DeFi Vocab: Yield Farming & Liquidity Mining

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Yield Farming

Yield Farming is a goofy phrase but it does elucidate, in a succinct way, what can be done within Ethereum decentralized finance. Now that a young ecosystem of applications have arisen with non-custodial and automated financial markets, there is a lot of opportunity to have your digital assets accumulate yield with a little savvy, risk taking, and effort. 

Ethereum users are taking advantage of DeFi applications early in their life cycles, but being an early adopter isn’t without its costs. These applications haven’t proven themselves over a long period of time and it usually takes some research and trial and error to come across these tools. 

Early adopters and backers of Ethereum and its ecosystem are putting their capital at risk by interacting with these nascent applications and protocols. But walking hand in hand with this risk is the potential for reward. Especially compared to the legacy financial system, which is an amalgamation of traditional banks and government entities, Ethereum-based financial applications are offering significant interest rates for participating in their pools and interacting with their applications. 

The term “Yield Farming” is techno-financial jargon for maximizing return on assets. Many Ethereum applications have been offering attractive interest (yield) rates and many DeFi users were farming or cultivating this yield in a highly effective manner in a totally new way. 

Holders of Ethereum and other Ethereum based assets are able to lend them out to applications that are administered by smart contracts and secured by an underlying blockchain. Obviously human beings are involved with the development of smart contracts and usable applications, but once those contracts are deployed and active the only thing standing between a user and their money is transparent, immutable, and deterministic code. 

The realization of this reality has been years in the works and has broad implications for the future of finance. 

However, each and every one of these applications have some ways to go in terms of increasing use, adoption, and most importantly, decentralization. 

At the beginning of many of these projects, even Bitcoin, only one to at most a few people were involved. But what was important is the architecture that was put in place and the actions of its founders. Are these projects decentralized in all the ways they would like to be? No. Can they be? Perhaps they can. Bitcoin was able to decentralize from an N of 1. 

One method of Yield Farming is also a path to decentralization for many of these applications: mining.

Liquidity Mining

The concept of Mining in crypto networks typically accomplishes two things: (1) it creates a costly signal that consensus can be built around and (2) it can be an effective way of distributing power and responsibility over a network. 

Mining, in the context of crypto networks, imposes a cost on the miner, but also offers a reward that compensates for that cost and allows the miner to use or influence the network. The cost is sufficiently high enough to signal that you have skin in the game, but low enough where a lot of users can afford to enter the game. 

And in exchange for these costs, which usually serve some type of service to the network, the miner is rewarded with cryptographic tokens. These cryptographic tokens can be stored, controlled, and used by an individual. The possession of tokens gives the user some ability to use the network, which can include direct influence over the direction of the network. 

While the concept of liquidity mining has been around for a while, it has exploded in popularity after Compound launched a token (COMP) that represents this concept. 

In DeFI jargon, liquidity “miners” are rewarded for providing the system with liquidity (in addition to the regular yield), both to the lending and borrowing side of the market. Instead of providing hashes or energy for security and consensus like in Bitcoin, a liquidity miner is providing liquidity, that is, putting their assets up for use in a financial market and being rewarded for it. It can also be thought of as “staking” as well as mining. Saying you are mining liquidity or staking liquidity are both conceptually valid. 

Not only are DeFi applications like Compound attracting more liquidity, a resource they need, they’re also able to distribute governing rights over the application itself in a fair and economically rational way. Two birds, hit with one stone. 

Applications like Compound are rewarding the users who provide the assets needed for a money market to exist by issuing economic and voting power. This decentralizes control in an efficient and rational way. Rational in the sense that you are distributing power and responsibility to a group based on their financial usefulness to a natively financial application. 

The distribution of governance tokens through liquidity mining helps stretch the locus of power away from the team at Compound Labs, which currently has outsized influence over the application and the market it exists in. 

Going forward we should see their ability to dominate decision making recede. This would be a win for their team and show a path forward to others to decentralize as rationally and as fairly as possible. This permits the elimination of single points of failure and a broad array of interested stakeholders having a seat at the governing table. 

In short, Compound, if successful, will be governed by a Decentralized Autonomous Organization or DAO.

COMP Token

COMP is an ERC-20 asset token that can be held, sent, received, and traded in the Edge Wallet. COMP tokens are valued by the market because holders have voting rights over the protocol and have the ability to earn fees from the protocol in the future. 

A fixed amount of 0.44 COMP is distributed to liquidity providers of the Compound money market every new Ethereum block. This translates into approximately 2,880 COMP being created each day. The COMP is distributed to users of Compound and is allocated to each market (ETH, USDC, BAT…), proportional to borrowing demand in that market.

Within each Compound market, 50% of the distribution is earned by suppliers, and 50% by borrowers. There are about 4,137,434 COMP left to be mined. 92,514 have already been mined by Compound users.

Coda

Decentralized finance is coming into its own and some early promise is being shown in real time with real assets. Novel ways of creating and interacting with a financial service are happening everyday and gaining steam with every interaction.

The DeFi community has a long way to go, but the emergence of activities like “yield farming” and “liquidity mining” show how vibrant the ecosystem has become. 

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