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Will Free Lunch Last? A Deep Dive into DeFi Liquidity Mining

All of a sudden, almost everyone starts to talk about DeFi, but what is it? The main idea behind Decentralized Finance (DeFi) is that by creating financial products and contracts using smart contract programs that run on a blockchain, we can create a much more open, transparent and fair market that is more amenable to innovation. One day, this new market may serve as a critical alternative to the incumbent financial market. DeFi has been growing significantly in its trading volume in 2019, while entering 2020, it experienced its first period of dramatic exponential growth in its Total Value Locked. Many believe that the main thrust pushing for much more rapid adoption of DeFi is the idea called liquidity mining applied first on Compound and then other DeFi projects as well. In this article, we provide a quick overview on liquidity mining in DeFi and then delve deeper into the rationales behind its rapid adoption and future prospects.

Before we look into DeFi liquidity mining, first let’s look at where we are standing in terms of the volume of the DeFi market? As per 23 July 2020, the total value locked in DeFi is US$3.3B. This number itself might fail to impress some. However, think of the fact that the DeFi market was about US$600M just 3 months ago. That is more than 5 times’ growth in 3 months, and quite an achievement even in the fast-moving blockchain space!

Source: DeFi Pulse

OK, I get it, but what is Liquidity Mining?

Simply put, liquidity mining provides additional incentives to users who in one way or another contribute to the “liquidity” of the market, in promoting higher usage, volume, and activities of the product. At the high level, the concept is not too distant from other incentive programs such as the one from Uber for its drivers, as both have the eventual objectives of bootstrapping and nurturing a self-sustaining positive loop in achieving network effect. There are, however, some fundamental and unique features of liquidity mining in DeFi which we will examine a bit later. Here we first attempt to give DeFi liquidity mining a proper Definition and scope.

We think that not all liquidity incentivizing schemes are necessarily liquidity mining. In this report, we follow two simple criteria below:

1. A project has its native token, and

2. Rewards its users with the newly minted native tokens to incentivize them to use its products.

With these criteria, projects such as Uniswap that reward liquidity providers with protocol fees will not be within the scope of this report.

The below diagram shows the landscape of the current liquidity mining in DeFi where Compound is dominating the market with few projects such as Curve, bZx and mStable coming up.

Data Source: CoinMarketCap

Where the story began: Liquidity Mining in DeFi Lending

There are different types of DeFi markets in existence or in the works, including lending, automated market making, decentralized exchanges, derivatives and insurance, oracles, as well as prediction markets.

The lending platforms are arguably the most popular and fastest-growing sector of DeFi, and also the first that rolled out a popular liquidity mining program. Most of DeFi lending markets are for collateralized lending products, where users can deposit assets into the product, which can optionally be used as collateral to borrow other assets. By supplying assets, interest receivable is accrued, while by borrowing assets, interest payable is accrued. 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 23 July 2020).

In traditional finance, creating a bank that provides lending and borrowing services requires a lot of money upfront. In the world of DeFi, the money is largely provisioned by a market that is entirely orchestrated by smart contracts in an automated manner. Therefore, there is no need to trust any middleman such as a bank for lending and borrowing. The rules are codified and will be executed by the blockchain. Nevertheless, to bootstrap this process, the projects need to come up with revolutionary ways to attract holders of idle assets to supply.

In practice, many DeFi lending markets use the concept of asset pools to allow smart contracts to automatically adjust the interest rates based on the supply and demand of different assets. This works well in principle and typically provides competitive interest rates to compensate for the steep learning curve, inconvenience in operating on cryptocurrency wallets, as well as technical risks compared to centralized lending options. However, these same factors can also prevent enough users from supplying sufficient liquidity into DeFi lending pools, and as a result, may cause irregular interest rates. What is worse, such unfavorable interest rates may make users move assets elsewhere and further dry up the pool ending up in a negative loop.

On the other hand, liquidity mining may provide a strong push for DeFi lending markets to run in positive cycles, especially when the incentives in the form of minted tokens outweigh the range of volatility in the interest rates. This is exemplified by Compound today, an interesting use case to illustrate how everything works for attracting sufficient liquidity.

Case Study: Compound

Compound is a pioneer in liquidity mining which is also referred by the term of yield farming. It started to distribute its governance token COMP on 15 June 2020. Since the introduction of this whole new yield-generating pasture, crypto users have been putting more and more assets into the DeFi market.

Source: Coindesk

In the case of Compound, the fundamentals of the governance token are primarily about the rights to vote on the proposals of updating the protocol. Note that given the nature of such projects that are fully automated by smart contracts, such voting rights are the only way to change how things work in the product. Compared to governance models in the traditional world, COMP tokens are like the paperwork for the eligibility to vote in the legislature.

How does Compound Yield Farming work?

Source: Compound Medium

In particular, a total of 4,229,949 COMP tokens will be put into a “reservoir” contract and will be distributed to suppliers (i.e., liquidity provider) and borrowers on a 50% and 50% basis. The distribution process will be an automatic process which transfers 0.5 COMP per Ethereum block (2,880 COMP tokens per day) for roughly 4 years. Compound users can simply earn COMP based on the dollar value of assets they have supplied to/ borrowed from the system.

Once an address has earned 0.001 COMP, any Compound transaction thereafter will automatically transfer unclaimed COMP tokens to it; for smaller balances, an address can manually collect all earned COMP.

The popular term “yield farming” not only refers to earning COMP tokens by transactions on Compound, it also refers to the strategy which puts crypto assets to work and generates the most returns possible on those assets. Examples of yield farming activities include:

1. Moving across DeFi lending pools even to those that are riskier in order to get a higher yield

2. Acting on different trading strategies. For example, spilling over to other protocols for arbitrage, supplying assets to borrow assets then supplying the borrowed assets back into the protocols in order to get higher yield.

Other DeFi projects starting liquidity mining too!

Besides the lending market, liquidity mining has gaining traction in Automated Market Makers (AMM) projects as well. To provide efficient low slippage trades, AMMs rely on the depth of the liquidity pools. Therefore, the intuition for introducing liquidity mining in this field is straightforward. Two prominent AMMs utilizing liquidity mining are Balancer and Curve. Liquidity providers on Balancer are able to “mine” BAL tokens since June 1, 2020. Within the first month since the BAL distribution has started, the total value locked on Balancer increased by 680%!

Source: DeFi Pulse

On the other hand, Curve plans to start the distribution of CRV tokens around the end of July and the token will be retroactively distributed to all of the liquidity providers based on how much and for how long they have contributed to the pools on Curve. As illustrated below, Curve has also attracted a large amount of deposits recently.

Source: DeFi Pulse

The table below compares some of the details of major DeFi projects that are providing liquidity mining (As per 23 July 2020):

Data Source: CoinMarketCap, CoinGecko

DeFi projects have generated numerous ways of employing hundreds of millions of dollars’ worth of tokens idly sitting in the wallets. Liquidity mining managed to attract a significant share of those funds in a relatively short period of time. Prior to introducing liquidity mining (i.e. before June) Compound, Balancer and Curve had roughly $135M locked in their pools, while as of July 23 this value exceeded $1.175 billion!

In case you’re wondering, because we’re! — — What causes the explosive growth and will it be sustainable?

To begin with, we think the peculiarity of Compound distribution where borrowers earn 50% of COMP allocation has been the main contributor to the explosive growth of the Compound network. In simple words, the borrowers were basically paid (by COMP tokens) to borrow from Compound!? Sounds perfect, doesn’t it? This led to a huge spike in the number of borrows (as illustrated below) that further pushed the interest rates higher (higher than what would otherwise be) making supplying money on Compound even more attractive in the short term.

Source: Alberquilla, I

Perhaps another potential factor for this price boom of governance tokens is that users are using “total value locked” (TVL) as a way to value DeFi projects.

Taking yearn as an example. The locked-in value of the yearn pool on Curve on 17 July 2020 was about 8 million USD. Three days later, this figure has been raised to 147 million USD as of Monday, 20 July 2020. The increase of TVL has boosted the price of its governance token YFI, which soared to 2,374 USD from its initial valuation price of 30 USD.

CoinGecko research analyst Daryl Lau pointed out that in the case of “liquidity mining”, the value is reflected by the token price itself, which also gave birth to a kind of “pseudo-Ponzi economics”. The increase in token price will bring more people to lock their assets into the platform thus the TVL will increase. The high TVL will further increase the token price forming a virtuous circle. We think this cycle will not last as the valuation is not sophisticated.

A zero-sum game?

The total value locked in DeFi skyrocketed from about $1 billion in the early June to about $2 billion in early July and a significant share of the new funds was allocated to Compound. Additionally, by looking at the total value locked in other lending protocols, we see that after 15th of June (when COMP distribution started) protocols such as Maker InstaDapp, DDEX, Nuo Network and bZx had a significant drop in the total value locked. Maker and InstaDapp had a fast recovery several days after, however, the other protocols still haven’t recovered from the drop.

Source: DeFi Pulse
Source: DeFi Pulse
Source: DeFi Pulse

Could this point to some trend of consolidation within the DeFi space? Possible. If so, it is even more important that they are based on sustainable models, because they would constitute a systemic risk for the whole DeFi. As of July 23, the top five DeFi projects (Maker, Compound, Aave, Synthetix, and Curve) control 78% of the Total Value Locked of the DeFi market. Considering that numerous projects are co-integrated in some way with the top DeFi protocol (e.g. Maker, Yearn, RenVM, Curve, and Compound are all inter-connected), an adverse event such as smart contract or oracle failure in one of the leading players would cause a domino effect over the whole DeFi. In case that happens, such a nascent market may take a very long time to recover.

Will the borrowers be able to keep earning by borrowing, i.e., will the free lunch last long?

It doesn’t take an expert to conclude that the high earnings borrowers are receiving on Compound are not sustainable.

If we assume that these incentives continue to attract new users, the increasing number of the users combined with the fixed number of rewards implies that each user will get only a smaller and smaller share of the minted token as time goes by.

COMP is designed only as a governance token. It is like buying a share in a company that gives you the voting right but no immediate plan for dividend payout. Currently, the largest share of the votes is controlled by the big players such as a16z and Polychain Capital. As of July 23, to buy one vote you need to spend about $158. That would give you 0.00001% of voting power and no cash inflow (dividend).

Some tokens are easier to evaluate since they promise concrete economic benefits to token holders, however, governance tokens that do not payouts are subject to a large degree of subjectivity. Currently, the COMP valuation seems to include a speculative factor, and we think that in the long term until COMP governance decides any specific payout to COMP token holders, COMP’s present value will probably converge to the inherent value of the token — value of a vote.

In addition, the correction is likely to accelerate if and when one of the following occurs to put additional downward pressure to the COMP market:

1. Excessive liquidations caused by adverse market events could make speculators trying to sell COMP on a massive scale;

2. Market panic of any sort, including technical risks associated with smart contracts in general, not specific to Compound; and

3. More likely than not, people chasing ever-higher profits will go after other higher-yielding venues, triggering a downward spiral of lowered liquidity and COMP valuation.

Therefore, it remains an interesting question when and how liquidity mining in DeFi projects will find its mid-to-long-term equilibrium, and whether that is still attractive to users going after yield when that happens.

There’s nothing new under the sun — — What can we learn from the FCoin example?

If we wind back a bit, the first high-profile trial of liquidity mining in the cryptocurrency space is probably FCoin. FCoin was a China-based crypto exchange that initiated an incentive to give out their platform token for rewarding users making trades on the platform in May 2018. There were 10 billions of FT (FCoin token) in total where 51% was distributed as rewards. In addition, it distributed 80% of its daily transaction fee in BTC to users who held FTs continuously throughout the day.

As a result, FCoin had over $5.6 billion daily trading volume at the end of June 2018, which was more than the sum of the top 10 coins’ trading volume all combined. Nevertheless, once Fcoin announced a delay in its FT payout, the price went from $1.25 down to $0.66. This means the majority of the users who used FCoin to trade did so for the purpose of profiting from FT rewards, creating a huge bubble for the price of FT.

In the end, the platform was closed down in Feb 2020, failing to pay out $67M to 125M to its users.

We think there is a critical difference between liquidity mining in DeFi and FCoin. The FCoin failure was largely accelerated by the embezzlement of funds without any governance which made it more like a scam. In the case of liquidity mining in DeFi today, the distributions of the token are trackable and use of funds fully dictated by smart contracts with full transparency. In addition, FT mining was encouraging wash trades, which are not really valuable, whereas liquidity mining incentivizes liquidity provision, which brings real value to the market depth.

Nevertheless, we do not think the differences above necessarily alleviate the concerns around token valuation as we discussed earlier, or merit a sustainable prosperity of current liquidity mining in DeFi. Yet, the transparency and value creation nature inherent in DeFi liquidity mining might provide a much more level playing field for all players to explore the paths to sustainability, which was not practically possible in the FCoin case.

What can we learn from traditional finance? A close look at

To understand how similar programs worked in traditional finance, we take a look at the example. (founded in 2014) was a start-up running a similar model to Amazon. It raised $80M in the early 2014 but they thought there was one thing that valued more than money — sign-ups. So, they offered give-away equity for new sign-ups.

The company decided to start a competition where whoever could refer the most users to their product would receive 100,000 shares of the company with the following nine receiving 10,000 each. This equity give-aways ended up with successfully bringing 350,000 new sign-ups. People were actually spending their own money on marketing and advertisements to make sure their referral was used, and these users were working like employees with a strong incentive to grow the business. The winner — Eric Martin spent $18,000 for attracting 8,000 referrals and got 100,000 shares. was then been acquired for 3.3 billion and Eric netted out over $10M.

The first question would be what could we learn from the success story of We think maintaining a long-term interest alignment between projects and users is the key for sustainability. The current liquidity mining in DeFi is more like a game where the users are playing. People are doing liquidity mining not because they are betting on the success of the company but focusing on short term profiting opportunities.

In the case of Eric, he mentioned that “I feel like I’m kind of linked to the success of the company now.” This is because he wasn’t able to cash out until the company goes public or gets acquired by another company, and thus he still maintained aligned interests with the company.

Therefore, we think that if DeFi projects were to align long term interests with their users and token holders, some form of lock in periods are necessary. Fortunately, we have seen progress towards this direction. For instance, Curve Finance announced that the users who lock their CRV tokens will be able to boost their share in inflation up to a factor of 5, which is expected to create organic lock up behaviors.

Specifically, the current proposal suggests CRV will be issued with a supply of 1B CRV which will be gradually inflated to a max supply of 3.03B Curve. Inflation is set to be the highest in the first year and scale up over time, suggesting early adopters will see the most upside from protocol usage.

Source: Curve Github

Likewise, they will use time-weighted voting to give those who lock their tokens more governance weight than someone who participates for the first time. To illustrate, one token locked for four years gives as much voting power as 200 tokens locked for one week. This weighting is likely to be modified relative to how the community sees fit and is really geared at trying to mitigate the 1 token 1 vote model which drastically favors those with deeper pockets.

Source: Curve Github

Doing so, Curve ensures its stakeholders will have the aligned interest with the protocol for the foreseeable future which sets the example for other projects to follow.

In summary: what we’ve learned so far for liquidity mining to sustain?

We expect and appreciate the prosperity of diverse protocols highly connected with one other with great composability built into DeFi protocols. Given this, and the fact that switching from one protocol to another is straightforward for most users, innovation capability and cohesive community will eventually play a crucial role in determining the long-term success of a protocol.

The capability of innovating not just once, but consistently, will decide the establish positioning between the protocols, where the most innovative protocols will seize the pole position. We believe this will be the case despite the highly composable nature of DeFi protocols, because a few protocols will emerge as part of a “backbone” used by most users and other protocols in the space.

A community that is strong and cohesive is essential to the continued success of DeFi protocols, as almost everything is dynamic amidst innovation, adaptation, and development. Due to their decentralized nature, DeFi projects will eventually be driven by their communities who will take on the ownership and steer the directions of the projects. This is especially critical for a fledgling space such as DeFi, where every project is competing for the best people to support and drive it.

The best is yet to come — — future prospect of DeFi Liquidity Mining

- Liquidity Mining — More projects to follow

Taking into account the importance liquidity has for the DeFi area, the emergence of innovative liquidity incentivizing schemes doesn’t come as a surprise. Considering the amount of funds Compound attracted, we expect to see more projects following the path. For instance, one of the projects that has been struggling to retain users recently bZx (total value locked went from $1.5 million before Compound started liquidity mining to $750,000 after the distribution of COMP has started), has also announced liquidity mining plan .

- How about bringing BTC to DeFi?

Talking about liquidity more broadly, we are closely following the projects that are trying to unlock Bitcoin’s liquidity on DeFi. After all, Bitcoin is still the most liquid cryptocurrency (>170B market cap), therefore, it is impossible to overlook the huge potential of the integration. We expect a steady flow of idle Bitcoin tokens to DeFi, primarily motivated by the attractive yield. One project to look at specifically is the sBTC pool on Curve, allowing renBTC, sBTC and wBTC holders to participate in yield farming. The project attracted more than $25 million worth of deposits within one month since introduction and we expect the growth to continue in the future.

Total deposits of sBTC Pool on Curve

Source: Curve Finance

- Oracle with liquidity mining? It’s possible!

“On-chain oracle” is becoming a hot topic in the Oracle industry and one great example is Nest protocol.

In the NEST system, there are “miners” who quote prices to the system for mining. Such “miners” are a bit like the liquidity providers in the Uniswap system. They need to input the quoted assets into the quoted contract according to the transaction pair and provide a trading pair quotation that anyone can take orders. At the same time, this quotation is subject to market arbitrage testing. That is to say, if there is a spread between the miner’s quotation and the mainstream exchange price, it will be eaten by the arbitrageur, and the remaining uncompleted order quotations can be considered as quote accurately.

Since on-chain oracle projects like Nest Protocol could potentially need additional quotations, we believe the idea of liquidity mining will also be a potential mechanism for oracle projects to attract users in order to improve its market’s liquidity.

- How to best use liquidity?

Ultimately, we believe that the blockchain community will move from resolving liquidity issues to having deep enough liquidity to export it. Therefore, it is important to start building the bridges from blockchain to the real world. After all, the idea isn’t to have the blockchain as a silo, but to have decentralized infrastructure and applications making the everyday work and life of ordinary people better. Initiatives such as credit delegation by Aave illustrates possible avenues that could help close this gap, with which Aave users can delegate their credit on the blockchain to anyone based on a legal agreement. This will enable people with no blockchain knowledge to get access to DeFi liquidity and other blockchain applications going forward. It is important to note that in this case, the pool does not bear any additional risk, as the collateral condition isn’t changed. This is yet only one of the many potential use cases to bridge between DeFi and the real-world financial demand, and we believe this is an area with great investment potential.

- Obstacles along the way– gas fees & complexity

Amidst all the wonderful yield users are receiving with liquidity mining, one complaint often heard is the high gas cost. This is especially true for protocols that are heavily integrated, e.g. Curve Finance which reinvests the funds from the liquidity pools to lending protocols such as Compound or Aave. Doing so, it generates extra yield to liquidity providers but also brings several times higher gas fees. On the other hand, as the complexity of DeFi applications increases, the risks around liquidation under sudden adverse market events could be exacerbated by excessive gas fees.

We believe the current liquidity mining will bring the attention back to the infrastructure level, and projects that can improve the scalability of Ethereum without compromising the user experience will be the next winner.

Source: Dune Analytics

Likewise, the increasing size of the DeFi market is followed by its increasing complexity, and thus we expect increasing demand for user-facing apps that can ease the interaction between end users and DeFi protocols. Specifically, user aggregators enabling all-in-one integration to access all DeFi protocols (e.g. Instadapp, Argent, Gnosis Safe) are set for growth and may play a particularly important role in attracting new crypto adopters.

Additionally, since more and more protocols are joining liquidity mining frenzy, it is getting harder to navigate the spectrum and find the most profitable opportunities. Those that focus on increasing yield will rely more on yield aggregators such as yEarn (refer to the diagram below to appreciate the sophistication behind the scene!). Therefore, it is expected that more optimizing yield protocols will emerge on the top layer to take the advantage of the short-term oriented traders.

Source: IOSG Ventures

Finally, the jump of about $1 billion in deposits within one month symbolizes a beginning of a heavily innovative era in DeFi and the whole blockchain ecosystem. The dramatic growth in the value built on blockchain in the time of global crisis will persuade even the skeptical to reconsider realizing blockchain-driven innovation as part of the new normal.

Free lunch may or may not last long, but what really matters is that technology and innovation powered by blockchain keep surprising us with great use cases and applications that were not quite possible before.


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