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Ethereum’s Liquidity Wars Have Begun


Hundreds of millions of dollars are funnelling into decentralized finance, bootstrapping the system with liquidity and rewarding users with fees and tokens in the process.

Total value locked in DeFi has almost doubled in 30 days. Source: DeFi Pulse

Those supplying the liquidity – whether it’s ETH, BAT or any other ERC-20 token – are seeing millions of dollars worth of rewards being paid out each week.

This is all happening because of a unique incentive structure that is creating win-win* conditions for both those who provision the liquidity and the financial products that benefit from it.

What started with Compound Finance’s launch of COMP (a token whose value shot to $650M in a matter of days), has turned into a long queue of both financial products and liquidity providers (LPs) all looking to gain from this new incentive structure.

The Fight for Liquidity

The enormous success of COMP has put a fire under their competitors. There is now an arms race taking place where first movers stand to make huge gains if they can strike a balance between their need for liquidity and the needs of LPs.

Liquidity providers want to put their idle ERC-20 and ETH tokens to work in the most optimal way, while DeFi products want to attract (and retain) the LPs that are critical in bootstrapping their platform.

A user’s liquidity can only be in one place at a time, yet it is free to move at any point should a more optimal yield be discovered. DeFi products, then, are constantly battling for the attention of LPs.

In the case of COMP, what began as a relatively low risk method of generating yields by borrowing and leveraging stablecoins (whose price is predictable) has morphed into a much higher risk activity of borrowing and leveraging the Basic Attention Token (BAT). BAT, like any speculative cryptocurrency, is subject to large swings in price; and under current conditions, a major downturn could see COMP farmers liquidated in huge numbers. As it stands today, $224 million BAT has been borrowed on Compound as a means of generating COMP. To put that into perspective, the BAT token has a market capitalization of $380 million.

Today, if an LP wants to remain at all competitive in the race to farm COMP, they must use BAT and take on this additional risk. As a result, many LPs have moved out of the system.

Balancer Labs was next in line. Having calculated LP rewards since June 1st, the Balancer token (BAL) was distributed yesterday at around 17:00 PT with arguably greater success than COMP. BAL quickly began trading at ~$20, creating a fully diluted market cap of $750 million in a matter of hours.

Balancer, a self-balancing Automated Market Maker (AMM) similar to Uniswap, allows LPs to deposit tokens in any one of the existing pools or via the creation of a new pool. These pools allow others to swap (trade) between the cryptocurrencies within them, generating fees and BAL rewards for the LPs.

Balancer isn’t the only other product battling for liquidity. Curve Finance is rewarding LPs with their yet-to-launch CRV governance token and Synthetix is distributing SNX for those who pool their minted synthetic tokens (sUSD, sBTC etc) in other platforms like Uniswap and Balancer. Curve, Synthetix and the blockchain interoperability project, Ren, have also partnered to allow LPs to “stack” yields with funds routing through multiple projects and generating multiple rewards on the way.

*How Does it End?

That’s a doozy.

COMP is currently scrambling to mitigate the risk of what was likely an unexpected outcome of their incentive structure; something which can be best described as the “wash trading” of the Basic Attention Token (a symptom of rewarding both borrowers and lenders). Their latest proposal aims to increase the reserve factor of BAT, REP and ZRX to 50%, helping to keep the system safe should prices tumble.

“This is an extreme situation caused by the COMP distribution. Currently, these assets are preferred for those who farming COMP, these carry high liquidation risk against the protocol; therefore increasing their Reserve Factor is needed to ensure the protocol safety.”

Robert Leshner, Compound Finance

The incentive for someone to successfully exploit one of these protocols increases with every new dollar deposited into DeFi. You can be certain that there are dozens, if not hundreds, of incredibly sophisticated users looking at novel ways to exploit the smart contracts that underpin this activity.

But, with the avoidance of major exploit permitting, there is no obvious end in sight.

The next few months will be awash with new DeFi projects joining the battle for liquidity in the hope of establishing the network effects required for a healthy financial system (and a healthy token price).

Decentralized futures exchange, Futureswap, is likely to make a return to the LP battle soon. The platform launched their Alpha LP rewards in April and were forced to close after just 3 days due to the “immediate overwhelming positive response“.

The darling of DeFi, Uniswap, has not yet made any comment on rewarding LPs, but it is extremely difficult to imagine that one isn’t under development and soon to launch. Who knows what else might be announced in the weeks and months ahead and the subsequent swell of attention directed towards the Ethereum blockchain.

ETH Price Remains Silent

Rapid growth in Ethereum’s decentralized finance market is likely the cause of recent price jitters. In the last 24 hours the price of ETH jumped from $243.08 to a high of $249.60 before swiftly returning back down.

Many DeFi speculators have doubted whether the success of DeFi translates to a growing price of ETH, instead anticipating that investors will be drawn to other cryptocurrencies on Ethereum that return significant yields.

While this pattern is certainly being observed among sophisticated Ethereum users, it ignores the broader retail market that may soon see yield farming as the next great opportunity.

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Nick Founder