Decentralized Finance - or DeFi for short - is probably the hottest concept in the crypto space. As new projects come online and valuations grow, users' attention to the possible gains to be made in this field has skyrocketed. But in order to understand how DeFi actually works, one has to first look at liquidity mining.
What is DeFi?
DeFi is short for Decentralized Finance. DeFi projects use public chains (such as Ethereum) as an underlying framework and smart contracts as their core mechanism, and are committed to providing open financial services that are available to everyone, cannot be tampered with, and do not require permission to be accessed.
Although they have not yet become fully inclusive financial instruments, they are at the center of everyone's attention these days.
What is liquidity?
Liquidity mainly refers to the "liquidity of funds", that is, the ability to buy and sell assets in the market without causing sharp changes in market asset prices. It is a crucial ingredient in the functioning of a new coin or a crypto exchange, and can be measured by looking at different elements:
l Transaction speed. The faster a transaction is completed, the better the liquidity of the market.
l Trading price. The closer the price of the transaction is to the "fair price" or "dominant price", that is, the smaller the "slippage" when trading on an exchange, the better the liquidity.
l Transaction depth of the order books. Transaction depth can be used to measure the degree of market price stability. The greater the depth, the smaller the impact of a certain number of transactions on the price.
What is mining?
Mining originated with Bitcoin. Simply put, mining a coin is the action of solving specific mathematical problems to win bookkeeping rights and confirm the transactions that occur on a blockchain. This usually entails miners being rewarded for their efforts.
Take a closer look and you will notice that mining serves two core purposes:
- Token distribution. In order to create and independent financial system, the issues of "to whom", "how much" and "how to send" are the first that need to be resolved. Mining tokens and validating transactions on a blockchain serves this purpose.
- Value anchoring and capture. Tokens have no value initially. Through mining, a simple "input-output" ratio can be added to the tokens, thus making them valuable. For example, under the framework of the POW mechanism, miners invest in computing power and operation and maintenance in exchange for block rewards and participate in transactions in the secondary market.
Therefore, the process of mining is the process of token distribution and obtaining anchor prices.
What is liquidity mining?
"Liquidity mining" in the world of DeFi refers to the process of depositing or lending designated token assets with a mining mechanism to provide liquidity for the product's fund pool and thus obtain an income.
A liquidity miner wins rewards in a specific project's native token, or the governance rights it represents.
Take the very popular Compound project for instance. Based on Ethereum, Compound's main business is mortgage lending. According to data from DefiPulse, Compound's lock-up amount on July 7 was approximately US$650 million. Users can mortgage their assets to obtain annualized income, or pay corresponding interest to lend assets, and while borrowing and lending, they can obtain a certain number of governance tokens distributed by the system. By design, holders of COMP can propose changes to the Compound protocol or vote on the proposals.
Functions of Liquidity Mining
Improve liquidity, and facilitate the cold start of a project
As mentioned above, the liquidity of funds is a core component of the liquidity of the economic system. Unlike traditional industries, the DeFi industry does not have a self-built capital pool to provide stable liquidity. Therefore, how to design a reasonable and innovative decentralized fund pool model and complete user incentives through an interest rate mechanism to inject higher liquidity has become a core issue of DeFi projects.
In addition, "liquidity mining" also provides incentives for joining a DeFi project. Since Compound launched "Liquidity Mining" on June 16, its locked-up amount has increased from approximately 180 million to 650 million in just 20 days, while the number of users has increased to approximately 6K.
Integrate value islands to promote price discovery
At present, with the rapid development of the blockchain industry and the steady progress of its underlying technology, an independent ecology based on the public chain has gradually formed, and a series of value islands has been born.
Liquidity mining effectively links value islands in a decentralized dimension, and accelerates the frequency of value exchange, and ultimately promotes price discovery.
Price discovery is a comprehensive reflection of traders' understanding of the current market supply and demand relationship and expectations of the future market. It will not only help the reasonable allocation of resources, but also enable investors and financial institutions to make reasonable decisions based on this price.
Risks of liquidity mining
Risk of liquidation
In June of this year, miners who participated in Compound mining were accidentally liquidated due to improper pledge rate settings and lost tens of thousands of dollars.
Potential Systemic risks
Recently, Compound modified the mining mechanism of COMP, which caused the demand for DAI to increase sharply. More people flooding into MakerDAO, pushing up the upper limit of CDP, may cause certain systemic risks.