【Explanation】What is Yield Farming? Liquidity mining, Yield farming

"Yield farming," a term frequently mentioned in recent reports by major blockchain media outlets both domestically and internationally. Yield farming? Income mining? Readers who do not regularly follow market trends may find it difficult to grasp what Yield farming actually is. Today, we will introduce the concept of "Yield farming" born in the midst of the decentralized finance (DeFi) craze.

What is Yield Farming?

"Yield farming" can be difficult to understand literally, so it is usually translated into Chinese as "liquidity mining." The concept of liquidity mining means that as long as users provide liquidity to the platform (such as trading, lending, borrowing), they can receive tokens issued by the platform as rewards.

These tokens can maintain a certain level of buying interest in the market due to either speculative potential (due to low initial token liquidity) or stable cash flow (through profit-sharing or burning mechanisms).

In fact, the concept of liquidity mining can be traced back to the "trading mining" trend brought about by the birth of the Fcoin exchange in 2018. At that time, almost every young exchange would issue platform tokens and design a "trading mining" issuance mechanism to create opportunities to compete with large exchanges. The liquidity mining trend sparked by DeFi in 2020 is essentially similar, just applying the same method to different areas.

Purposes of Liquidity Mining

DeFi adopts liquidity mining to issue tokens for several purposes. The first is to "allow users to participate in governance." Most tokens issued through liquidity mining are "governance tokens." Liquidity mining can directly distribute tokens to users of the platform, allowing the platform's "users" to have governance rights over the future development of the protocol, which is the fairest practice for decentralized governance. However, this vision faces some challenges in practical operation, which we will further explain in the following content. Fernando, CEO of Balancer, stated in an interview with blockchain media Chainnews:

"I think the significance of liquidity mining is remarkable. It achieves true decentralization and actively involves users. I believe this is the only way for protocols to obtain healthy token distribution and truly achieve decentralization. Without a healthy token distribution mechanism, on-chain governance has no meaning."

The second purpose is to "increase the platform's adoption rate." Similar to exchange trading mining, liquidity mining offers users high profitability, so DeFi platforms adopting liquidity mining can attract a large amount of funds and liquidity in a short time, quickly gaining market attention. This serves as a good marketing strategy for the early development of projects. The total value of assets locked in the decentralized lending platform Compound can be seen in the figure below, even without telling you, you should be able to easily guess when Compound started liquidity mining.

For DeFi platforms, this is the most attractive and direct impact of liquidity mining.

Examples of Liquidity Mining

Let's briefly look at a few actual examples of projects using liquidity mining mechanisms.

Compound Lending Platform

Compound operates in the "lending, borrowing" category of liquidity mining. Specifically, the platform puts 4,229,949 governance tokens COMP into a smart contract named "Reservoir." For each Ethereum block added, the contract transfers 0.5 COMP to the protocol and distributes it proportionally to users lending and borrowing on the platform. An average of 2,880 tokens is distributed daily, and Compound plans to continue this liquidity mining project for four years until all tokens are distributed. This reward mechanism has attracted the attention of many investors. Since the launch of this project, many have transferred their assets to Compound for lending and borrowing to share the COMP rewards.

Balancer Liquidity Pool

Balancer is a decentralized liquidity pool protocol (think of it as a decentralized exchange), which, unlike Uniswap's 1:1 liquidity pool, allows users to create liquidity pools composed of multiple ERC20 tokens. This makes Balancer's protocol more flexible in terms of liquidity. Since the team hopes the governance of the protocol can operate in a more decentralized manner in the future, they have issued their governance token BAL and started liquidity mining to distribute tokens.

Balancer's mining method falls under the "trading" category of liquidity mining. Users can provide digital assets to the platform to offer liquidity in the pool and receive Balancer's governance token BAL as a reward. The total supply of this token is around 100 million, with as many as 65 million BAL reserved as rewards for liquidity providers. Currently, Balancer distributes 145,000 BAL to these participants weekly.

Potential Issues with Liquidity Mining

Although liquidity mining has driven the recent development of the entire DeFi industry, it still has potential risks and issues.

Firstly, the main purpose of distributing tokens through liquidity mining is to allow users to obtain governance tokens and participate in network governance. However, in reality, apart from the team itself and the investment institutions behind the platform, most governance tokens ultimately end up in the hands of speculators rather than users. Liquidity mining attracts many speculators who do not have faith in the protocol itself. These speculators, like vultures, rush in when they smell profit opportunities, bring in a large amount of capital to share governance tokens, and sell them for profit on the market. Once the profit opportunity disappears or the mining project ends, these speculators will simply leave, leaving a mess behind without any loyalty to the platform.

Another issue is the extremely high annualized return rate in the early stages of liquidity mining, attracting a large number of participants. However, participants in liquidity mining need to be aware that the "annualized return rate" is a predicted value calculated based on the market conditions at that time, and does not guarantee that you will actually earn that much profit by the end of the year. Additionally, factors affecting liquidity mining returns are complex, such as the market price of governance tokens, the number of participants, and any changes in token distribution mechanisms, leading to highly volatile annualized return rates. For example, in the case of Compound's liquidity mining, mining returns dropped from over 100% to 10-15% within two weeks, causing many participants to exit with actual earnings insufficient to cover costs such as exchange rate losses and miner fees.

Clear Understanding Is Key

Overall, liquidity mining is almost no different from trading mining in 2018. This is not to say that liquidity mining is doomed to fail, but rather it should be seen as a lesson from trading mining to avoid repeating past mistakes. While liquidity mining, like trading mining, can bring a lot of liquidity and attention to the platform in the early stages, retaining users and sustaining liquidity will be the key point that previous trading mining exchanges failed to achieve, which DeFi platforms must carefully consider.

Furthermore, although DeFi platforms are decentralized, it does not mean that liquidity mining is without risks. Participants in mining must be aware of the risks involved, such as potential vulnerabilities in smart contracts or asset liquidation risks. Especially with the emergence of flash loans (Aave), which has provided hackers with many opportunities to exploit vulnerabilities, many DeFi projects have suffered. Not long ago, a hacker used a flash loan attack to exploit Balancer and steal assets from the liquidity pool. Investors must pay special attention to these risks to avoid losing their capital before making profits.