An overview of what liquidity mining is in one article

With the rise of DeFi, people want to follow blockchain principles and change centralized exchanges, hoping to replace the "centralized link" with smart contracts to achieve a safer decentralized exchange (DEX) for trading. However, since there is no third-party market maker on DEX, the lack of order depth results in large spreads between users. At this point, the blockchain smart contract-based Automated Market Maker (AMM) mechanism develops a special pool of liquid assets, and this liquidity pool can then provide order depth to the DEX, thus ensuring the stability of trading.

For liquidity providers LPs who deposit token assets into the DeFi project's liquidity asset pool, they are rewarded with a percentage of the fee as an incentive to come and provide liquidity. The reward may be the project's native tokens, or tokens representing its governance rights, which is liquidity mining.

II. The role of liquidity mining

The rapid growth of the DeFi industry is due to the rapid development and innovation of DeFi technology, of which liquidity mining has helped countless projects to accelerate their growth and promote the rapid rise of the overall volume of the DeFi space. There are two main positive effects of liquidity mining.

1. Since the birth of the Ethernet public chain, many DeFi projects have landed, gradually forming an independent ecology based on the public chain and forming "value silos". Liquidity mining injects liquidity into different DeFi projects, linking one independent DeFi ecology, breaking value silos, accelerating the frequency of value exchange, and ultimately promoting price discovery.

2. Liquidity mining injects liquidity into DeFi projects, increasing DeFi's total locked-in volume (GVL/TVL) and funding availability. TVL can represent the total liquidity in the liquidity pool, which is a very effective indicator of DeFi health and the overall liquidity mining market. Increased liquidity can effectively reduce transaction slippage and improve the competitiveness of the application, thus attracting more users to join.

III. Typical Project Compound

On June 15, 2020, Compound launched liquidity mining of its governance token COMP, triggering an explosion of liquidity mining across the DeFi market. In just one week, Compound's total locked position grew from $111 million to $587 million, an increase of 500%; 20 days later, total internal borrowing grew from $23 million to $764 million, an increase of 3,300%.

The Compound protocol is based on Ether creating a lending pool of its own for each ERC-20 token, and the protocol automatically calculates the lending rate for each coin in the pool through supply and demand. Unlike other peer-to-peer lending protocols, the Compound protocol does not require communication between borrowers and lenders, and directly trades in the corresponding lending pool itself.

In a peer-to-peer solution, the lenders and borrowers would do the matching, and then the lenders and borrowers would communicate, and they would agree on the interest rate, maturity time, collateral items, etc. for the borrowed funds themselves. In the Compound protocol, each ERC-20 token has its own lending market, which contains each user's balance in this market and historical interest rates for each period, etc. In the Compound protocol, each ERC-20 token has its own lending market, which contains each user's balance in this market and historical interest rates for each period, etc. Users can seamlessly borrow money from the protocol through a line of credit on collateral; you only need to see which coin you want to borrow, and you don't need to communicate with anyone about repayment dates or interest rates, and you can borrow money right away.

Compound's success has prompted more and more projects to start liquidity mining, which in turn affects the total lock-in volume of the entire DeFi space. For example, Balancer, the second project to launch liquidity mining after Compound, saw its TVL grow by about 15x in June 2020, and its trading volume was among the top three during that time, behind Uniswap and Curve. total DeFi lock volume grew from $938 million to $1,703 million in June 2020, and Almost all of it was brought about by liquidity mining.

IV. Risks of liquidity mining

1. Bubble risk

The high yield of liquidity mining attracts more and more new entrants, and the price rises quickly in the short term, further incentivizing the lock-up of more tokens to push up the price. The phenomenon of high returns for early participants creates a herding effect, creating a huge "bubble".

2. Smart contract risk

The proliferation of DeFi has caused many small teams to flock to build and develop nascent protocols, which increases the risk of bugs in smart contracts. Even the larger protocols have been hacked regularly.

3. Liquidation risk

MakerDAO, Compound, and other lending agreements are established through overcollateralization. The liquidation mechanism will be triggered when collateral prices fluctuate resulting in insufficient collateral, and their collateral will be sold to pay off the debt.

Summing up

The essence of liquidity mining is to provide liquidity for decentralized transactions to obtain returns, and it is an innovative application in the DeFi space that can realize value in two dimensions. First, it injects liquidity into different projects, breaks value silos and accelerates the frequency of value exchange; second, it increases the total lock-in volume of DeFi, enhances the competitiveness of the application and attracts more users to join.

Liquidity mining has helped countless DeFi projects to accelerate their growth, and the total lock-in volume of DeFi has now peaked at $129 billion, more than 100 times of what it was a year ago. innovation in the DeFi space is non-stop, and liquidity mining as a financial model, although it may experience the expansion and bursting of the bubble, will definitely leave behind valuable and innovative projects.