IOSG: What does liquidity mining bring to the DeFi ecosystem?

Original title: "Will the free lunch last? - IOSG in-depth research: What does liquidity mining bring to the DeFi ecosystem? "

Original author: Dong Xinshu, Zheng Bohan, Momir, Xiao Rui, IOSG

Suddenly, as if a spring breeze came overnight, thousands of people talked about DeFi. Suddenly, DeFi, which was once questioned as a pseudo-demand, began to be discussed and expected again. What is DeFi? Do you really understand it? We believe that the main logic behind decentralized finance (DeFi) is to create financial products and protocols by using smart contracts running on the blockchain, so that we can create a more open, transparent and fair market, which is more suitable for financial popularization innovation.  DeFi has been experiencing a significant growth in transaction volume in 2019, and as it enters 2020, its total value locked has experienced its first sharp exponential growth period.  With the recent trend of the market rebounding, innovations in early DeFi projects have sprung up like mushrooms after rain. We believe that the main driving force behind the faster implementation of DeFi is the concept known as liquidity mining, which was first applied to Compound and then to other DeFi protocols.  In this article, we provide a quick overview of liquidity mining in DeFi, and then delve into the reasons behind its rapid adoption and its prospects.

First, let's take a look at the market size of DeFi. As of July 27, 2020, the total value locked in DeFi is $4 billion ($4.06B).  This number itself may not be large, however, the DeFi market was only $600 million 3 months ago, and DeFi has grown 7 times in 3 months, which we think is a remarkable achievement even in the rapidly developing blockchain field.

Source: DeFi Pulse

Overview: Why Liquidity Mining Is Emerging

Simply speaking, liquidity mining is a description of how users provide "liquidity" to the market in some way and will receive additional incentives in addition to interest, thereby increasing the activity and usage of the product.  But at a higher level, the concept is very similar to other incentive programs (such as Uber's ride incentive program), because the ultimate goal of both is to hope that users can spontaneously continue to use their products to achieve network effects. However, liquidity mining in DeFi has some basic and unique features. Here, we first try to give a proper definition of DeFi liquidity mining and make some explanations about its scope.

We believe that not all liquidity incentive schemes are liquidity mining.  In this report, we follow the following two simple criteria:

A project has its native governance token;

Use the protocol layer governance native token to reward its liquidity providing users to incentivize them to use its products.

Based on these criteria, projects like Uniswap that reward liquidity providers with protocol-level fees will not be within the scope of this report.

The following figure lists the current liquidity mining situation in DeFi, with Compound dominating the market and the remaining share divided among several sporadic projects (Curve, bZx and mStable).

The amount in the figure is the monthly allocation amount for the project's liquidity mining. The price is calculated based on the price on July 9. Data source: CoinMarketCap

Starting with traditional lending business, DeFi lending is surging with liquidity mining

The types of DeFi markets vary, including lending, automated market makers, decentralized exchanges, derivatives and insurance, oracles, and prediction markets.

Lending protocol platforms are arguably the most popular and fastest-growing area of DeFi, and the first DeFi area to launch a liquidity mining program. Most DeFi lending projects offer traditional mortgage products, where users can pledge assets to the lending platform vault and use the pledged assets to borrow other assets. Users earn interest income by providing collateral assets, and at the same time, users also pay interest on loans by lending assets.  According to DeFi Pulse, the popular DeFi lending platform Compound is one of the projects currently dominating the DeFi market, as 19% of the total value locked is contributed by Compound (as of July 23, 2020).

In traditional finance, it takes a lot of money to create a bank that provides lending services. In the world of DeFi, this money is mainly provided by markets that are orchestrated entirely by smart contracts in an automated manner. Thus, the rules for lending without trusting any middlemen (such as banks) are already in place and will be enforced by the blockchain. However, to bootstrap this process, projects need to come up with revolutionary methods to attract supply from holders of idle assets.

In fact, many DeFi lending protocols are starting to use the concept of asset pools to allow smart contracts to automatically adjust interest rates based on the supply and demand of different assets. DeFi lending can offer competitive interest rates compared to centralized lending projects, but DeFi lending has barriers such as a steep learning curve, inconvenience of operating on a cryptocurrency wallet, and technical risks, which may also prevent enough users from providing liquidity to DeFi lending pools, resulting in a reduction in interest rate advantages. Worse, this unfavorable interest rate may cause users to transfer their assets elsewhere and further deplete the capital pool, eventually forming a vicious cycle.

On the other hand,liquidity mining may greatly promote the DeFi lending market in a positive direction, especially when the benefits of liquidity mining exceed interest rate fluctuations.This article will explain how liquidity mining is carried out through an analysis of Compound.

The first project to add USDT as a protocol asset: Compound

Compound is a pioneer in liquidity mining. It began distributing its governance token COMP on June 15, 2020. Since the introduction of this new yield-generating product, more crypto users have invested their assets in the DeFi market.

Source: Coindesk

In the case of Compound, the core of the governance token is the right to vote on proposals to update the protocol.  Since the project is automatically run by smart contracts, such voting rights are the only way to change the way things work in the product. Compared to the governance model in the traditional world, COMP tokens are like instruments that qualify to vote in legislatures.

Source: Compound Medium

In Compound's liquidity mining, a total of 4,229,949 COMP tokens will be placed in the "reservoir" contract and distributed 50/50 to depositors (i.e. liquidity providers) and borrowers. The tokens will be distributed fully automatically over 4 years. Currently, 0.5 COMP will be distributed per Ethereum block (meaning 2,880 COMP will be issued per day). Compound users can earn COMP based on the value of their assets simply by lending/borrowing digital assets to the system.

Once the COMP tokens accumulated by an address reach 0.001, the system will automatically transfer the COMP to be collected to the user for any transaction conducted on the Compound platform thereafter. If the accumulated COMP tokens are less than 0.001, the user has the right to collect COMP manually.

Recently, overseas communities like to call liquidity mining "Yield Farming" (or can be literally translated as "yield farming"), which not only refers to trading through Compound and earning COMP, it also represents a strategy of using cryptocurrencies and creating the greatest returns from them.

Examples of Yield Farming include:

-In order to obtain higher yields, transfer funds to riskier lending pools.
-Adopt different trading strategies. For example, arbitrage in other protocols, pledge the borrowed assets and lend other assets, and reinvest the borrowed new assets into the lending pool to obtain higher returns.

Data: COMP price @July 9, 2020 $184.64 USD; USDC deposit APY 1.67%, USDT borrowing APY: 8.62%, USDT deposit APY: 2.1%, deposit USDC COMP APY: 3.65%, borrow USDT COMP APY: 13.03%; deposit USDT COMP APY: 3.92%; Chase's annualized deposit rate announced on July 3, 2020 is 0.01%
Note: This model does not take into account macro factors such as time cost and inflation. This model does not take into account complex investment logic and transaction fees. In the comparison, the risk of bank deposits is different from the risk in the Defi lending agreement. The comparison results are not adjusted according to the risk. This comparison is only for general reference and does not constitute any investment advice.

The DeFi protocol building block effect emerges, and liquidity mining protocols emerge!

In addition to the loan market, liquidity mining has also gained increasing attention in automated market maker (AMM) projects. In order to provide effective low-slippage transactions, AMMs rely on the depth of the liquidity pool. Therefore, it is straightforward to introduce liquidity mining in this field. The two most prominent projects that apply liquidity mining to AMMs are Balancer and Curve. Since June 1, 2020, liquidity providers on Balancer have been able to "mine" BAL tokens. In the first month after the distribution of BAL began, the total locked position on Balancer increased by 680%!

Source: DeFi Pulse

On the other hand, Curve plans to start issuing CRV tokens around the end of July, and the tokens will be retroactively distributed to all liquidity providers based on the amount and duration of their contributions to the Curve pool. As shown in the figure below, Curve has also attracted a large number of deposits recently.

Source: DeFi Pulse

The following table compares the major DeFi projects that provide liquidity mining (as of July 23, 2020):

Data source: CoinMarketCap, CoinGecko

DeFi projects have generated many ways to call mining tokens worth hundreds of millions of dollars idle in wallets. Liquidity mining has attracted a large portion of the funds in a relatively short period of time. Before the introduction of liquidity mining (June), only about $135 million was locked in the funds pool of Balancer and Curve, and as of July 23, this value exceeded $1.175 billion!

Thinking about the essence: Why is there such an explosive growth in liquidity mining, and is it sustainable?

First, we believe that the reason for such explosive growth is due to the peculiarity of Compound's reward distribution, that is, borrowers can also earn 50% of the total COMP distribution by borrowing on Compound. In simple terms, borrowers can earn COMP tokens by borrowing! ? Sounds perfect, right? This has led to a huge surge in the number of borrowings (as shown in the figure below), which has further pushed up interest rates, making it more attractive to supply funds on Compound in the short term.

Source: Alberquilla

Perhaps another potential factor for the price growth of governance tokens such as COMP is that users are using "total value locked" (TVL) as a valuation method for DeFi projects.

Take yearn as an example. On July 17, 2020, yearn's locked value (TVL) on Curve was about $8 million. Three days later, as of Monday, July 20, 2020, this figure had increased to $147 million. The increase in TVL has driven the price of its governance token YFI, which has soared from its initial valuation of $30 to $2,374.

Daryl Lau, a research analyst at CoinGecko, pointed out that in the case of "liquidity mining", the value of the project is reflected through the token price itself, which has also spawned a "pseudo-Ponzi economics". The rise in token prices will cause more people to lock their assets on the platform, thereby increasing TVL. High TVL will further increase token prices, forming a cycle. We do not believe that this cycle will last because this valuation method is not mature.

01Some people believe that this will be a zero-sum game?

The total value locked in DeFi soared from about US$1 billion in early June to about US$2 billion in early July, and a considerable portion of the new funds were allocated to Compound. In addition, by observing the total locked value of other lending protocols, we found that after June 15 (the start of COMP distribution), the total locked value of protocols such as Maker, InstaDapp, DDEX, Nuo Network and bZx declined significantly. Maker and InstaDapp recovered quickly after a few days, but other protocols still have not recovered from the decline.

Source: DeFi Pulse

Source: DeFi Pulse

Source: DeFi Pulse

Does this mean that DeFi funds are gathering in a certain direction/project? We think this is possible. If this is the case, these projects must be based on a sustainable model, otherwise they will pose a systemic risk to the entire DeFi.As of July 23, the top five DeFi projects (Maker, Compound, Aave, Synthetix, and Curve) controlled 78% of the total value locked in the DeFi market. Considering that many projects are in some way common to the top DeFi protocols (for example, Maker, Yearn, RenVM, Curve, and Compound are all interconnected), if one of the top projects has an adverse event in terms of smart contracts or oracles, it will have a domino effect on the entire DeFi. Since DeFi is still a nascent market, once such adverse events occur, it may take a long time for the entire ecosystem to recover.

02Can borrowers continue to earn income through borrowing, that is, will the free lunch last for a long time?

It doesn’t take an expert to conclude that the high returns borrowers are earning on Compound are unsustainable.

If we assume that these incentives continue to attract new users, then the dramatic increase in the number of users over time means that each user will receive a smaller and smaller share with a fixed reward.

COMP is designed to be a governance token only. It is like buying a stock in a company that gives you voting rights but no immediate dividend plan. Currently, the largest voting rights are controlled by large institutions such as a16z and Polychain Capital. As of July 23, it costs about 158 yuan to purchase each voting COMP token, but each COMP token only provides 0.00001% of the voting rights and there is no cash inflow (dividends).

Tokens that bring concrete economic benefits to token holders are easier to value, however, the valuation of governance tokens that do not pay dividends will be highly subjective. Currently, COMP's valuation seems to include speculative factors, and we believe that in the long run, before COMP governance decides to give COMP token holders some kind of dividend, COMP's present value is likely to converge to the intrinsic value of the token (voting value).

In addition, we believe that the following situations will bring additional downward pressure to the COMP market, and the correction of such valuations with speculative factors is likely to accelerate:

1. Excessive liquidation caused by adverse market events, which may cause speculators to sell COMP on a large scale;
2. Any form of market panic, including general technical risks related to smart contracts and;
3. More likely, speculative holding purposes will cause holders chasing high profits to choose other higher-yield projects, causing liquidity and COMP prices to decrease.

Therefore, it remains an interesting question when and how DeFi projects' liquidity mining will find a medium- and long-term balance point, and whether it will still be attractive to users seeking yield at that time.

03There is nothing new under the sun - what can we learn from the example of FCoin?

If we go back a little further, the first project in the cryptocurrency space to test liquidity mining in a high-profile manner might be FCoin. FCoin is a Chinese crypto exchange that launched an incentive in May 2018 to issue their platform tokens to reward users who trade on the platform. There are a total of 10 billion FT (FCoin token), of which 51% are issued as rewards. In addition, it also distributes 80% of the daily transaction fees in the form of BTC to users who hold FT continuously throughout the day.

As a result, FCoin’s daily trading volume exceeded $5.6 billion by the end of June 2018, which was more than the combined trading volume of the top ten exchanges. Despite this, when Fcoin announced the delay of FT compensation, the price of FT dropped from $1.25 to $0.66. This means that most users who used FCoin to trade were looking to profit from FT rewards, creating a huge bubble for the price of FT.

Ultimately, the platform was shut down in February 2020, failing to pay out $67 million to $125 million to users.

We believe there is a key difference between DeFi and FCoin’s liquidity mining. FCoin’s failure was largely due to the misappropriation of funds and the lack of any community governance, which made it more like a scam. With DeFi’s liquidity mining today, the distribution of tokens is traceable, and the use of funds is completely governed by smart contracts and transparent. In addition, FT mining encourages wash trading, which has no real value, while liquidity mining incentivizes the provision of liquidity and brings real value to market depth.

Nevertheless, We do not believe that the above differences necessarily alleviate the concerns around token valuations discussed earlier, nor do they indicate that DeFi’s current liquidity mining will continue to prosper. However, we believe that the inherent transparency and value creation nature of DeFi liquidity mining can provide a more level playing field for all participants, allowing us to try to explore its sustainable development path, which is impossible in the case of FCoin.

04What can we learn from traditional finance? The case of Jet.com

Jet.com (founded in 2014) is a startup that operates similarly to Amazon. It raised $80 million in early 2014, but they decided that attracting new users was a more important thing than getting funding. So they offered a stock reward program for new user registrations.

The company decided to launch a contest where the participant who introduced the most new user registrations could receive 100,000 company shares, and the contest participants ranked 2nd to 10th would each receive 10,000 shares. This stock reward program eventually succeeded in bringing in 350,000 new registered users. In order to get the shares, the event participants actually spent their own money on marketing and advertising to ensure that new users could register through their personal referral links. These participants worked like employees and had a strong motivation to grow the business. The winner - Eric Martin spent $18,000 to attract 8,000 new users and received 100,000 shares. Jet.com was subsequently acquired for $3.3 billion, and Eric made $10 million.

First we wonder, what can we learn from Jet.com's success story? We believe that long-term alignment of interests between projects and users is key to sustainability. DeFi's current liquidity mining is more like a game played by users. People do liquidity mining not because they are betting on the success of the company, but because they are focused on short-term profit opportunities.

Eric in the Jet.com case mentioned: "I feel closely tied to the success of the company." This is because he cannot cash out until the company goes public or is acquired by another company, so he still has aligned interests with the company.

Therefore, we believe that if DeFi projects want to maintain long-term alignment of interests with users and token holders, then some form of lock-up period is necessary. Fortunately, we have seen some projects moving in this direction. For example, Curve Finance announced that users who lock their CRV tokens will be able to increase their share of the tokens by 5 times in inflation, and the project hopes that this incentive will generate natural lock-up behavior.

The current lock-up plan proposal is: CRV proposes a total supply of 1 billion, and then gradually expands the supply to a maximum of 3.33 billion. The inflation rate will be set to the highest in the first year, and then the inflation rate will decrease, but the total supply will gradually expand over time, indicating that early token holders will get the most benefits.

Source: Curve Github

Similarly, they will use time-weighted voting, giving those who lock up their tokens more governance weight than newer users. For example, 1 token locked up for four years gives the same voting weight as 200 tokens locked up for a week, mitigating the 1 token = 1 vote model (which heavily favors those with deep pockets).

Source: Curve Github 

In doing so, Curve ensures that its stakeholders will have interests aligned with the protocol for the foreseeable future, setting an example for other projects.

05Summary: What have we learned so far to make liquidity mining sustainable?

We expect different DeFi projects to continue to develop, as these protocols are highly interconnected and provide great composability in DeFi.  Given this, we believe that switching from one protocol to another is very easy for most users, in which case innovation and a cohesive community will ultimately play a key role in determining the long-term success of a protocol.  

The ability to innovate is not just once, but continuously, and the most innovative protocols will seize the top position.  We believe that despite the high composability of DeFi protocols, there will eventually be a few projects that will acquire the vast majority of users and be heavily integrated by other projects to become the "backbone" of the DeFi field.

A strong and cohesive community is critical to the continued success of DeFi protocols, as almost everything is dynamically changing in innovation, adaptation, and development. Due to its decentralized nature, DeFi projects will ultimately be driven by their communities, who will take ownership and guide the direction of the project.  Community is especially important for a nascent field like DeFi, as each project is competing for the best talent to support and drive it.

The fully community-based governance of the yield aggregator Yearn shows us the power of decentralized community governance.

A few days after the launch of Yearn's token YFI, someone realized that its founder Andre had the ability to mint tokens at any time. So he also handed over control of the governance contract to the community (including 9 community members including Compound's Calvin Liu). As of the afternoon of July 27, 2020, YFI has proposed a total of 32 proposals, 3 of which have been passed, and the remaining proposals are all under voting/discussion. In just one week, the enthusiasm of YFI community members has been very high. What is even more rare is that founder Andre Cronje did not allocate YFI tokens to himself. These measures have enabled the project to transition to community governance at the fastest speed.

On the other hand, the community also changed the voting mechanism. Because the use of BPT in the original design of the "98% yCRV / 2% YFI" pool caused an imbalance in voting weight, because yCRV needs to be pledged in stablecoins to obtain it, which makes it possible for users with a large number of stablecoins to mint a large amount of YFI supply through a proposal. Therefore, the community improved this mechanism and established a voting structure dominated by YFI.

In the future, the yearn protocol will also expand to areas such as trading, futures, and clearing. We also look forward to more projects that can innovate between sustainable business models and maintain decentralization, and truly build a BTC in the DeFi field.

The future outlook of liquidity mining,New opportunities brought by liquid interactions at the protocol layer

Will more projects join liquidity mining?

Given the importance of liquidity to the DeFi field, the emergence of innovative liquidity incentive programs is not surprising. Considering the amount of funds attracted by Compound, we expect more projects to launch liquidity mining incentives. For example, bZx, a project that has been struggling to retain users recently (total value locked went from $1.5 million before Compound launched liquidity mining to $750,000 after COMP started distributing), also announced a liquidity mining plan.

What about bringing BTC to DeFi?

Speaking more broadly about liquidity, we are keeping a close eye on projects that are trying to bring Bitcoin liquidity to DeFi. After all, Bitcoin remains the most liquid cryptocurrency (market cap >1700B), so we can’t ignore the huge potential of integration. We expect a steady flow of idle Bitcoin to DeFi due to attractive yields. Such projects include the sBTC pool on Curve, which allows renBTC, sBTC, and wBTC holders to participate in liquidity mining. The project has attracted over $25 million worth of deposits within a month of its launch, and we expect it to continue to grow in the future.

Curve's sBTC pool deposit total

Source: Curve Finance

Oracles can also do liquidity mining

"On-chain oracle" is becoming a hot topic in the oracle industry, and the Nest protocol is a good example.

In the NEST system, there are some "miners" who quote prices to the system for mining. This kind of "miner" is a bit like a liquidity provider in the Uniswap system. They need to input the quoted assets into the quote contract according to the trading pair and provide a trading pair quote, and anyone can take the order. At the same time, this quote is also subject to market arbitrage testing. That is, if there is a price difference between the miner's quote and the mainstream exchange price, this price difference will be eaten by arbitrageurs, and the remaining unfilled order quotes can be regarded as accurate quotes.

Since on-chain oracle projects like Nest Protocol are likely to need more quotes, we believe that the idea of liquidity mining will also be a potential mechanism for such projects to attract users to improve the liquidity of their markets.

How to best use liquidity?

We believe that the blockchain community will shift from solving liquidity problems to having deep enough liquidity to output. Therefore, it is very important to start building a bridge from blockchain to the real world. After all, our idea is not to make blockchain an island, but to make decentralized infrastructure and applications benefit ordinary people's daily work and life. Initiatives such as Aave's credit delegation provide a possible way to narrow this gap. Aave users can delegate their credit on the blockchain to anyone according to a legal agreement. This will enable people without blockchain knowledge to participate in DeFi and other blockchain applications. It is important to note that in this case, the liquidity pool does not bear any additional risk because the conditions of the collateral have not changed. This is just one of many potential use cases that connect DeFi to real-world financial needs, and we believe this is an area with huge investment potential.

Obstacles along the way—gas fees and complexity

While users have received good returns through liquidity mining, one complaint we often hear is that gas fees are too high. Especially for highly integrated protocols such as Curve, which reinvests funds from the liquidity pool into lending protocols such as Compound or Aave. This brings additional returns to liquidity providers, but also brings several times the transaction fees. On the other hand, as the complexity of DeFi applications increases, the risk of liquidation under sudden adverse market events may be exacerbated by excessively high transaction fees.

We believe that the current liquidity mining will bring people's attention back to the infrastructure level, and projects that can improve Ethereum's scalability without affecting user experience will become the next winners.

Source: Dune Analytics

As the DeFi market continues to grow in size, along with its complexity, we believe there will be an increasing need for products that can ease the complexity of interacting with DeFi protocols. Projects such as user aggregators that enable "one-click" access to all DeFi protocols (such as Instadapp, Argent, Gnosis Safe) will see growth and may play an important role in attracting new cryptocurrency users.

While more and more protocols are joining the liquidity mining craze, it is not easy to find the most profitable opportunities. We believe that more projects will develop products like yield aggregators to help users increase their yields. The following figure shows how yearn interacts with multiple DeFi projects. We can see that yearn actually integrates many protocols in the DeFi field to maximize the returns of liquidity providers, and deeply binds the interests of products and users through governance tokens.

We expect that more projects focusing on yield optimization will appear in the application layer of DeFi to attract traders who focus on short-term interests.

Source: IOSG Ventures

Finally, the jump of about $1 billion in deposits in one month symbolizes that DeFi and the entire blockchain ecosystem have begun to enter an era of heavy innovation. The massive growth in value built on blockchains during a time of global crisis may convince even skeptics to reconsider implementing blockchain-driven innovations as part of the new normal. The free lunch may last, but it may not, and what really matters is that blockchain-driven technology and innovation continue to surprise us with great use cases and application scenarios that were previously unlikely.

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