Is the liquidity mining incentive mechanism without the "Nakamoto Consensus" reliable?

Liquidity mining is not a completely innovative concept, but a derivative development based on the concept of Bitcoin mining. As the name suggests, in addition to normal income, users are rewarded for providing system liquidity to borrowers and lenders in the DeFi market. Its essence is the incentive mechanism and token distribution mechanism.

Compound launched Compound V1 in September 2018, building a liquidity pool model, an algorithmic interest rate model based on supply and demand, interest rate guidance measures, etc. Then, Compound V2 launched the cToken concept. This tokenization measure makes it more flexible, which can enhance its embedding depth in the DeFi ecosystem and increase its usage. This has made the previously tepid liquidity mining suddenly popular.

How Liquidity Mining Works and How Proof-of-Work (PoW) Mining Compares

There are many similarities between the way liquidity mining works and proof of work. For example, in Compound, each Ethereum block allocates a fixed amount of 0.44 COMP to the market, and this "reward" is valuable to market participants. In order to make money, market participants will provide Compound with a very valuable service, namely: providing liquidity. In the Bitcoin and Ethereum networks, one of the main functions of proof of work mining is the initial distribution of tokens for circulation; another is to reward miners for the valuable service they provide in proving blocks.

At the same time, there are obvious differences between the way liquidity mining works and proof of work, that is, the priorities of the two mining goals are different and the implementation methods of the two mining are different.

Let’s compare the differences between the two types of mining in detail.

1. First, there is a difference in priorities. In proof-of-work mining, paying miners to prove blocks may be more important than the fair distribution of tokens to market participants in DeFi. Without proof, there will be no distributed consensus, let alone a functional blockchain. However, in the Compound protocol, this priority is reversed. Compound does not need to pay liquidity providers to operate properly, which also alleviates some people's concerns that liquidity mining may be a "Ponzi scheme."

Since the token distribution itself attracts new users, and COMP tokens can vote on various changes to the Compound protocol, it is easier to convince regulators that COMP tokens are not securities when users earn money by working for each other rather than using token users to repay early investors. Therefore, Compound decided to distribute COMP tokens to a wider range of token holders.

At the same time, COMP tokens have positive value because liquidity mining participants who hold COMP tokens can receive fees from the protocol in the future. If those early investors participated in the pre-mine, they can also sell the tokens they received on the market later.

2. Secondly, the implementation methods are different. It is crucial to formulate incentives correctly. In Bitcoin, the incentive mechanism is to make miners include and verify as many transactions as possible, and at the same time, miners are required to always mine at the top of the blockchain. Incentive-compatible Bitcoin mining protocols can resist minority collusion attacks and incentivize miners to mine in the manner specified by the protocol. Miners need to follow this specific strategy to ensure network security. The famous "Nakamoto Consensus" is such a strategy, that is, incentives must always be the most profitable in the Bitcoin network. Because in a market economy, every rational economic person will have a selfish side, and their personal behavior will act according to the rules of self-interest; if there is an institutional arrangement that enables the behavior of the actor to pursue personal interests, it coincides with the goal of the organization to maximize collective value. However, this strategy is also considered to be a "selfish mining" strategy. Although it can allow a few mining pools to obtain more benefits than they honestly implement the mining protocol, it will potentially undermine the stability of Bitcoin and promote the centralization of mining. Although no clear evidence of selfish mining has been found in the market, this risk always exists.

Unlike Bitcoin’s incentive mechanism, Compound’s optimal incentive strategy for liquidity miners has changed a lot and made many improvements. Since users need to pay a certain amount of COMP tokens to take any action in the Compound protocol, Compound’s liquidity miners have many incentive strategies to choose from.

It is worth mentioning that the priority of the Compound protocol is not to incentivize specific behaviors on the network (such as Bitcoin miners mining is a specific behavior, and they will also be rewarded with BTC tokens for mining), but to provide tokens to a large number of users. Generally speaking, the higher the deposit rate, the more efficient COMP mining is, but miners basically strictly abide by the incentives because their share of COMP token rewards is based on the interest paid. However, for a period of time, BAT, as the currency with the best COMP liquidity mining income, almost monopolized COMP mining, but unilaterally increasing the size of BAT deposits has not been able to increase interest rates, because the factor that directly affects interest rates is the loan ratio. As a result, BAT big holders deposited other assets in their accounts, continuously increasing the size of collateral until all the previously deposited BAT was lent out. This model has become "paying interest while collecting interest", and ultimately the utilization rate of funds has been pushed up, and mainstream assets that use "real" assets for supply and lending have been marginalized, and they cannot receive the due incentives.

Is there an alternative best-practice motivation strategy?

It is definitely a huge success for a cryptocurrency system like Compound to attract billions of bank deposits. Simple users who deposit USDC and USDT in Compound are like the easiest and most stable flow of funds in the existing banking system.

Compared to proof-of-work mining, liquidity mining does not have a "Nakamoto consensus" and does not explicitly require miners to follow a strategy. They just hope that at least some rewards will not be captured by abnormal strategies. If the protocol is prioritized from the mining aspect, many behaviors on the network can be rewarded, which will also stimulate the emergence of more possible incentive strategies. Perhaps the next excellent incentive strategy is not far away. (Golden Finance)