I think this is very important point. From a technical perspective, Merkl distributes the incentives based on three factors:
- Fees earned
- Active liquidity for asset A
- Active liquidity for asset B
The weights of these three components is determined by the distributor, and as a result can be controlled by the DAO. The question is how much each component should be weighted? Here it stops being a purely technical discussion, as different stakeholders will have different preferences.
Fees are determined by and proportional to swap volume, so one of the stated goals of the Uniswap’s grant (“Volume gained per incentive spend”) is already optimizing for them, unless you meant something else.
The interesting aspect is that paradoxically, directly incentivizing fee generation is probably the worst option for LPs. Compare two extreme cases:
a) 100% weight on fees
b) 0% weight on fees, 50% on asset A liquidity, 50% on asset B liquidity.
The first option incentivizes rapid reallocation of capital, creating a very competitive environment where active LPs create a “race to the bottom”. Gains are expected to be minimal for most LPs due to inter-LP competition, operational costs, and impermanent loss. The second option incentivizes all in-range LPs equally, meaning that full-range positions probably get the best returns, as they have the least IL. In the real world, a case somewhere between these extremes probably is the best, but the selection of weights is actually a hard problem.
Also I encourage everyone to read Gauntlet’s blogpost on why liquidity mining was selected to be incentivized in the first place, and what are the alternatives.