Deribit: Differences between DeFi Liquidity Mining Yield Farming and Bitcoin Mining

The working mechanism of liquidity mining is very similar to proof of work mining, with differences in priority and implementation.

Written by: Deribit Market Research
Translated by: Moni (sourced from Deribit WeChat account)

Although the concept of liquidity mining has been around for some time, it was not very popular before. However, with the decentralized finance (DeFi) protocol Compound launching a new mechanism and distributing its governance token COMP to users, liquidity mining suddenly became a hot topic. Liquidity mining, as the name suggests, is the reward users receive for providing system liquidity to both borrowing and lending parties in the DeFi market, in addition to normal returns.

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The DeFi community has come up with some peculiar new terms for liquidity mining, such as "Yield Farming" and "Crop Rotation," among others. However, behind the scenes, you may find that the working mechanism of liquidity mining is actually very similar to proof of work (PoW) mining.

In the Bitcoin and Ethereum networks, proof of work mining serves two main functions:

Initial distribution of circulating tokens;
Rewarding the network for valuable services provided by miners to prove the blocks, enabling distributed consensus to be achieved. This proof mechanism gives value to the Bitcoin held by users who purchase it from miners.

From a higher-level perspective, the working mechanism of liquidity mining is quite similar to proof of work: for example, in Compound, each Ethereum block allocates a fixed amount of 0.44 COMP to the market, a "reward" that is valuable to market participants (especially now that COMP tokens are tradable). To earn money, market participants provide a very valuable service to Compound, which is providing liquidity.

Of course, there are also two differences between proof of work mining and liquidity mining:

Differences in the priority of the two mining objectives;
Differences in the implementation of the two mining methods.
Let's analyze this in more detail below;

Different Priorities

In proof-of-work mining, paying miners to validate blocks may be more important than fairly distributing tokens to market participants in DeFi. Without validation, there is no distributed consensus, and the blockchain won't function properly. Token distribution can lead to a side effect where pre-mining based on experience (as seen with some tokens on the Ethereum blockchain) can still result in a functioning blockchain.

However, this priority is reversed in the Compound protocol. Technically, Compound doesn't need to pay liquidity providers to function properly, which helps alleviate concerns that liquidity mining may resemble a Ponzi scheme. COMP tokens have inherent value, as holders of COMP tokens from liquidity mining can earn fees from the protocol in the future. Comparing the distribution of COMP tokens to past practices in the DeFi industry, early investors who participated in pre-mining could sell the tokens they acquired on the market later.

Compound decided to distribute COMP tokens to a wider range of token holders for several reasons:

The act of distributing tokens itself can attract new users (similar to how CPU/GPU mining in the cryptocurrency industry attracts new users);
COMP tokens can be used to vote on various changes within the Compound protocol, and due to the large number of token holders, the community is less likely to bypass Byzantine fault tolerance or implement short-term changes, which were common issues in highly centralized entities in the past;
When users earn money by working together rather than using tokens to repay early investors, it becomes easier to convince regulators that COMP tokens are not securities.

Different Implementations

It's important to note that both Bitcoin and Compound exert a level of control over actions when implementing incentives. Through this "control," specific incentive mechanisms can be created for miners in both Bitcoin and Compound.

In Bitcoin, the incentive mechanism aims to encourage miners to include as many transactions as possible for verification while continuously mining at the top of the blockchain. Overall, the proof-of-work, block producer, timestamp, and incentive mechanisms make Bitcoin a trustless electronic cash system. Bitcoin requires miners to follow a specific strategy to ensure network security, known as the Nakamoto Consensus.

It is crucial to correctly formulate incentive measures. The Nakamoto Consensus has a clear definition that the incentive measure must always be the most profitable strategy within the Bitcoin network. Nakamoto believed that an incentive-compatible Bitcoin mining protocol could resist attacks by a minority group and motivate miners to mine according to the protocol. In a market economy, every rational economic actor has a self-interest, and their individual actions follow rules of self-interest; if there is an institutional arrangement that aligns individual self-interest with maximizing collective value for the organization (or network), it will be successful.

However, scholars like Eyal in 2013 argued that the Nakamoto Consensus might not be perfect. He proposed a strategy called "Selfish Mining" that allows a few mining pools to earn more revenue than they would by honestly executing the mining protocol. In this strategy, "Selfish Mining" could potentially disrupt Bitcoin's stability and lead to mining centralization. While clear evidence of selfish mining has not been found in the market, the risk remains.

In contrast, Compound has undergone significant changes in the best incentive strategy for liquidity miners and has made many improvements. Compound can achieve this because their liquidity miners have many incentive strategies to choose from—after all, users in the Compound protocol need to pay a certain amount of COMP tokens for almost any action.

Indeed, Compound's design intentionally allows for this, as the protocol's priority is not to incentivize specific behaviors on the network (such as Bitcoin miners mining, which rewards them with BTC tokens). Compound aims to provide tokens to a large number of users. As an example, let's consider Synthetix, a DeFi protocol that uses its token SNX in a more targeted manner. To defend the peg of the synthetic stablecoin SNX, the Synthetix protocol rewards those who provide liquidity on Curve with Dai/USDC/USDT/sUSD pools (liquidity providers).

However, for a period, the BAT token, which was the most profitable for COMP liquidity mining, almost monopolized COMP mining. Generally, the higher the deposit rate, the more efficient the COMP mining, but miners strictly adhere to incentive measures because their COMP token reward is based on the interest paid. Unilaterally increasing the BAT deposit size cannot raise interest rates because the factor directly affecting interest rates is the loan-to-value ratio. As a result, BAT holders would deposit other assets into their accounts, continuously increase the collateral size until all previously deposited BAT is borrowed out. This scenario turns into a "paying and receiving interest simultaneously," ultimately pushing up the capital utilization rate and marginalizing the mainstream assets of "real" asset supply and borrowing, failing to receive the deserved incentives.

Conclusion

Compound quickly patched the issuance mechanism for the above-mentioned issues, but the problem seems to persist: Is there an alternative optimal incentive strategy? Indeed, Compound lacks the "Nakamoto Consensus" and does not explicitly require miners to follow a specific strategy, possibly hoping that certain rewards will not be captured by abnormal strategies. Simple users who deposit USDC and USDT in Compound are like the most easily accessible and stable capital flow in the existing banking system. Regardless, the success of a cryptocurrency system like Compound in attracting billions of bank deposits can be considered a huge success.

Of course, whether it's liquidity mining or proof-of-work, these mechanisms ultimately require trade-offs. Instead of implementing a very specific incentive strategy and building a distributed protocol around it, we may need to prioritize the protocol through mining—this way, many behaviors on the network can be incentivized, stimulating the emergence of more possible incentive strategies.

【This article is authorized for reprint by ChainNews, original author from Deribit WeChat official account, original article here】