How did the liquidity mining that set off the DeFi wave eventually die? (Wu says trend)

1The rise of liquidity mining

Let’s talk about two concepts first: “liquidity” and “mining”

Liquidity:

Any market needs to be traded at any time, which means there must be buy orders and sell orders. The matching of buy orders and sell orders is called market liquidity.

Short-term trading in the financial market is not about trading securities themselves, but about trading risks. The market only provides a place for risk to flow, and traders gain benefits from taking risks. Market participants will also price the current risks, and the vote on risks is the buying and selling price.

Anyone who has traded in cryptocurrencies or stocks should know that in the financial market, one is not afraid of not making money or being trapped. The most feared thing is the depletion of liquidity.

Think about this year's several waves of ups and downs. Do they represent a sudden increase in the value of Bitcoin? No! Rather, the market lacks counterparties. When liquidity dries up in the market, the price will show a drastic one-sided trend, and even endanger the survival of the entire market. This is the importance of liquidity to the market.

Mining:

"Mining" in the blockchain world comes from Bitcoin. For a complete financial system, the issuance of system currency needs to consider these questions: "Who to issue it to?", "How much to issue?", "What is the criterion for judgment?" By incentivizing ecological participants and maintainers, the system can become a self-operating distributed system.

On the other hand, tokens initially have no value. Through mining, the value is finally anchored and captured, making the tokens scarce and "costly to acquire." For example, under the framework of the POW mechanism, miners invest in computing power and operation and maintenance in exchange for block rewards and participate in transactions in the secondary market, thus giving rise to the concept of "shutdown price."

Liquidity Mining:

Now that we have a clear understanding of "liquidity" and "mining", let's combine them and define "liquidity mining": it refers to the process of obtaining income by providing liquidity for the product's funding pool through DeFi products with a mining mechanism, depositing or lending specified token assets as required, thereby increasing the activity and usage of the product.

Take the Compound project as an example. As a DeFi protocol based on Ethereum, Compound's main business is mortgage lending. According to DefiPulse data, the locked amount of Compound on July 7 was about 650 million US dollars. Users can pledge their assets to obtain annualized returns, or pay corresponding interest to lend assets. While borrowing and lending, they can obtain a certain amount of system-distributed governance tokens COMP.

2What is the underlying logic behind the high returns of liquidity mining?

Let me first state the conclusion: in liquidity mining projects, the price of project tokens often rises with the increase in participating funds. In this case, the increase in the number of participants and the funds locked in the platform will drive up the price of project tokens, and the price increase of project tokens will in turn continue to stimulate more funds to participate in the platform's liquidity mining. The high liquidity fund participation will further increase the token price, thus forming a cycle, and even giving birth to a "false prosperity" and a "pseudo-Ponzi spiral".

Source: Alberquilla

Source: Non-small

Taking the Compound platform as an example, as long as the borrower borrows money on the Compound platform, he can obtain 50% of the platform's daily COMP token allocation. As long as the value of the COMP obtained can cover the repayment interest rate, arbitrage can be made without loss. This is also the main reason why the number of loans has risen rapidly with the rise in COMP prices.

Taking the popular YFI project as an example, users can complete different liquidity mining strategies through yearn.finance, which is a liquidity mining aggregation platform. On July 17, 2020, yearn's locked volume (TVL) on Curve was about 8 million US dollars. Three days later, as of July 20, 2020 (Monday), this number had increased to 147 million US dollars. The increase in TVL has driven the price of its governance token YFI, which has soared from the initial valuation price of 30 US dollars to 13,616 US dollars.

3. Can the high returns from liquidity mining be sustained?

Liquidity mining is new to Westerners and they even gave it a name called “Yield Farming”, but after our analysis we found that the model seems very familiar. Isn’t this the model of FCoin back then?

FCoin launched a liquidity incentive policy that year, using its own platform currency FT to reward users who traded on the platform. The platform's trading volume exploded rapidly within a month. However, such a rapid growth in trading volume was not due to real trading demand, but rather speculation by investors with many volume-boosting robots. In the end, the FCOIN platform was closed in February this year, failing to pay $67 million to $125 million to users.

Let’s go back to the example in the previous section. As long as the borrower borrows money on the Compound platform, he or she can obtain 50% of the platform’s daily COMP token allocation. As long as the value of the COMP obtained can cover the repayment interest rate, arbitrage can be made without loss. This is also the main reason why the number of loans has risen rapidly with the rise in COMP prices.

We soon discovered the root of this model. Whose money do speculators make? Speculators transfer the risk to those who buy reward tokens by circulating the reward tokens in the secondary market. As a speculator, they do not have real borrowing or trading needs. They just want to get reward tokens and sell them in the trading market for profit.

Obviously, this model incentive itself does not stimulate real lending or trading demand, nor does it really solve the mismatch between supply and demand. Most traders come for the stimulus itself, not for trading needs.

The risk of this stimulus model lies in the fact that due to the positive growth cycle, speculators quickly pour in, and the proportion of speculators in the system is much higher than the proportion of real trading demand. Once at a certain moment the cost (transaction commission or borrowing cost) for speculators exceeds the distribution of profits, speculators will withdraw from the transaction, leaving only a small number of real traders.

Therefore, no matter how the positive cycle flows in during the prosperous period, the ending will be the same as the death spiral. Once the situation is reversed, the system has no time to establish negative feedback support (or due to the explosive growth of the release volume, it is impossible to carry out any effective negative feedback management), which accelerates the price decline, accelerates the exit of speculators, and causes the system to collapse.

When the FCOIN team was in a negative cycle, they tried to conduct artificial negative feedback, such as acquiring some assets in the secondary market, but in the end it was just a drop in the bucket and still couldn’t withstand the flood of negative feedback.

In addition, liquidity mining is now exposed to security risks and systemic risks. The flash loan attack against bZx is a typical example. The attacker arbitrages more than one million US dollars in a dozen seconds according to the rules without stealing tokens. Defi products with the spirit of cross-chain protocols are getting closer and closer to the leverage game of traditional finance. The popularity of liquidity mining aggregation platforms has intensified the mutual influence between mainstream projects, which may cause certain systemic risks.

China's overall market has not yet fully recovered from the big bubble in 2017. As practitioners, we also cherish the current gradually developing ecology and do not want to see a big systemic crisis. For project parties, liquidity mining has attracted users and players, but whether it can capture value and realize real value supply should be the key issue we think about. We are pessimistic about the outcome of this model. (Special author: Zhang Bumeng Editor: Wu Shuo Blockchain)