Defi Liquidity Mining and Long-term Growth

  • Commentary
  • August 30, 2020

Surges in DeFi usage, particularly on Ethereum, have proven a defining narrative of the blockchain and cryptoasset industry thus far in 2020. In large part, such progress in adoption can be attributed to the DeFi governance tokens, the recent proliferation of which has brought renewed attention to the practice of so-called ‘liquidity mining.’ Liquidity mining programs refer to the practice of distributing native cryptoassets to users based on their interactions with a platform, In the case of contemporary DeFi protocol’s, users are typically awarded governance tokens, with varying value-capture mechanisms, for initiating loans or providing liquidity in some capacity. This dispatch overviews a recent piece published by Multicoin Capital, wherein Tushar Jain & Spencer Applebaum explore and critique the current state of DeFi liquidity mining and consider design implications for long-term growth.

The report notes that the first meaningful instantiation of liquidity mining protocols was that of FCoin, a Chinese-based exchange that began offering its native cryptoasset to those who traded on and provided liquidity for its platform. Such incentive structures resulted in widespread wash trading and artificially raised FCoin’s liquidity to seemingly surpass that of nearly all its peers, from which parallels can be drawn to Compound’s current liquidity mining program. In an earlier dispatch, the Smith + Crown research team noted the distribution mechanics of Compound’s COMP token may serve, in part, to compensate for hitherto significant imbalances between the provision of loans and the demand therefor. As ‘yield farming’ incentivized borrowing at any rate, COMP distribution likewise obscured Compound’s inability to offer rates competitive with its centralized peers. Expanding upon these theories, Jain and Applebaum point out that increases in rates are likely to have alienated genuine users of the platform. Further, they acknowledge, when COMP mining rewards decrease or are arbitraged away, there is likely to be a mass exodus of assets from the platform, which users instead migrating to more profitable platforms. Thus, such liquidity program designs are most likely to result only in short-term spikes in usage.

Using Compound as a case study of sorts, Multicoin concludes that a key design goal of liquidity mining programs, one that is likely to be unrealized by current instantiations in DeFi, is the incentivization of long-term growth over short-term spikes in usage. To achieve this, the report prescribes four key design alterations:

  • First, a lack of lock-up periods allows arbitrageurs to pinpoint which actions will be profitable in an granular manner and immediate timeframe, disregarding any long-term attachments to the protocol. Including vesting periods instead may incentivize such actors to become long-term stakeholders in the platform and allow for clawbacks to discourage wash trading or lending. Likewise, protocols should create sustainable distribution mechanisms–unlike COMP’s, which ends abruptly after four years.
  • Second, to similar effect, protocols can retroactively reward users who keep its native asset on the platform for extended periods of time.
  • Third, greater rewarding of service providers, such as insurance pool stakers and keepers, will provide protocol stability and mitigate capital flight based on inefficiencies or vulnerabilities.
  • Finally, rather than distributing a fixed number of cryptoassets per period, protocol’s should implement variable payout schedule based upon value generated for the protocol, thus incentivizing more meaningful interactions with the ecosystem.

Ultimately, liquidity mining programs are simply the latest distribution mechanisms intended to immediately boost adoption, yet they have the potential to evolve into to a genuine method of generating meaningful long-term growth. In the near future, we are likely to see increased variations of such mechanics and flaws and room for potential in current iterations become apparent. Whether Multicoin’s design alterations are enough to correct for liquidity mining’s existing shortcomings is an issue Smith + Crown will be tracking.