Dear Crypto Enthusiasts:
The DeFi ecosystem is literally going through the roof.
While the world is heading to the worst economic recession of the century,
DeFi reaches the milestone of USD 2.8b total value locked and growing by the minute. Not only this figure is an All Time High figure, but more importantly, is growing exponentially:Total value locked in the system increased 2x in the last month!
What is happening here?
The hyperbolic growth curve was triggered by the announcement last month of Compound, a permissionless borrowing and lending platform, to issue and distribute a new governance token (COMP) through a novel incentive mechanism called liquidity mining or more colloquially, yield farming.
Yield farming is a novel incentivisation tool for bootstraping communities and markets of emerging platforms. It rewards active users who provide value to a network with political rights to decide on future protocol updates, and sometimes economic rights, such as cash flows or other value accrual mechanisms.
Other projects like Uniswap, a decentralized exchange and automated maker maker (AMM) and Synthetix, a DeFi derivative protocol, pioneered yield farming in the DeFi ecosystem. However, it was the announcement of Compound program last month which brought the topic to the headlines. In Compound’s program, a new governance token, COMP, is freshly minted and distributed to users who actively provide value to the system.
In this program, tokens go to liquidity providers. Although it is now possible to acquire the COMP token in decentralized exchanges like Uniswap, the idea is that users can “earn” the token by participating actively in the protocol.
This distribution of the governance token is additional to the accrual of interest rates for depositing or lending funds to the protocol.
This novel incentive mechanism is an implementation of the SAFG model (Simple Agreement for Future Governance), which is an iteration of Y Combinator’s SAFTE model. In the SAFG model, people who participate in the protocol earn governance tokens that can eventually be used to vote on protocol changes.
The COMP token had by design no economic rights attached (v.gr. cash flows or other value accrual mechanisms), but only political rights (voting in future protocol changes). However, the speculation that COMP token holders can in the future vote for implementing value accrual mechanisms, threw the price of the COMP token through the roof.
Users rushed in to provide liquidity to the network, increasing value locked by 6x in only 1 month!
As its name “liquidity mining” implies, this framework alludes to the original Bitcoin incentive structure, where users which provide value to the network (v.gr. providing security) are rewarded with freshly minted coins of the network. Is a form of incentivizing active community involvement in the growth of the protocol. Is a way of subsidizing the supply side of a two side money market.
Imagine for a moment you were an early user of the google search machine in the 1990s and you were rewarded with Google shares! Interesting, right? Something similar happens with liquidity mining. Early users are rewarded with a share of the network. The difference now is that only active users which provide value to the network are rewarded, and if they are passive they will get diluted with the time.
For users, liquidity mining has become a very profitable passive income opportunity. We have seen in the last weeks annual percentage yields (APY) in excess of 100%, which has attracted many additional investors into the space. Calculate here the expected COMP rewards! Beware of the risks!
Since the COMP announcement, more and more complex and profitable yield emerging opportunities have emerged. Protocols such as Synthetix (synthetic and derivative asset platform) Balancer (automated market maker, and fund management), Curve (decentralized exchange) and Futureswap (futures) have implemented similar and more complex programs for incentivizing liquidity providers in diverse platforms simultaneously . We expect that all DeFi protocols will implement some variation of liquidity mining to reward active users who actually use the protocols and provide them with liquidity. The interaction of different protocols also brings additional earning opportunities but also risks to the table.
Generally speaking, as in traditional finance, the higher the yield, the higher the risk. And like in the rest of the DeFi ecosystem, risks are still not yet fully understood and uncovered. Please be diligent and take into account that this is still experimental technology! The most important are recognized until now are: Smart contract risk, Platform risk, Oracle risk, Exchange rate risk and black swan events.
Smart contract risk is the most common risk in DeFi protocols. The technology is new and code could have bugs and vulnerabilities that can be exploited. One way to mitigate this risk is to acquire a smart contract insurance by Nexus Mutual.
Platform risk: Refers to the systemic risk of the Ethereum platform as a whole.
Exchange & liquidation risk: Cryptoassets are very volatile. If the value of the collateral uses for borrowing suffers a sudden drop, the smart contract can liquidate the position, which can lead to a partial or total loss of funds.
Oracle Risk: Oracles are priced feeds that use data from the outside world. They have always centralization points and could be manipulated. Chainlink has adopted solutions widely used in the DeFi ecosystem which can minimize these risks.
Black swan risk: In the market crash in March, priced fell >40% in a single day. Due to the uncertain global economic situations, unforeseen vents can not be discarded.
If you want to learn more about liquidity mining and yield farming, we recommend:
Bankless. Best DeFi resource out there. Newsletter, Podcast and DeFi community
Newsletter daily Gwei by Anthony Sassano
The DeFiant: Newsletter by Camila Russo