01 Mar Yield farming is not the organic future of blockchain
High APY won’t last long, Defi + upgraded DAO is the true future
The farming mania
Have you enjoyed the yield farming in the last couple of days? The price of COMP has jumped from $30 to $340 in just a week. And by supplying token assets on Compound, the lenders(of some tokens) could earn 20%+ APY (not counting the incentives COMP yet).
On Saturday, June 20, Compound has overtaken MakerDAO to become the largest decentralized finance protocol by total value locked according to data from DeFi Pulse. There is over $580M in cryptocurrency locked on Compound compared to $470M on MakerDAO.
Behind the halo
It happened so quickly that people on Twitter kept comparing it with the ICO scam. Not to judge for that yet, let’s understand the mechanism of how Compound works first.
In a nutshell, it’s called “Liquidity Mining.” The more people borrow or lend, the more rewards(COMP token) they can “farm,” which increases the liquidity of the financing and the size of the balance sheet.
It’s not different from that you save money to the bank and earn the interest rate (it’s very low). However, on Compound, borrowers are willing to pay a lot more, because they think they can make more money with what they borrow from you than what they have to pay you. How does it work?
- They are getting paid to borrow. When they borrow from you on Compound, they are getting COMP Token as a sort of cashback. The more they borrow, the more COMP Token they get. At this time, the cashback(big juicy subsidies) is actually worth more than the cost of the fees to borrow, which means people are incentivized to borrow just to “farm” the cashback.
- As liquidity miners are compensated for both lending and borrowing, the optimal strategy is to lend the highest interest rate asset, borrow as much as they can against their tokens and then add the remaining assets back into the lending pool.
So, People are borrowing funds to “farm” COMP, then using the same funds out to lend, increasing their yield (COMP reward) even further. As a result, now they can earn 100% APY instead of the 0.01%-1.00% your banks are offering you, which is a 100–10,000X increase.
What’s going to happen next?
While almost everyone agrees that when something becomes too good to be true, it either won’t be sustainable or won’t exist at all.
- Since you can lend, borrow, then lend and borrow again, just like using leverages to do the arbitrage, it has the material risks of liquidation, especially the APY rate is fluctuating severely. And actually, it has already happened in some users’ accounts.
- Do you remember the Trans-Fee Mining(the more you trade, the more FT you can farm) introduced by Fcoin? Within a few weeks after launching the incentive program, FCoin’s 24-hour trading volume reached a whopping $17B on June 26, 2018 (3 times the total trading volume of other top 10 exchanges). However, the surge did not last long. As reported on CoinMarketCap, FCoin’s 24-hour trading volume dropped to $0.16B on August 12, 2018. It collapsed when people started to dump FT, and it was a speeding-up vicious cycle when people saw the FT price was dropping. So, same here, there would be a tricky point that when people dump COMP token to secure their profit, the price of the COMP token keeps dropping and becomes unattractive or hard to compensate for the difference between the borrowing and lending cost, then people start to withdraw their token assets from the platform, and the tragedy begins.
- As an “insider” of the blockchain and crypto field, few of my friends borrow or lend from these Defi platforms, or holding COMP or MKR tokens. It might be some selection bias, but it reminds me that the size of this Defi market is actually limited to the level of speculative activities in the crypto industry. If there are no breakthrough use scenarios to bring in new users, the imagination that the existing user base will support a new giant will also be limited. It’s just another zero-sum game.
Is Defi a Pseudo-proposition？
Definitely no. But I don’t think Defi will replace the Cefi. On the contrary, they will co-exist in the long term. Like the day and night, Defi and Cefi will complement each other to serve different business/people, and they will have interactions, like the stable coin/Fiat and KYC.
Defi is still at its early stage. If it is only borrowing or lending to gain arbitrage, it will just become another alternative investment. How could it change the world as it intends to be?
In the physical world, companies create value, and that’s what the stocks, bonds, or alternative investment products are pegging.
In the decentralized world, distributed collaborations constitute the Decentralized Autonomous Organization (DAO). As the counterpart of the traditional company and as a reasonable logic, Defi should peg to the value creation entity- DAO.
Different DAOs are set to accomplish various goals, so borrowing and lending is only a small part of the whole landscape. As an organization lives on the blockchain and internet, all the activities that the distributed community members carry out (like finish a task, conduct a transaction or share knowledge) will be recorded and tracked in almost real-time, which offers the edge for Defi to be different from traditional centralized finance.
So, not as in the traditional finance scenario that the information asymmetry forced investors to gauge the past business data and bet on the future almost blindly, or invest in a project to try their luck, Defi investors or Defi service providers could scrutinize the “atomic” layer (in theory), with their investment or alternative investment pegged to the progress of the collaboration or the project in the DAO.
Too complicated or not real?
No worries, DAO has the capability to backbone that, and now almost all the Defi projects are leveraging the DAO’s governance structure. However, the DAO’s governance protocols need to be upgraded, voting and budget allocating (which most governance protocols are focusing on) are not enough, because that is only the beginning of the whole collaboration process in the DAO. A systematic framework should be built up to regulate the distributed collaborative relationship, to manage the collaboration, and to protect the interests of all the collaborators.
With the framework, Defi investors or service providers can peg to the project’s real value, controlling their own destiny while also providing the liquidity for the project, which is a win-win.
So, to conclude, Defi + DAO (with updated governance framework) will become the real organic field to farm.
Contributed by Kevin Liu