September 2020: Liquidity Miners Chase Rewards and Drive Competition Within DeFi
Decentralized finance (DeFi) is an extension of the original use case for cryptocurrency and digital assets: a means to transact value without the interference of third party middlemen or governmental systems. While digital assets have performed well in peer to peer transactions, performing wider services such as credit and lending have since eluded cryptocurrency developers. As the pandemic has constrained access to credit and caused banks to lower interest rates, customers have begun searching for alternatives, leading to the explosive growth of decentralized currency; banking services provided more cheaply and transparently on the blockchain.
The Complicated Mechanics of Liquidity Mining
Liquidity mining allows you to stake a digital asset holding that you own, holding it in a liquidity pool which will then provide rewards via a smart contract. There have previously been options for holding an asset and reaping rewards, but they have previously also come with severe disadvantages. Simply holding an asset pegs your entire investment to its price, subjecting to its characteristic volatility. Some exchanges allowed you to purchase hashing power and receive the payouts from that hashing, but then you were subject to that mining operation’s logistics, which could result in you holding the bag if the operator decided to close up shop (commonly known as a rug pull). Liquidity mining solves these problems by letting you keep access to your deposited funds while also holding them in stablecoins, Ethereum, or other assets, allowing for a bevy of options depending on the investor’s risk tolerance
Miners participate in the process as liquidity providers by depositing their assets into a pool, which facilitates an exchange where users can lend, borrow or exchange tokens. The health and success of a pool, as well as decentralized finance as a whole, can be measured by total value locked, or the sum of all assets that providers currently hold in the pool. Because funds can be withdrawn and shunted to other pools, or distributed among many pools at a time, yields can vary greatly depending on the strategy used; some providers use APR and APY such as with traditional assets, but the space is gradually moving to estimating returns on a daily or weekly basis instead.
Those that stand to gain the most from mining are those that take the time to dig in and understand its mechanics. Because of the near-instantaneous nature of digital assets, liquidity can be moved in and out of pools to chase bigger, riskier rewards to the investor’s taste. For example, pools in need in liquidity could offer an incentive to investors for depositing, and miners would be driven to deposit there to chase that temporary reward. The best liquidity miners will seek out edge cases and opportunities in the market to maximize their returns rather than letting their deposits passively sit. Money markets such as Compound and Aave can benefit the more sedate investor with a low appetite for risk, but experiences such as Uniswap are where the paradigm really begins to shine.
Unique pitfalls await the unwary or untrained investor. Impermanent loss can result if you deposit into a pool and volatility causes a shift in market rates; this is deemed ‘impermanent’ as potentially accrued fees paid out to the investor could catch up to the loss taken, if the assets are held in the pool. If the liquidity is withdrawn before this occurs, then the loss becomes permanent. A series of poor decisions could very easily compound themselves. It takes skill to navigate a decision of tying up liquidity and letting fees erase the loss, or simply taking the loss as it is and moving to greener pastures to make it up elsewhere. Even by digital asset standards, token volatility is also extremely high which can make high-pressure decisions even harder.
Uniswap’s New Balancing Act
Rather than paying fees to investors from transactions, Uniswap was instead designed as a public good using the Ethereum protocol. After being announced and deployed in November 2018, and receiving a $100,000 grant from the Ethereum Foundation, Uniswap was open for business. A proprietary mechanism called the “Constant Product Market Maker” provides an exchange rate based on the amount of available liquidity in the pool and the extant demand for that liquidity. This determines the relative value of a trade on the platform, and the rate is charged for the trade accordingly. A small liquidity provider fee of approximately 0.30% is taken from trades and added to the reserves, which is paid out to providers when they withdraw their funds. This ensures that the reserve pool is constantly growing, and helps bolster the faith of investors that their deposits will be available on demand.
Uniswap, perhaps fittingly, has become one of the ‘unicorns’ of the DeFi space, reaching $300 million in total locked value in August of 2020. The success of Uniswap has led to one of the aforementioned promotions where just last week they announced the launch of UNI, a governance token (UNI) with a run of 1 billion; and anyone that had used the platform prior to September 1, 2020 was able to claim 400 of them. One day later, the token was listed on several exchanges and driven almost $2 billion in trading volume. With these tokens initially priced at $3, and reaching a high of $8.60, it provoked a ‘gold rush’ effect leading to a great deal of positive sentiment and interest in the platform. Although the token’s value has since corrected, some investors spoke highly on Twitter, with Crypto Medici commenting that UNI is still extremely undervalued and expects a conservative total of $3 to $5 billion.
Events such as these on a specific platform are a unique benefit to DeFi and provide much of the excitement and returns for liquidity mining, capitalizing on FOMO (fear of missing out) and providing an avenue for different liquidity pools to compete to attract investors.
How liquidity mining is good for the ecosphere
First off, liquidity mining drives participation, which is always a good thing with emerging technologies. DeFi could potentially upend how money is lent out, but the liquidity has to come from somewhere. DeFi’s elevator pitch is that liquidity is aggregated from many small sources rather than titanic, extremely vertical institutions. The sudden burst of invested funds will allow pools to grow and offer more services to prospective lenders. Secondly, liquidity mining isn’t just shuffling coins between accounts, but provides a useful service. As this liquidity is still being provided to prospective borrowers, it will help drive sentiment and interest in the products.
Thirdly, liquidity mining allows for a great deal of skill expression and constant, active involvement with investing. While putting money in a pool and letting it sit is an option, it won’t provide anywhere near the returns as being involved with the deposits, moving them between pools, and balancing them appropriately. This will ensure that DeFi gets the exposure and activity that it needs for the space to be successful long-term, especially at this early stage in the game. It should be noted that all types of investors will have a role to play in promoting liquidity pools and a DeFi ecosphere that will be viable for everyone. Stable liquidity from more passive investors provides the base and legitimacy to build it on and activity from skilled miners will give the sphere the activity and word of mouth that it needs to grow.
Concluding Thoughts
It takes all kinds of individuals to make a sustainable ecosphere, and miners are turning out to be the rockstars taking on the high risk investments and turning out extremely high yields for their trouble. Because the field is so new, glitches and bad deals are bound to happen at some point, and their “stress-testing” of the process will make it a safer place for everyone involved.
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