Tougher regulation and a healthy dose of investor skepticism has meant that Initial Coin Offerings will never again drive the buying frenzy that was seen in 2017/18. But that doesn’t mean something else won’t take its place.
Decentralized Finance (DeFi) is now a 1 billion dollar market consisting of borrowers, lenders, bridges, derivatives and exchanges. Many of these platforms operate without a token, instead choosing to bootstrap their startups with grants or private funding.
Some of the most successful projects, Uniswap and InstaDapp, were built on a shoestring. Uniswap, a decentralized exchange who started with a meagre $100K grant from the Ethereum foundation, famously outstripped the trading volume and liquidity of Bancor – whose token (BNT) raised $150 million at ICO.
The ability for a DeFi project to thrive without an ICO shifted the conversation. It turns out that having tens of millions sloshing around on the balance sheet doesn’t necessarily beat a visionary founder and a team enthralled to work at the bleeding edge of finance.
The failure of ICOs to provide long-lasting returns to investors tarred the entire token market with the same brush – at least to outsiders. While retail investors refused to touch tokens again (if they could stomach crypto at all), entirely new and more complex formulas for using tokens were underway.
One of the greatest challenges for any DeFi project is in generating liquidity. Whatever the purpose, be it an exchange, borrowing platform or derivatives contract, its value as a protocol is underpinned by how much liquidity is available. Can a trader use a decentralized exchange without slippage, are options contracts priced correctly, can a loan be fulfilled and at what rate?
Despite all of its success, Uniswap has seen liquidity growth stall. Being a Liquidity Provider (LP) at Uniswap can provide a significant yield by collecting trading fees, however the incentive to become an LP is hindered by “impermanent loss” (a kind of opportunity cost). This problem has been exacerbated by the emergence of new protocols that have adopted liquidity mining.
What is Liquidity Mining?
Liquidity mining aligns incentives between protocols, LPs and users. Put simply, liquidity mining is the distribution of a token (often a yield-earning governance token) that is programmatically distributed to LPs based on the amount of liquidity provided.
This simple mechanism aligns incentives in an extremely elegant way:
- Liquidity Providers earn passive rewards and influence over a protocol.
- Users are drawn to the platform due to the increased liquidity.
- The protocol benefits from increased liquidity and additional users.
- Positive feedback loop ensues.
To provide an example of this effect, Balancer Labs recently introduced liquidity mining and the positive impact on trading volume and users was immediate.
The Liquidity Mining Bubble
In the case of ICOs, raised funds were held in cold storage or converted to fiat so that founders and VCs could live lives of luxury (mostly true). On the whole, the vast inflows of retail money that came into Ethereum at the time had little long-term benefit to the ecosystem.
*Speaks without irony*: This time it’s different.
With concepts like liquidity mining, retail funds that end up in the system stay in the system. Investors retain custody of their deposits while they earn additional tokens – tokens whose value will, the investor hopes, increase by orders of magnitude in the years ahead (à la ICO).
Liquidity mining has the potential to form a bubble like no other.
First, we will see hoards of funds entering Ethereum with investors buying ETH to then access other tokens; providing liquidity and then waiting for their ICO-style token rewards.
Second, the selling pressure of ETH will be nothing like what was seen during the ICO bubble. Tokens will remain in the system, earning protocol fees and generating yields. Assuming no gargantuan-sized exploit (ugh, it’s probable), investors will become euphoric, increasing their deposits and earning greater returns without any of the selling pressure of past bubbles.
At this point, decentralized finance will be unleashed. Access to liquidity for protocols and users will be on a mind-blowing scale and incumbent platforms will also have to introduce liquidity mining in order to compete. Derivatives contracts will come into their own and suddenly an entire financial system built on Ethereum will begin rearing its head.
Well, maybe. The Ethereum network is already struggling for capacity in its current state. Fees are through the roof and complex gas-consuming DeFi functions will be prohibitive to low-stakes players with more being excluded as fees go up.
Then there’s the user experience. While we saw that ICO buyers were capable of buying ETH and sending an Ethereum transaction, liquidity mining requires a little more understanding.
And finally, there is the risk that a DeFi contract was deployed with a bug, allowing someone to exploit it in some way. That said, this risk could well pale in comparison to ICO participation, given that the user retains custody of funds when liquidity mining.
Where can I follow this?
As ever, Twitter is the best place to keep up to speed with developments here. There are dozens of people worth following on the subject but to short list just a few:
Always DYOR. Expect shilling!
As for the price of ETH?
There’s a definite correlation between DeFi tokens and the price of ETH; but how this might behave in a liquidity mining bubble is much more unclear.
If public interest does indeed form, retail investors will first need access to ETH in order to then access liquidity for other tokens.
It is also unlikely that there will be the same selling pressure on ETH as was seen during the ICO craze thanks to funds remaining in DeFi. In fact, with Phase 0 starting later this year and Layer 2 starting to take form, the bull case for Ethereum is already extremely strong without a potential demand shock.