【Selected Blockchain News】Symbiosis or Parasitism? Understanding the Relationship between Index Growth in DeFi Lending and Exchange Protocols
A symbiotic DeFi protocol is encouraging profit-seekers with strong incentives to touch as many protocols as possible. Will Balancer be more likely to become Compound in the coming years? Or will Compound be more likely to become Balancer?
Original Title: "Aquaponic Yield Farming"
Written by: Dan Elitzer, Investor at IDEO CoLab and Founder of the MIT Bitcoin Club
Translated by: Jane Zhan
This article was first published in the English electronic magazine focusing on open finance, "Bankless." The Chinese version of the article was jointly released by Bankless and ChainNews. Subscribe to Bankless at: bankless.substack.com
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Over a year ago, in the article "Super Liquid Collateral in Open Finance," I outlined some thoughts: the over-collateralization required by DeFi lending protocols can lead to capital inefficiency, which could potentially be resolved by allowing assets to be used for multiple purposes simultaneously. The title of this article reads "Open Finance" rather than "DeFi," a fact that indicates how much progress the ecosystem has made during this time. The following two diagrams illustrate this significant change:
Many specific concepts proposed in the article "Super Liquid Collateral" have since been realized, including the creation of Compound cTokens, the use of cTokens in Uniswap pools, and using shares of Uniswap pools as collateral for loans.
Nevertheless, I still believe we are just scratching the surface of super liquidity of DeFi assets. Fortunately, the crypto space is witnessing a trend where profit-seekers are being incentivized with incredibly strong motives to touch as many protocols as possible.
Table of Contents
Understanding SAFG / Liquidity Mining / Yield Cultivation
On May 27th, Compound Labs, the original designers of the popular Compound lending protocol, announced their plan to distribute 42% of the COMP governance token to users of the protocol over the next four years, taking a significant step towards their vision of fully decentralizing the protocol.
My colleague Gavin McDermott was the first to draw public attention to this design pattern, which he refers to as "Simple Agreement for Future Governance" (SAFG), as opposed to the previously popular SAFE (Simple Agreement for Future Equity) and the infamous SAFT (Simple Agreement for Future Tokens) frameworks. The core concept of SAFG is to distribute governance tokens to users based on the amount of liquidity they provide or use within the protocol, aiming to encourage protocol usage and distribute ownership to active stakeholders.
This is a simple, rational, and well-intentioned concept. However, the alignment of theory and practice seems rarely perfect. In cases we have seen so far, the distributed governance tokens have exceeded the market value of various forms of behavior by far, attracting hundreds of millions of dollars in capital to these protocols in search of opportunities.
This phenomenon is referred to as "liquidity mining" or "yield farming," with the latter term becoming increasingly popular.
Prior to the distribution of COMP, Henry He predicted this behavior. He pointed out that the valuation disclosed by Compound's last private round indicated that the initial distribution subsidy had reached over $43,000 per day, more than 25 times the daily interest paid in the market previously. As Henry anticipated, the incentives quickly got out of control, with yield farmers earning higher returns from borrowing assets than lending assets. Over the following week, this issue became more severe as COMP's trading price surged over 1,000%.
While token holders and governance representatives are currently working to address some extreme distortions in the Compound lending market, it is undeniable that this has had a significant impact on the growth of the Compound protocol, with the value of assets locked in the protocol increasing sixfold in the first week, exceeding $600 million.
Compound is not the only case; we can also cite other examples of yield farming driving protocol growth:
- In April, Futureswap, a decentralized futures exchange protocol offering up to 20x leverage, conducted an alpha launch that included distributing their governance token FST to users of the protocol. Within three days, they attracted over $17 million in trading volume, then prematurely ended the alpha to ensure user fund security while completing an additional audit.
- Balancer, a decentralized exchange protocol similar to Uniswap, which supports liquidity pools with up to 8 assets, announced shortly after its launch on March 31st that it would distribute its governance token BAL based on the amount of liquidity provided to their pools. In less than three months, their liquidity grew from zero to over $55 million.
Clearly, we are entering a phase where there will be a comprehensive liquidity war, based on providing extremely large subsidies in the form of governance tokens, which holders may or may not decide to use their governance rights one day to capture some value flowing through various protocols.
Is this a zero-sum game? Liquidity providers need to choose where to park their assets, where they can capture the highest subsidy returns, and freely move between different protocols? When subsidies decrease to a somewhat sustainable level, will savvy providers slip away, leaving a pile of meager returns behind?
Are there more short-term developments to this phenomenon, such as creating enough non-subsidized capital efficiency to keep assets in these protocols long term? I believe some type of modern cultivator may be particularly suited to answer this question.
Symbiosis and Symbiotic Relationships
In my early twenties, I briefly entertained the idea of urban agriculture. It started with community gardens like the Red Hook Farm in Brooklyn, then evolved into vertical farming, efficiently utilizing space in dense urban areas to provide healthy locally grown food.
The concept of aquaponics particularly caught my attention. This system combines aquaculture (raising fish or other aquatic animals) with hydroponics (growing plants in water instead of soil). These two activities are symbiotic, with waste from the aquaculture system breaking down to provide nutrients for the hydroponic system, and the purified water recirculating back to the aquaculture system. Combining this process benefits both. Additionally, the hydroponic system offers farmers two income sources, increasing potential income and diversifying revenue streams.
I'm sure you can see why I mentioned this...
Lending and exchange protocols, especially those utilizing pooled liquidity and automated market makers, are inherently symbiotic. Lending protocols like Compound and Aave aim to have a significant amount of assets deposited in their liquidity pools to maximize loan availability and minimize borrowing costs. Exchange protocols like Uniswap and Balancer hope to have a large amount of assets deposited in their liquidity pools to maximize potential trading volume and transaction size while minimizing slippage—they are not concerned about the assets in their pools being collateral receipts for loans, as long as there is enough unused liquidity in the lending pool to withdraw as needed.
Under normal circumstances, in lending protocols, liquidity providers earn fees based on the duration of asset borrowing; in exchange protocols, liquidity providers earn fees based on the amount of asset trading. Under the same conditions, two or more assets in a liquidity pool are unlikely to earn the same interest rate when available for lending, so their proportions in the pool naturally deviate from their target. This creates opportunities for arbitrageurs to enter the pool to trade and rebalance it, generating transaction fees. Thus, returns from lending encourage returns from trading, which are then used for lending... It's a wonderful, rational, and natural symbiotic relationship.
But now is not the time for wonderful, rational, and natural interactions—it's the beginning of a period of super industries, genetically modified biofuels, and helicopter subsidies.
Within the first week of this new era of crypto-agriculture, yield farmers are already thriving. Look at the image below, a Balancer pool with the strongest liquidity.
Yes, that's cDAI and cUSDT, representing DAI and USDT deposits in Compound. Well done!
Cultivating Symbiosis Is Not Easy
It is worth noting that lending and exchange protocols are sometimes structured in ways that are not conducive to cultivating symbiotic yield farming. For example, astute readers may have noticed that the pool in the image contains 2% COMP. Why is that? The standard public pool on Balancer, at its launch, has fixed asset allocation without a management controller. If a pool does not include COMP as part of its composition, any accumulated COMP will be irreversibly locked in that protocol. This can be addressed on Balancer by using a Smart Pool, but this may introduce additional attack vectors and currently cannot be managed through the Balancer interface.
Curve has been one of the protocols benefiting the most from the externalities of COMP distribution (yield farmers are doing a lot of trading with USDT and other stablecoins to leverage chips, often using InstaDApp's COMP maximizing tool). On Curve, all accumulated COMP in existing pools will be permanently stuck there, and LPs or Curve's creators/administrators cannot withdraw. While I heard they are exploring how to address this issue in future upgrades, it also illustrates that unexpected challenges may arise at the intersections of various protocols.
If you want to see how crazy these cross-protocol yield farming opportunities can get, take a look at this concoction planned by OG liquidity subsidy institution Synthetix: the BTC yield farming pool. It features three different flavors of Bitcoin on Ethereum (wBTC, renBTC, and sBTC), and offers yield farming opportunities on four crops—SNX, REN, CRV, and BAL. It's simply Monsanto-esque.
What's Next?
Remember, symbiotic relationships can take various forms. In the short term, yield farming ensures compatibility between lending and exchange protocols is mutually beneficial, benefiting both protocols due to the excess accumulated returns. However, once yield farming subsidies drop to a more sustainable level, we don't know if this connection will be commensalistic or parasitic, whether the gains of one protocol will come at the expense of another.
In the long run, I speculate that protocols capable of doing this may evolve into those that are both lending and trading, creating a DeFi prime brokerage protocol that maximizes potential returns in a given risk allocation by offering a variety of opportunities for assets simultaneously. If I'm comfortable holding a fixed ratio of various assets in my wallet and want them to passively generate the highest returns, why wouldn't I put them all in a private Balancer pool to earn trading fees? And if this pool contains assets like ETH, DAI, REP, and ZRX, why wouldn't I be willing to lend out all my assets as long as the loans are overcollateralized with other assets in the pool that match my asset types? Of course, should the assets in the pool also be available for flash loans at a minimal fee? Perhaps I'm willing to take on more risk by providing them to traders looking to leverage 20x perpetual contracts, like Futureswap? In any case, it can be seen as the ultimate evolution of passive and personalized investment.
If this type of prime brokerage protocol method indeed becomes a viable dominant strategy in the next few years, the most fascinating topic to watch will be: will Balancer more easily become Compound, or will Compound more easily become Balancer.
Yield Farming Is Not for the Faint of Heart
Let me be clear: we are almost certainly entering a period of speculative frenzy. We will see capital cultivation returns reaching billions of dollars based on token valuations, an unsustainable level, while symbiotic yield farming will push the situation to even higher levels.
There are likely to be hacks, exit scams, short-term asset price manipulation leading to liquidation cascades, and a host of other situations that could result in significant losses for people (likely including some professional funds). With many of these protocols having inherent interdependencies, combined with the massive financial incentives of liquidity mining, they are likely to be deeply stacked as much as possible, potentially leading to a system collapse.
Even if a collapse occurs, it will be rebuilt. The promise of truly open, permissionless financial services is too great to die.
For now, what can yield farmers do? Make hay while the sun shines—or, if you're really ambitious, skip the hay and engage in that symbiotic yield farming with your liquid funds.
Builders: Do what is necessary for competition and survival, but do not lose sight of your long-term vision. Constructing new financial infrastructure is a marathon that will span decades, so don't overdose on steroids before we've even crossed the starting line.