【ChainNews Selection】Yield Farming liquidity mining, all-inclusive coverage of yield farming projects, what are the opportunities and challenges?

This article is authorized by ChainNews for reprinting, the original title is "Inventory of over a dozen liquidity mining projects, we discovered these trends and challenges"

In addition to this collection of liquidity mining projects, we also summarize their origins, trends, and challenges for you.

Written by: Pan Zhixiong

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The distribution method of cryptocurrency project tokens is a crucial part of the entire project ecosystem. Designing a reasonable token economic model to incentivize various stakeholders within the system plays a vital role in the development of the project.

For the currently popular decentralized finance (DeFi) ecosystem projects, they are exploring a token distribution method that can both "incentivize user participation" and "drive platform iteration." In the domestic community, these token distribution methods are referred to as "mining," although project parties may give their token distribution methods special names, such as "staking airdrops," "rewards," "liquidity mining," etc., but the essence is similar.

Liquidity mining has directly driven the rapid development of DeFi protocols. Referring to DeBank data, after the milestone event of lending and mining on Compound, the total value locked in all DeFi protocols increased from the original $1.1 billion to a peak of $2.6 billion, and in the lending market, Compound's market share increased from 10% directly to 80%.

In addition to incentivizing the growth of the supply-side asset lock-in, it has also driven the growth of the demand side. Taking the decentralized trading protocol Balancer as an example, trading volume has increased significantly since the introduction of liquidity mining in June. It is worth noting that Balancer's trading pairs do not have additional mining income, so these trading volumes are not generated due to incentives.

Differences Between Liquidity Mining and Staking

This type of "mining" mechanism is somewhat similar to last year's popular concept of Staking, although both are financial services (yield), there are still some differences:

Staking generally refers to native tokens based on public chains, and usually does not require exposure to smart contract security risks.

Staking typically involves pledging tokens to obtain another type of similar token, while liquidity "mining" mechanisms involve obtaining the project's tokens through other activities such as trading, asset collateralization, quoting, etc.

In recent months, the number of projects announcing the adoption of liquidity mining mechanisms has rapidly increased, attracting widespread attention from cryptocurrency traders, speculators, and enthusiasts both domestically and abroad, making it the hottest topic in the industry.

Interestingly, the overseas community collectively refers to the concept of liquidity mining as "Yield Farming," with miners being called Farmers. Yield can be translated as "output (of crops)" or "profit (from investments)," while Farming here may correspond to a meaning similar to Mining.

The Birth of Liquidity Mining

Many DeFi protocols have never ceased exploring whether to issue tokens, the distribution method of tokens, the role of tokens, and how to achieve the initialization and scaling of the entire protocol through incentives during the development process over the past two years.

The decentralized trading protocol Uniswap was officially launched at the end of 2018, allowing participants to receive a share of transaction fees in trades, but the distribution is based on the fees valued in the underlying assets and did not issue the protocol's native tokens. Another problem is that Uniswap operates on an AMM (Automated Market Maker) model, where users who provide assets may not necessarily receive actual profits, especially when asset prices fluctuate significantly. Uniswap had one foot in the liquidity mining model, but just missed it by a hair.

At the beginning of this year, the DeFi lending protocol Compound took the final step and explored a "minimal" liquidity mining solution, which was later adopted as the foundation by most projects that adopted liquidity mining: rewarding tokens to actual users of the protocol, which would incentivize more users to participate, with the tokens used for project governance.

These key points may be the reasons and process for the gradual emergence of the liquidity mining mechanism.

Due to the characteristics of DeFi protocols being permissionless, open-source, and patent-free, and the logic of token distribution and token roles are also public, whenever a project explores a new model, other DeFi projects can easily follow suit and design customized "mining" schemes based on their own business needs.

The following summary of a dozen or so projects are currently or will soon be launching popular liquidity mining projects:

What Value Can DeFi Provide Without Liquidity Mining?

If we abstract the business logic of most liquidity mining projects, the value provided by DeFi protocols is to match liquidity suppliers and demanders through smart contracts, reallocate profit components, and the business process is similar to:

For example:

The lending market Compound matches lenders and borrowers;

The oracle NEST and Tellor match price sources and data demanders;

The cross-chain asset protocol tBTC matches asset custodians and cross-chain asset demanders;

The decentralized trading protocols Balancer, Curve, MCDEX match traders (Takers) and liquidity providers (Makers).

Of course, the above is a general process, and projects may have many customizations in the specific implementation process to incentivize specific user behaviors, such as Compound rewarding governance tokens to borrowers, but other projects may not.

Why Add Liquidity Mining?

The above business logic can ensure that the protocol can operate normally and generate income without setting up a "liquidity mining" mechanism, further iterating the development of the product.

However, because some DeFi protocols need to initialize liquidity in order to provide services with larger funds (and serve more demand), the "mining" mechanism plays this role perfectly by allocating the protocol's potential future income to early liquidity providers.

After "mining" these tokens, users can choose to immediately sell them to increase their short-term profits, or hold the tokens to tie their long-term interests to the project, participate in the governance of the project together with developers and investors, and become part of the project's community.

For liquidity providers, the essence of DeFi protocol "mining" is to use the time value of assets to exchange for short-term or long-term profits and bear potential risks, including smart contract, systemic, and related risks.

For demanders, after the liquidity mining mechanism helps to increase liquidity, they can execute larger-scale financial services.

For the DeFi protocol itself, "mining" can attract more users to participate in the use of the protocol, and allocate governance rights that determine the platform's future development to actual participants, not just investors or developers.

For cryptocurrency users who have not yet paid attention to the DeFi ecosystem, this liquidity mining event is a large-scale "advertisement," although there is no specific data, it has certainly contributed a lot of fresh blood to the DeFi ecosystem.

Differences from CeFi

Some people compare these liquidity mining projects to the "trade-to-mine" scheme launched by the Fcoin exchange two years ago, believing that there is no fundamental difference between the two. However, from a risk perspective, they are actually different. For DeFi projects, all data is publicly available on the chain, and all business logic is executed by smart contracts.

Therefore, liquidity providers of DeFi protocols do not need to custody assets with a specific institution or individual but are instead held in smart contracts. Although there are smart contract security risks or systemic risks, auditing agencies can reduce security risks, and more importantly, no one can misappropriate user assets. In contrast, the trading data of Fcoin exchange and the on-chain custody assets are two separate ledgers, which have the potential for misappropriation and are more susceptible to it.

So, when comparing decentralized on-chain services with centralized services that require asset custody, there are these differences:

Joint Mining is a Trend, but Risks Increase Exponentially

DeFi also has a feature of "composability," where different protocols can be combined or nested with each other. Based on this advantage, some projects have launched "joint mining" activities, where users can further increase their profits by participating.

Participants can earn rewards from multiple protocols by investing in specific pools of funds, such as Synthetix, Curve, and REN, which have initiated similar activities. Synthetix is particularly adept at playing in this liquidity mining activity; their mining mechanism is unique, but in addition, they also reward users who use the Synthetix protocol, so they often collaborate with third-party protocols to incentivize liquidity in Synthetix-related assets and protocols.

However, it is important to note that this will bring additional security risks. Since this type of joint mining involves multiple types of assets and multiple protocols, if the underlying assets deviate or if one of the protocols is hacked, it could potentially affect all users participating in the related joint mining.

Still in the Early Stages

Although the concept of liquidity mining has had a good market impact and promoted the rapid development of the DeFi ecosystem, from the current progress of mining, it is still in the early stages.

Except for NEST, Tellor, and Synthetix, a few projects have a mining progress of less than 2%, and nearly half of the new projects have not yet started mining, only revealing some details. Therefore, the circulation of project tokens is relatively small, making the token price more susceptible to manipulation.

In addition, for most projects that have chosen governance token models, the exploration of governance has not yet started, and the changes involved are relatively limited. Many people hope to see governance proposals with dividend or repurchase mechanisms put on the agenda as soon as possible.

Questions and Challenges: Transparency, Token Utility, Security

After the concept of liquidity mining emerged, the community also raised many skeptical voices. Some views believe that liquidity mining projects' issues include: opaque overall token distribution models, uncertain token utility, and inadequate security risk control in line with the growth of liquidity.

One of the major characteristics of DeFi is openness and transparency, so the mining mechanism also needs to be very transparent since this logic is written into smart contracts. In addition, projects introduce venture capital during the early development stage, and later distribute it to investment institutions in the form of equity or tokens, usually locking it for a period of time or unlocking it in stages.

However, some projects do not disclose detailed information about unlocking investment institutions, which may lead to unclear project circulation issues, and investors are not sure when a large number of tokens will be unlocked, causing price fluctuations. This mainly affects token buyers, and has a smaller impact on ordinary mining participants since it only affects mining investment returns without bringing additional risks.

Another major challenge is the utility of tokens and how tokens capture the project's actual value and income. Since most projects use governance token models, it is difficult for rational investors to reasonably value the project.

While the governance process can indeed help the project develop in a better direction, the project's scale and related income are not directly related to the tokens. This may be because the project is still in the early stages and requires an increase in scale and user numbers, while income and dividends are things to consider in the future.

Moreover, governance tokens designed with only voting rights actually represent a minimal token solution with scalability. Its permissions can only be used for voting, but it has good scalability and can add mechanisms such as dividends through governance in the future.

The final and more critical issue is how to continuously maintain the protocol's security. For DeFi protocols such as Uniswap, Compound, and Maker that have been operating for over a year, liquidity growth in the early stages is relatively slow, and as the protocol is adopted on a larger scale, smart contract security vulnerabilities gradually decrease.

However, new projects using liquidity mining mechanisms have benefited from this wave, and the assets custody within the protocols have grown rapidly, far exceeding the natural growth rate. However, since the security and risk control mechanisms of these new projects have not been tested over time, the probability of security incidents is higher. This may mean that the returns users receive are disproportionate to the risks they need to bear.

Some projects have already realized this issue and are considering mutual insurance or backup solutions. For example, more and more DeFi protocols support the smart contract insurance services of on-chain mutual assistance insurance Nexus Mutual, and project parties can also finance through governance tokens to fill the losses caused by the deficit.

Projects Taking a Wait-and-See Approach

Many well-known DeFi projects have not yet supported liquidity mining, such as Uniswap, Maker, dYdX, etc. Of course, they also have their own special circumstances. For example, Uniswap has never had a native token (and does not have plans for one), and Maker's governance token was distributed through fundraising and does not have an allocation for mining.

These projects need to be concerned that since the total amount of assets on the Ethereum chain is constant, with limited incremental users, the total funds of existing users have an upper limit, i.e., a stock game. If users are attracted by the profits of supported liquidity mining projects and lock assets in their protocols, it will inevitably affect projects that do not support liquidity mining.

From the data perspective, although Maker, Uniswap, dYdX, Bancor, and Kyber have maintained an increasing lockup volume, the growth rate is relatively stable, and they have not received additional influence or growth from the liquidity mining event.

Conclusion

Overall, liquidity mining is a system worth paying attention to, especially for DeFi projects that require liquidity initialization to operate. However, whether DeFi projects themselves are useful, solve problems, and provide value to users requires an evaluation of the project's own business logic and business model, which is not directly related to whether liquidity mining is adopted.

This mechanism is still in the relatively early stages, with many experiments yet to be conducted, many projects yet to join, and tokens yet to circulate widely. Governance tokens provide projects with great scalability, and as projects further develop, they need to find value capture methods suitable for their own business.

For users who want to try liquidity mining, the most important thing is to evaluate the risks and rewards, especially the risks, which are the "growing pains" that must be endured in the early stages.