Is Yield Farming the New Transaction-Fee Mining? By Mohamed Fouda Liquidity Begets Liquidity
Whether you're a professional trader or a crypto speculator, the exchange you typically want to use to execute your trades is the one that has the highest activity and largest volume. The reason is simple: more liquidity means deeper order books and less slippage and, hence, better execution of your trade. As a result, exchanges that have large liquidity attract even more liquidity, and so on. Although liquidity concentration is great for existing users, it makes competition more difficult. Liquidity provisioning is one of the hardest cold start problems to solve, especially if your product doesn’t have a strong enough (or niche enough) differentiator to compel users to switch from existing exchanges.
Solving The Liquidity Problem
In 2018, a lesser-known exchange called Fcoin thought they'd finally cracked the liquidity problem. They invented something called “Transaction-Fee Mining” or “Trade-Driven Mining.” The Fcoin team created an exchange token and distributed these tokens to Fcoin liquidity providers and traders. The amount was proportional to respective trading volumes and how much of the exchange token each party already held. Does this sound familiar?
Initially, the model was a huge success and other Asian exchanges copied it. The exchange tokens at the center of the transaction-fee mining skyrocketed in value. Back then, I wrote some analysis on the strategy, and my article went fairly viral. In it, I described the Fcoin incentive mechanism and how it resulted in millions of dollars worth of revenue.
Exchanges and investors close to the exchange, not the transaction-fee miners, were the winners of this design. Traders were incentivized to perform wash trading, and pay fees, between several accounts to increase their share of the distributed tokens. Price discovery was warped - the tokens had experienced phantom inflation of price which made traders believe they were profitable. They continued holding the exchange tokens as the token value increased. In the meantime, exchanges sold millions of exchange tokens that were printed out of thin air at high prices. Exchanges realized millions in cash value and simultaneously dumped the token price to more realistic levels. As price plummeted, wash-traders were burned or got bored and left the exchange. The exchange volume disappeared with them, proving yet again that speculation is not equivalent to a network effect.
Are DeFi Projects Reinventing The Wheel With Yield Farming?
Over the last couple of weeks, users on several DeFi protocols, including Compound, have instigated a behavior reminiscent of 2018 transaction fee mining. The community has used the term Yield Mining or Yield Farming to describe the phenomenon.
In Compound’s case, the goal is to distribute control over the protocol by distributing the protocol governance token $COMP to protocol participants ie. the lenders and borrowers of the protocol. Similarly, Balancer started Liquidity Mining which distributes the protocol governance tokens $BAL to users providing liquidity to the AMM pools.
In both cases, the system design resulted in a rush to harvest these token distributions. In Compound’s case, the volume of tokens locked in the protocol increased by 6x in a matter of days. Similarly, $COMP token price jumped from around $70 to more than $330 before pulling back to around $200 - totaling a fully diluted market cap of about $2B.
How Can Yield Mining Succeed Long Term?
So far, Yield Mining looks very similar to 2018 trade-driven mining. People are rushing to game the system and extract the most value. For instance, DeFi frontend application Instadapp is creating several ways to farm yield from the Compound token distribution.
The important question here is whether yield farming can create a stable and long-lasting network effect for these DeFi protocols and their governance systems or if it will be more of a farm-and-dash situation.
Largest Owners of $COMP Token
At the peak of trade-driven mining cases, exchanges and their investors made the most money. In DeFi yield farming, the burden is on DeFi protocols and their investors to protect the experiment and support over time until a stable equilibrium point is realized.
This will only happen if the network effect becomes large enough (read: have enough momentum) to carry these protocols for the long term without collapsing (read: reach escape velocity).
Early signs are encouraging. For one, there's more transparency around early owners and investors in $COMP. These investors are mostly well-known venture funds that are inclined to avoid headline risk and take a longer-term position in the projects they back. In a line, they'd be less likely to dump on the community than, say, a free agent speculating on exchanges. Still, only time will tell if the yield farming experiment will lend itself to something sustainable or if it'll face a fate similar to Fcoin.
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