Why DeFi and liquidity mining in Ethereum will not continue to grow

Yield farming has been all the rage this year, with some even calling it the “rocket fuel” that DeFi needs. Hyperbole is good, but the question remains: is yield farming the real deal? Or is it just another one of those fantasies that often catch the attention of many in the crypto community?
It’s been 90 days since liquidity mining was first introduced, and it certainly marked the beginning of a new wave of liquidity mining excitement. At the time of writing, it still does. However, in the past few weeks, more and more scrutiny has also begun to set in, with VM Capital co-founder Baptiste Vauthey being one of the latest to criticize this new “trend.”

Is liquidity mining still shining?
In a recent post, Vauthey went on to make what he calls the “case for liquidity mining.” He claims that this may soon fade away and perhaps be unsustainable in the long run. According to him, users may use the protocol for a short period of time before moving on to discover the “next shiny thing.”
He believes that this is so because many projects have not prepared for the situation where incentives dry up, and most projects incentivize action by subsidizing the cost of action. However, most subsidies are paid in the project's own token, which is usually issued in batches after a few lines of code and has no intrinsic value unless the community attributes it to it.
According to Vauthey, these tokens lack “value capture mechanisms” and, while they confer certain governance rights, they fail to function as proper currencies.

Playing the Incentive Game <br />Given how quickly liquidity mining has captured the imagination of many in the crypto community, this in itself is a very bold claim. There may be some examples that can support his argument.
Look at the case of GUSD - back in 2019, Gemini offered GUSD to OTC desks at a discount. What did users do? Well, they saw an arbitrage opportunity where they could buy GUSD at a discount and redeem it for Paxos Standard. Here, users were not interested in GUSD or the fact that GUSD was near its peak market cap. Instead, they were interested in the incentives provided by discounted GUSD.
Fast forward to 2020, and several cases have popped up in the past few months alone. For example, Compound itself was a well-crafted target, seeing some users exploit the steep interest rate curve in the BAT and ZRX markets to mine large amounts of COMP. Later, they engaged in a practice called recursive lending, giving a false illusion of liquidity, where they borrowed most of the liquidity they themselves provided without any other users of Compound coming in.
Balancer was also at the center of such an incident, with Alameda Research providing evidence that it was possible to manipulate these protocols. As Vauthey put it,
“What Alameda is showing here is that it’s possible to offer two assets that no one particularly wants to trade between, while still getting most of the rewards of the protocol.”
A risky business This is not the first time that the risks associated with liquidity mining have been highlighted. In fact, the DeFi space itself has been at the center of much scrutiny over the past few months as the “total value locked” figure has grown exponentially.
In a previous article, we highlighted how Binance’s CZ was quick to highlight the risks involved. However, he is not alone, Ethereum’s Vitalin Buterin also commented on the future of this trend,
“(Liquidity mining) is a short-term thing. Once the traction is gone, you could easily see yields falling back to very close to zero.”
In fact, the increasing complexity of DeFi and efforts such as liquidity mining have also caught the attention of Deribit, whose Insights report commented that multiple DeFis are being mixed together. The report also stated that there are too many layers in these "money Legos", making them more vulnerable to security risks.
Risk isn’t the only issue here, so is regulation. Or rather, the lack of it. According to Kristi Swartz, managing partner at Swartz Binnersley & Associates,
“….DeFi operators seem to have an unspoken ‘code of conduct’ and they are the best in the space. Regulators are clearly watching the space carefully and are known to be reactive rather than proactive in their approach. Arguably, one transaction could derail the whole thing.”
This is a critical point, but one that is often overlooked. It’s surprising because this isn’t one of the times the crypto industry has been accused of failing to flag a vulnerability. Well, the least that can be said is, be careful and keep your fantasies to yourself! (Blockchain Knight)