TL;DR: A new on-chain mechanism to incentivize LPs to compete to provide best-priced liquidity, and to reward delegators for helping to direct incentives to useful pairs.
Penumbra’s DEX is possibly the most advanced spot DEX engine ever created, with a batched intent system for incoming order flow, fine-grained control for concentrated liquidity providers, and an integrated on-chain solver that joins the parts together. While these attributes are attractive to sophisticated active LPs, there is a gap with respect to traditional bootstrapping mechanisms used by less sophisticated mechanisms like a UniV2 pool.
This UIP would propose a new mechanic to bootstrap DEX activity in a decentralized, open, and permissionless way: an ongoing, multi-round Liquidity Tournament which incentivizes competitive liquidity provision.
As the goal is to incentivize useful, capital-efficient liquidity, rather than merely locking capital, incentives are distributed according to a two-tier structure, first according to delegator preferences on trading pairs, and then according to volume within those pairs.
Liquidity providers maximize their score by filling users’ trades – but because Penumbra’s DEX executes trades in batches with optimal on-chain routing, liquidity providers cannot trade against their own positions, unless those positions are offering the optimal market price to all users of the system, or, in other words, unless those liquidity providers are winning the competition to provide best-priced liquidity on the DEX.
Delegators choose which pairs to direct liquidity incentives to, and are rewarded for participation. This decentralizes decisionmaking and rewards active participation in the protocol – effectively providing a bonus for “active stakers”.
How it Works
Each round of the Liquidity Tournament corresponds to a single staking epoch, and completes at the end of the epoch. In each round, a fixed-size Tournament Incentive Pool is programmatically withdrawn from the Community Pool, then split into two sub-pools, an LP Incentive Pool and a Delegator Incentive Pool.
During the round, delegators perform gauge voting on which assets they feel the protocol should incentivize. Assets that receive more than a parameterized threshold (e.g., 5%) become eligible for rewards.
The LP Incentive Pool is sub-divided into per-asset incentive pools according to the results of delegator gauge voting. The incentive pool for asset XYZ is allocated to liquidity positions on the UM:XYZ pair, according to the volume those positions have processed during the round, by crediting UM incentives into the position reserves.
The Delegator Incentive Pool is programmatically distributed to the delegators who voted on asset allocation, pro rata to their share of the total votes cast, but independent of how they voted. These incentives are issued as additional delegation tokens, pre-bonded to the same validator the delegator used for voting, so that delegators can auto-compound their stake.
Rationale
Penumbra’s DEX is designed to promote a competitive liquidity environment – all concentrated liquidity, with the best-price liquidity winning all of the order flow it can handle – and this mechanism incentivizes useful participation in the system, creating competitive dynamics between participants that align behavior and prevent manipulation, while reducing overall risk.
First, overall risk is capped by a constant, top-level parameter controlling the rate of incentives that flow into the system. All user-driven incentive steering directs this fixed-rate stream of incentives, and cannot increase it. This means that even if all other design safeguards and mechanisms fail, an attacker who found a way to mis-direct incentives would have a bounded per-block payout, while their exploit strategy would be visible to all other users of the system.
This structure also incentivizes early participation, breaking the cold-start problem. If no users are participating, the first user to participate can claim all of the fixed-size reward pool, creating a strong incentive to participate. At the same time, the second user also has a strong marginal incentive to participate, promoting the competition that makes the mechanism work.
Next, user-driven decisionmaking by delegators further subdivides the incentive streams. This encourages participation by delegators, who must actively engage with the protocol in each round to receive rewards.
Then, per-pair substreams are allocated on the basis of volume provided. On other DEXes, this would be easily manipulable, with LPs wash trading against their own positions to pump the volume metrics. However, this is not possible on Penumbra, which (a) processes all trades in batches at the end of each block and (b) optimally routes those trades across all available liquidity on the basis of price. The only way for an LP to execute a swap against their own liquidity is to ensure that their liquidity position is the best-priced position across all pairs. But they cannot do this without offering that liquidity, at the best price, to all users of the system. In other words, the economic mechanism design of the DEX requires attempts to subvert the system to actually perform the desired behavior.