Liquidity mining. The concept is nearly as old as DeFi itself, and goes by many names:
- Staking rewards
- Yield farming
- Incentivized liquidity
- Token inflation
- Expansion phase
Note that this nomenclature becomes ever more opaque as the advertised APY approaches trillions. One can’t help but wonder why.
Still, the now largely defunct meme of rewarding liquidity providers with (mostly useless) governance tokens was once hailed as revolutionary, and kicked off the infamous DeFi Summer. So how did that happen, and what caused the downfall? Join us for a stroll down memory lane, won’t you?
StakingRewards: a Compounding tale
The very first instance of a DeFi protocol rewarding its users with governance tokens was actually derivatives protocol Synthetix.io. Users depositing liquidity into the sETH/ETH pool received SNX (the protocol’s native token) as an extra incentive. The distribution was handled by the grandsire of liquidity mining, the StakingRewards contract.
While Synthetix and their legendary StakingRewards contract originated the rocketfuel of DeFi (Summer), it was actually money market Compound that widely popularized the concept.
Compound
In June 2020, the protocol started distributing COMP tokens to the its users. The way this scheme was structured actually grew demand for the token, causing the price to quadruple in just under a week.
Ironically, data from November 2021 shows that the top 100 wallets, representing roughly 70% of all mined COMP, sold off the majority of their rewards.
Less than 20% of the liquidity miners held on to more than 1% of the COMP they claimed. Similarly, only 1% of these wallets participated in governance voting.
This is not great. At the same time, that’s easy to say with the 20/20 vision of hindsight. Back when it was all still fresh, Compound’s strategy caused a frenzy in the DeFi space, with countless other protocols copying or adapting it.
Sushiswap
One notorious example is the vampire attack by Sushiswap. The founding team forked the bulk of Uniswap’s code, and then offered SUSHI tokens to liquidity providers (LPs), successfully luring over more than a billion dollars worth of (mercenary) capital and temporarily outshining Uniswap in terms of Total Value Locked (TVL).
Not much later, Uniswap followed suit and retroactively airdropped a $18,000 PS5 to its users (if you don’t understand this meme, see below), followed by their own liquidity mining program.
Both projects are still around today, with Uniswap doing $1,6M in 7 Day Average Fees — more than the Bitcoin and Binance Smart chains combined. Sushiswap comes in at a respectable $200k average.
Uniswap currently has a TVL of $4,2B at a marketcap of $5,4B, with Sushiswap coming in at $2,3B TVL with a marketcap of just $225M.
Hilariously, Uniswap doesn’t share swap fees with its token holders, while xSUSHI holders (staked SUSHI tokens) have been receiving a percentage of swap fees since the protocol’s inception. Apparently people prefer a gaming console over a Japanese fish dish.
Liquidity mining woes
All things considered, the use of protocol token emissions as a way to attract users has been successful. Some analysts have compared the strategy to the web 2.0 products, stating that it’s simply web3’s version of Customer Acquisition Costs (CAC).
Instead of spending top dollar on (digital) advertising, web3 protocols simply print protocol tokens, and hand them directly to their users. This cuts out expensive middlemen like Google and Facebook, and advertising agencies.
Added benefit: if the protocol tokens hold DAO voting rights, your users become part of your organization and governance structure. Pay less for users and turn them into co-owners right off the bat. On paper, this is the stuff growth dreams are made of. In practice, there are a few problems.
Inflation
Liquidity mining is relatively straightforward: you give people money so that they use your protocol. When yields are high, this is fine and dandy for the users. For the protocol, not so much. See, the yield that’s paid out to users has to come from somewhere.
If the yield comes from protocol token emissions, then inflation is happening. An ever larger number of protocol tokens becomes available to the market. In normal circumstances, this should cause the price to drop as the supply is growing without a demand incentive.
During the manic buying frenzy of the recent bull market, demand actually outpaced this inflation, making it seem like this scheme was sustainable. Farmers were printing double and even triple digits APYs, all while token prices kept on soaring. Pure unadulterated euphoria blinded people to the inherent ponzinomics.
As capital injections from new market participants dried up, (reward) token prices started dropping. Yield percentages also declined, prompting many users to sell off their tokens, withdraw their liquidity and stop using the protocol(s). The detrimental effects of inflationary emission schemes came into view.
See, if you’re renting users by paying them with equity (governance tokens), your scaling costs are not linear. They are exponential. Once token prices start dropping, you need to pay out higher and higher absolute amounts of your tokens in order to sustain the percentual yields.
This in turn leads to a higher number of tokens available on the market (supply increase), which means more demand is required in order to simply sustain token prices. If this supply is unmet by demand, token prices drop further, requiring even more tokens to be printed.
This can effectively destroy a protocol — Original AMM Bancor is an unfortunate example. While technically still up and running, the protocol is practically dead as a result of Celsius dumping BNT token rewards for their deposits while leveraged shorting BNT, causing a hyperinflationary doom spiral.
User retention
User retention is another major issue with liquidity mining schemes. Let’s start by making it clear that paying for customer acquisition is fine — this is why marketing departments exist at all. As long as marketing spends less money on acquiring a customer than the Lifetime Value of an average Customer (CLV), sustainable growth happens.
But when your acquisition of a user only lasts as long as the rental period (LM scheme), then you are not sustainably growing your customer base. You are merely attracting mercenary capital, famously called “liquidity locusts” by DeFi legend Andre Cronje.
What happens is the inevitable decline of the user numbers when rewards start to dwindle. As demonstrated by the image above, this generally results in token incentive costs outpacing revenue by quite a bit. Since CAC is frontloaded while most of the CLV happens over a long(er) period of time, this occurrence is only logical.
Conclusion
- Token incentives as a method of attracting users works — it just doesn’t work for keeping them around. This is the result of mistimed value exchange: frontloaded versus distributed over lifetime.
- Massively diluting token holder equity by inflationary printing is bad business for everyone. If users are incentivized to dump tokens in order to maximize their returns, the longevity of the project is jeopardized. Dwindling token prices push the team, advisors and investors to also sell off their tokens while their ROI is still acceptable or even positive.
So what can be done instead? In our next essay, we will explore a different model for reward tokens, as well as a new mechanism to reflect revenues in the token price.
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