More and more people are familiar with DeFi now. If you aren’t, you can navigate here for a quick introduction.
One of the biggest applications and ways of participating in DeFi is providing liquidity, whether that’s providing liquidity to lending pools or liquidity pools for decentralized exchanges. Liquidity pools essentially allow for smart contracts to use crypto from other people to do activities such as borrowing or exchanging one token for another.
A liquidity provider will thus get a fee for doing this. In the current financial world all loans or exchanging is done through the bank who is the middleman between the person lending and the person borrowing, in DeFi instead of the institution doing this work it is a smart contract and so you as a lender get the full piece of the interest pie rather than the bank taking a piece of that pie.
Now of course all these decentralized applications (Dapps) have the chicken and egg problem- if no one is providing liquidity then no one will use the Dapps, but if no one is using the Dapp the person providing the liquidity won’t be getting paid. So Dapps have thought about how they can incentivize people to join or use their protocol. This is where a token and yield farming or liquidity mining comes into play.
Yield Farming/Liquidity Mining definition: The process of using a platform by adding or taking liquidity from a protocol, where on top of the interest that you earn you also earn the protocol token.
Compound- The First Protocol to Introduce Yield Farming
The idea of yield farming originated from Compound and their COMP token. The initial reason and idea for the token were not yield farming, but to function as a decentralized lending and borrowing protocol in order to fully decentralize the protocol. Compound believed that the governance of the protocol needs to be decentralized as well. It shouldn’t be the company Compound Labs who develops the protocol that decides which direction the protocol takes, but rather it should be anyone that uses the platform. We explain why it transitioned to yield farming up next.
The Compound Token
In order to be able to achieve decentralized governance, Compound thought of creating the COMP token so that people who hold the COMP token no matter who or where they are can propose or vote on new paths the protocol should take. An example of governance and voting could be- should it be allowed to also lend and borrow a different cryptocurrency or should fees be increased. The big question was how to distribute the COMP tokens in order to make the distribution of them in a fair way?
Of course, we have heard of ICOs- where tokens get sold and anyone can take part in buying the tokens and with anyone, I mean, and entity or person that manages to get into the token sale that has the knowledge and also the money to purchase an ICO. So in order to get decentralized governance, this wasn’t the best way of distributing a token. So what was the other alternative?
Compound meets Yield Farming
This is the interesting “Yield Farming” (also called “Liquidity Mining”) part. Compound thought of the idea to distribute 2880 COMP tokens every day to users of Compound, 50% of them to lenders and 50% of them to borrowers. This distribution will occur over the next 4 years to make it fair and to give a reward to people that use the protocol over a long period of time.
This means that if you lend out a cryptocurrency you are earning the x% of interest plus a proportion of the 2880 COMP tokens. The distribution of the COMP tokens is allocated to each of the different markets (ETH, DAI, BAT, or any ERC20 token-BTC is in the pipeline) proportionally to the interest rates.
If you decide to stop lending your money out it just means that you stop earning COMP tokens, but there are no further consequences.
Thus the longer you use the protocol the more COMP tokens you get, the more voting power you have. Makes sense right?
Compound’s Voting System
Now you may ask yourself so why should the COMP token have monetary value if it’s equivalent to a vote?
People believe it should have value because being able to vote on certain decisions is powerful. Think of the fact that if I own 1% or more of the tokens I can propose that 5% of the borrowing fee should go to all COMP token holders, or that every time a user first time interacts with the protocol they need to pay a “entry” fee to COMP token holders. So all though right now the only value is voting and proposing changes, this could change in the future.
Yield Farming in the Future
Crypto market participants saw the $COMP price fly through the roof, so everyone wanted to start yield farming. Shortly after COMP, Balancer, a decentralized exchange (DEX), announced their yield farming token. Now, Curve Finance and 1inch, also DEX, announced their yield farming tokens. To an extent, the hype feels like the ICO hype of 2017.
If people are farming these tokens, why is the price going through the roof?
The problem is that people who don’t have the knowledge of how these tokens are being distributed may think that people are buying the token. The reality is though that most people are not buying the token (??? 😕).
The people that are buying $COMP tokens are buying these tokens because they have extremely low supply. Everyday 2880 COMP gets distributed, meaning if demand is high the people wanting to buy the token are fighting over a very low amount of coins.
Hence, the problem that creates is that people that are borrowing the only factor in the making of COMP tokens. If volatility in the market starts increasing, we could see a lot of these borrowers get wiped out.
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