IOSG: What does liquidity mining bring to the DeFi ecosystem?

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, Author: Dong Xinshu & Zheng Bohan, reproduced by Odaily with authorization.

Source: DeFi Pulse

To put it simply, liquidity mining describes how users provide “liquidity” contributions to the market in a certain way and at the same time receive additional incentives other than interest, thereby increasing the activity and usage of the product. But at a high level, the concept is very similar to other incentive programs (such as Uber’s ride incentive program), because the ultimate goal of both is to hope that users will continue to use their products spontaneously to achieve network effects. However, liquidity mining in DeFi has some basic and unique features. Here, we first try to give a proper definition for DeFi liquidity mining and give some explanations for its scope.

Use the protocol layer governance native token to reward its liquidity provider users to incentivize them to use its products.

The following figure lists the current liquidity mining situation of DeFi, in which Compound dominates the market, and the remaining share is divided by several sporadic projects (Curve, bZx and mStable).

There are different types of DeFi markets, including lending, automated market makers, decentralized exchanges, derivatives and insurance, oracles, and prediction markets.

The lending agreement platform can be said to be the most popular and fastest-growing field of DeFi, and it is also the first Defi field to launch a liquidity mining plan. Most DeFi lending projects provide traditional mortgage loan products. Users can mortgage assets to the vault of the lending platform, and use mortgage assets to lend other assets. Users obtain interest income by providing mortgage assets. At the same time, users also pay loan interest by lending assets. According to DeFi Pulse, the popular DeFi lending platform Compound is one of the projects currently dominating the DeFi market, as 19% of the total value locked is contributed by Compound (as of July 23, 2020).

In traditional finance, it takes a lot of capital to create a bank that provides lending services. In the world of DeFi, this money is largely provided by markets orchestrated entirely in an automated fashion by smart contracts. Therefore, the rules for borrowing and lending without trusting any intermediary (such as a bank) have been formed and will be enforced by the blockchain. However, to steer this process, projects need to come up with revolutionary ways to attract holders of idle assets to supply.

On the other hand, liquidity mining may greatly push the DeFi lending market in a positive direction, especially when the benefits of liquidity mining exceed interest rate fluctuations. This article will explain how liquidity mining works through the analysis of Compound.

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Source: Coindesk

In the case of Compound, the core of the governance token is the right to vote on proposals to update the protocol. Since the project is run automatically by smart contracts, such voting rights are the only way to change the way things work in the product. Compared to the governance model in the traditional world, the COMP token is like an instrument of eligibility to vote in the legislature.

Source: Compound Medium

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In Compound’s liquidity mining, a total of 4,229,949 COMP tokens will be put into the “reservoir” contract and distributed 50/50 between depositors (i.e. liquidity providers) and borrowers. Tokens will be distributed fully automatically within 4 years. Currently 0.5 COMP will be distributed per Ethereum block (meaning 2,880 COMP per day). Compound users can earn COMP based on the value of the asset simply by lending/borrowing digital assets to the system.

Once the COMP tokens accumulated in a certain address reach 0.001, for any subsequent transactions on the Compound platform, the system will automatically transfer the COMP to be claimed to the user. If the accumulated COMP tokens are less than 0.001, the user has the right to manually claim COMP.

Recently, overseas communities like to call liquidity mining "Yield Farming" (or literally translated as "yield farming"), which not only refers to earning COMP through Compound transactions, but also represents the use of cryptocurrencies to create maximum returns Strategy.

• Examples of yield farming include:

• For higher yields, transfer funds to riskier lending pools.

Adopt a different trading strategy. For example, carry out arbitrage in other agreements, mortgage the lent assets and lend other assets, and reinvest the lent new assets into the lending pool to obtain higher returns.

Note: This model does not consider macro factors such as time cost and inflation. This model does not take into account complex investment logic and transaction fees. In the comparison, the risk of bank deposits is different from that in the Defi lending agreement, and the comparison results have not been adjusted according to the risk. This comparison is only for general reference and does not constitute any investment advice.

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Source: DeFi Pulse

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Source: DeFi Pulse

The table below compares the major DeFi projects that provide liquidity mining (as of July 23, 2020):

(TVL) as a valuation method for DeFi projects.

CoinGecko research analyst Daryl Lau pointed out that in"Liquidity mining"Liquidity mining"In the case of the project, the value of the project is reflected by the token price itself, which also gave birth to a". An increase in the token price will allow more people to lock their assets on the platform, thereby increasing TVL. A high TVL will further increase the token price, forming a cycle. We don't think this cycle will last because this valuation method is not mature.

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The total value locked in DeFi soared from about $1 billion in early June to about $2 billion in early July, and a considerable part of the new funds were allocated to Compound. In addition, by observing the total lock-up value of other lending protocols, we found that after June 15 (the start of COMP distribution), the total lock-up value of protocols such as Maker, InstaDapp, DDEX, Nuo Network, and bZx dropped significantly. Maker and InstaDapp had a quick recovery after a few days, however, other protocols still haven’t recovered from the drop.

Source: DeFi Pulse

Source: DeFi Pulse

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Does this mean that DeFi funds are gathering in a certain direction/project? We think it's possible. If so, these projects must be based on a sustainable development model, otherwise they will constitute a systemic risk for the entire DeFi. As of July 23, the top five DeFi projects (Maker, Compound, Aave, Synthetix, and Curve) controlled 78% of the total value locked in the DeFi market. Considering that many projects are in common with the top DeFi protocols to some extent (for example, Maker, Yearn, RenVM, Curve, and Compound are all connected to each other), if one of the top projects has a smart contract or oracle Adverse events will cause a domino effect on the entire DeFi. Since Defi is still a nascent market, once such adverse events occur, it may take a long time for the entire ecology to recover.

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02 Can the borrower continue to earn income through borrowing, that is to say, will the free lunch last for a long time?

It doesn’t take an expert to conclude that the high yields borrowers get on Compound are unsustainable.

If we assume that these incentives will continue to attract new users, the number of users will explode over time, which means that each user will get less and less shares when the reward is fixed.

COMP is only designed as a governance token. It's like buying stock in a company that gives you voting rights but no immediate plans to pay dividends. Currently, the largest voting shares are controlled by large institutions such as a16z and Polychain Capital. As of July 23, it costs about 158 ​​yuan to purchase each voting COMP token, but each COMP token can only provide 0.00001% of voting rights, and there is no cash inflow (dividend).

Tokens that provide concrete economic benefits to token holders are relatively easy to value, however, the valuation of governance tokens that do not pay dividends can be subject to a large degree of subjectivity. Currently, the valuation of COMP seems to contain speculative elements, and we believe that in the long run, before COMP governance decides to pay some kind of dividends to COMP token holders, the present value of COMP is likely to approach the intrinsic value of the token (vote value).

Furthermore, corrections to such speculative valuations are likely to accelerate if we believe the following would put additional downward pressure on the COMP market:

1. Excessive liquidation caused by unfavorable market events, which may cause speculators to sell COMP on a large scale;

2. Any form of market panic, including general technical risks associated with smart contracts and;

Therefore, it is still an interesting question when and how the liquidity mining of DeFi projects will find a medium-to-long-term balance point, and whether it will still be attractive to users who pursue yield.

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03 There is nothing new under the sun - what can we learn from the example of FCoin?

If we go around a bit further, the first project in the field of cryptocurrency to mine high liquidity may be FCoin. FCoin, a Chinese crypto exchange, launched an incentive in May 2018 to issue their platform tokens, which are used to reward users for trading on the platform. There are a total of 10 billion FT (FCoin token), 51% of which are issued as rewards. In addition, it also distributes 80% of the daily transaction fee in the form of BTC to users who hold FT continuously throughout the day.

As a result, as of the end of June 2018, FCoin’s daily trading volume exceeded $5.6 billion, which is more than the combined trading volume of the top ten exchanges. Nevertheless, when Fcoin announced the delay of FT payouts, the price of FT dropped from $1.25 to $0.66. This means that most of the users who use FCoin to trade are to profit from FT rewards, creating a huge bubble for the price of FT.

Ultimately, the platform was shut down in February 2020, failing to pay users between $67 million and $125 million.

Nevertheless, we believe that the above differences do not necessarily alleviate the concerns surrounding token valuations we discussed earlier, nor do they explain the continued prosperity of DeFi’s current liquidity mining. However, we believe that the inherent transparency and value creation nature of DeFi liquidity mining can provide a more level playing field for all participants, allowing us to try to explore its sustainable development path, which is not the case in FCoin’s case. possible.

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04 What can we learn from traditional finance? The case of Jet.com

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Also, they will use time-weighted voting, so that users who lock tokens will have more governance weight than new users. For example, 1 token locked for four years gives the same voting weight as 200 tokens locked for one week, mitigating the 1 token equals 1 vote model (which greatly benefits those people with deep pockets).

We look forward to the continuous development of different DeFi projects, because these protocols are highly related to each other and provide great composability in DeFi. Given this, we believe that switching from one protocol to another should be fairly easy for most users, where innovation and a cohesive community will ultimately play a key role in determining a protocol's long-term success ."The ability to innovate is not just one time, but continuous innovation, and the most innovative protocol will seize the pole position. We believe that although the DeFi protocol is highly composable, in the end there will still be a small number of projects that will acquire the vast majority of users and be gathered by other projects in large numbers, becoming the leader in the DeFi field."。

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A strong and cohesive community is critical to the continued success of a DeFi protocol, as nearly everything is dynamic in innovation, adaptation, and development. Due to its decentralized nature, DeFi projects will ultimately be driven by their communities, which will assume ownership and guide the direction of the project. Community is especially important for a nascent field like DeFi, as each project competes for the best talent to support and drive it.

The fully community-based governance of revenue aggregator Yearn shows us the power of decentralized community governance.

A few days after the launch of the Yearn token YFI, someone realized that its founder Andre had the ability to mint tokens at any time. So he also handed over the control of the governance contract to the community (9 community members including Calvin Liu from Compound). As of the afternoon of July 27, 2020, YFI has proposed a total of 32 proposals, 3 of which have been passed, and the remaining proposals are under voting/discussion. In this short period of one week, the enthusiasm of YFI community members is very high. What's more rare is that the founder Andre Cronje did not allocate YFI tokens to himself. These moves make the project transition to community governance at the fastest speed.

In the future, the yearn protocol will also expand to trading, futures, clearing and other fields. We also look forward to more projects that can innovate between sustainable business models and maintaining decentralization, and truly build a DeFi field BTC.

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