Technical Analysis | How is liquidity mining implemented and what are its advantages and disadvantages?

With the launch of Compound and Balancer projects, the popularity of liquidity mining has exploded. In the past month, the locked position of liquidity mining projects on Ethereum has continued to grow. As of now, the locked position of Compound project has exceeded 1.6 billion US dollars.

What is Mining?

Since Satoshi Nakamoto published a paper titled "Bitcoin: A Peer-to-Peer Electronic Cash System" in 2008, the term "mining" has been given a new meaning.

Mining originally refers to the process of miners mining minerals to gain wealth. After Satoshi Nakamoto invented Bitcoin, the characteristics of Bitcoin such as immutability and total conservation of Bitcoin made Bitcoin very similar to the characteristics of minerals such as "gold" and "diamonds". Therefore, people in the industry call the act of "providing computing power to compete for bookkeeping rights" "mining".

Let's briefly analyze the process of Bitcoin mining, as shown in the following figure:

△ Figure 1

1. Receive transactions broadcast on the chain

2. Verify the transaction and package it

3. Calculate a specific value through hash

4. Broadcast block information to the chain

5. Blockchain nodes (miners) receive broadcast blocks

6. Get mining rewards and mining is successful

Of course, this is just an imaginary successful mining state. When many miners are mining at the same time, if one miner succeeds in mining, it means that the other miners have failed in the competition and have to start mining again. Therefore, the size of the miner's computing power directly affects the final profit situation. The greater the computing power of the miner, the greater the probability of successful mining .

Under this mining mechanism, "mining" is actually exchanging "electricity costs" and "computer hardware costs" for Bitcoin, that is, "consuming real-world resources in exchange for virtual currency value" ; and "liquidity mining" is very different from this method.

Liquidity Mining

Liquidity mining is also known as "borrowing is mining" . Compared with "computing power mining" under POW consensus and "equity mining" under POS consensus, liquidity mining is a model of obtaining rewards for providing liquidity for virtual currencies .

As a pioneer of "liquidity mining", Compound has received explosive attention since its project token COMP was officially launched on June 16, and achieved a 500% increase on the first day of launch. This is undoubtedly a star project in DeFi projects. Let's take a Compound on-chain transaction as an example.

( 0x3d6dd94815fbcaeafc331da9183caac5f13a8ef5752fc76c075769373432f88a ) to explore the implementation of Compound’s liquidity mining.

The external account " 0xf91bf " returned 2.00576 WBTC to Compound Wrapped BTC and obtained the borrowed "mining" income of 3.35160429 COMP, as shown in the figure below:

△ Figure 2

By tracking the call log of the event, we can see the code implementation of the entire "mining" process.

The external account calls the repayBorrow function of Compound Wrapped BTC to repay, as shown in the following figure:

△ Figure 3

The repayBorrow function calls the internal repayBorrowInternal function, as shown in the following figure:

△ Figure 4

The repayBorrowInternal function calls the internal repayBorrowFresh function, as shown in the following figure:

△ Figure 5

The repayBorrowFresh function calls the proxy contract Comptroller of the Compound:Comptroller contract

The repayBorrowAllowed function in ( 0x9D0a0443FF4bB04391655B8cD205683d9fA75550 ) is shown in the following figure:

△ Figure 6

The repayBorrowAllowed function contains the distributeBorrowerComp function, which is the function of Comp obtained from dividend mining, as shown in the following figure:

△ Figure 7

Let's draw a flowchart to understand this transaction more intuitively, as shown below:

△ Figure 8

To summarize, liquidity mining actually refers to rewarding users who participate in lending (fund flow) at the smart contract level .

The pros and cons of liquidity mining

In traditional finance, currency carries value, and the circulation of currency is the process of value transfer. Only when currency circulates can value be effectively exchanged and commodities can generate their corresponding value. If commodities cannot reach the hands of those who need them, the phenomenon of "rather pouring out milk than selling it to the poor" during the Great Depression in the 1930s may occur, so the liquidity of currency is crucial .

In the traditional financial field, the liquidity of money is mostly controlled by centralized banking institutions through the regulation of interest rates and reserves, thereby ensuring that the value of social commodities can be realized.

In the blockchain world, digital currencies have not yet been directly linked to real-world commodities, which makes the currency on the blockchain more of a conceptual value, similar to investment assets such as stocks. And the starting point for users entering DeFi projects is mostly arbitrage and investment. Therefore, the stability and liquidity of digital currencies on the blockchain have been greatly affected. Under this premise, it is obviously unlikely to be a currency that can be used on a large scale.

Liquidity mining is actually a decentralized way to promote currency circulation, and it is a milestone innovation in the development of blockchain. Different from the unique model of "flash loan" on blockchain, "liquidity mining" is a decentralized implementation of "centralized liquidity regulation by authoritative institutions" in the traditional financial system.

However, there are also some worrying factors in "liquidity mining". At present, "liquidity is mining" is different from "computing power mining". "Computing power mining" is backed by real-world resource consumption, while "liquidity mining" does not.

Take COMP as an example. The COMP coins generated by its liquidity mining are officially issued tokens, and their value endorsement relies on the official project. Judging from the current situation, the project has attracted widespread attention and the popularity remains high, so of course the currency value has been rising. However, the current sources of this popularity are mostly those who want to "get a piece of the pie", so behind this superficial prosperity, there is not much real value generated by lending, which is bound to be a bubble; in addition, the blockchain security situation is very serious. The recent incident about the Balancer vulnerability also shows that there are still many security issues in the current DeFi project. Therefore, we should not be overly optimistic about "liquidity mining" and "DeFi" projects, and we need to be vigilant and invest rationally.