Systemic Risk Warning Signs? Taking stock of a series of unexpected extreme phenomena in "DeFi" liquidity mining

Since Compound issued its governance token COMP, "liquidity mining" has immediately become a focal point in the cryptocurrency market, driving significant growth in both the attention and adoption of the DeFi sector. However, liquidity mining is not without its flaws. Blockchain media outlet The Defiant has outlined some unexpected issues brought about by Compound's implementation of liquidity mining in a recent article.

DAI Decoupling from the US Dollar

Under normal circumstances, the exchange rate between DAI and the US dollar should remain at 1 to 1. However, the current market trading price is $1.02, and in the past few days, the price of DAI on decentralized exchanges like Uniswap V.2 has even surged to $1.029. The premium on DAI is closely related to the changes in Compound's liquidity mining rules.

As reported earlier, Compound's governance proposal 011 has been approved, which adjusts the distribution mechanism for COMP. Instead of allocating COMP mining rewards based on the interest rates in the lending market, it is now based on the "asset size" in the lending market.

After the proposal was passed, there was a significant shift in interest rates and fund sizes in Compound's lending market. Prior to the proposal, the locked value of DAI in the lending market was around $50 million, but with the introduction of the new proposal, the locked value skyrocketed to $700 million, making it the largest lending market on the Compound platform.

However, the MakerDAO community had long been aware that Compound's upgrade could impact the pegging mechanism of DAI to the US dollar and proposed many measures to mitigate the risk of premium.

Users Borrowing from Themselves

This is closely related to Compound's liquidity mining. Since participating in Compound's liquidity mining solely through lending is not very profitable, many people engage in both lending and borrowing simultaneously, maximizing mining rewards, similar to "wash trading" on centralized exchanges. Under normal circumstances, it would not make sense for users to borrow from themselves, but due to liquidity mining, the mining rewards users can obtain exceed the costs of executing these operations, which is why the total locked value of DAI on the Compound platform was 2.7 times the total circulating supply.

Extreme Interest Rates

As mentioned earlier, the original rule for Compound's lending mining was to allocate COMP mining rewards based on the interest rates in the lending market. In other words, lending or borrowing in markets with higher interest rates would yield more mining rewards. This design led to the phenomenon of extreme interest rates in some lending markets, with BAT being a typical example.

It is said that some large BAT holders deposited a large amount of BAT into Compound and borrowed BAT repeatedly using other assets as collateral, leading to a significant increase in borrowing rates. According to official data, the lending rate on the Compound platform soared to 26.8% (annualized) on June 23rd.The locked value of the BAT lending market reached over $300 million at its peak, becoming the largest lending market on Compound until the abnormal situation in the BAT lending market was resolved after Compound changed its mining mechanism.

Miners of liquidity mining are pouring a large amount of funds into DeFi protocols, and many new tokens and DeFi projects continue to go live. This DeFi frenzy may take some time to cool down. However, it is still unclear whether this artificially driven demand can drive the long-term growth of DeFi or if it will end up like the transaction mining in 2018, leaving behind a mess once the profit margins disappear.