidity in the pool which lowers trading fees which increases trading volume which increases LP returns which increases the price of $RUNE which creates larger liquidity pools.  It's circular.

Source: Andrew Kong 

As we see the price of $RUNE increase, the liquidity mining yields go up correspondingly. This is a liquidity feedback loop on steroids.

Source: Andrew Kong

Before taking the next step in describing the Liquidity Black Hole Theory, let's review the concept of reflexivity.  

What is reflexivity?

According to Wikipedia, "Reflexivity refers to the self-reinforcing effect of market sentiment, whereby rising prices attract buyers whose actions drive prices higher still until the process becomes unsustainable. This is an instance of a positive feedback loop. The same process can operate in reverse leading to a catastrophic collapse in prices."

If people anticipate large $RUNE Liquidity Provider yields, they will buy more increasing the price creating a self-fulfilling prophecy.

This is why $SNX did a mind-blowing 50x pump over 9 months.

Source: Andrew Kong

But Wait, There's More

THORChain has Continuous Liquidity Pools (CLP) that use an alternative fee model. Instead of a standard 30bps fee, fees are proportional to the slippage created by a trade (scale of 1 to 10000 bps). While patient traders can split trades to minimize fees, impatient traders will execute large trades with large fees because they are lazy or can profit.

On Uniswap and Balancer, most of the volume comes from arbitrage at the expense of LPs. However, CLPs allow LPs to capture more value from arbitrage trades due to higher fees. Higher fees drives the price of $RUNE up, thus further supercharging the loop.  Consider this quote.  

Source: Andrew Kong

Impermanent Loss Protection

And to add my own personal touch on the theory, THORChain will feature impermanent loss protection.  This feature was not contemplated at the time of Andrew's original Tweet so he obviously excluded it.  But with the official announcement on February 24, 2021 in the Weekly Developer Update #82 impermanent loss will NOT exist on THORChain after posting liquidity for more than 100 days.  That means you can post liquidity, borrow against that liquidity, and use the yield generated from the liquidity to pay the interest due.  It's a circular within a circular.  Or a black hole within a black hole.  Here is what NASA says happens when two black holes collide.  BOOM!!!

In Summary

We could see a Liquidity Black Hole when THORChain goes live in March 2021.  It could supercharge the price of $RUNE.  As of February 25th, 2021 $RUNE is trading at $5.06 at 5:57AM.  Could we see a $RUNE go to $100 or $1000?  Maybe.  THORChain has all the characteristics of a Liquidity Black Hole.  And the value of $RUNE is deterministic.  You can calculate the actual value based on Total Value Locked.  

And to back test the speculative price against THORChain's deterministic pricing model, how do we get there?  

For $RUNE to achieve a $1000 price target the following would need to be true.

  • Total Value Locked = $16.7 Billion
  • Circulating Supply of $RUNE = 500 Million
  • Speculative Premium = 10x (see image below, the premium on 2/26/21 is 8.59)

or

  • Total Value Locked = $33.4 Billion
  • Circulating Supply of $RUNE = 500 Million
  • Speculative Premium = 5x

And if you don't have a Binance account and want to buy $RUNE, here is a short instructional article on how to do it.  How to buy $RUNE.  

Source: Thorchain.com
Source: Leo Finance

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