Biological or parasitic? Understanding the relationship between exponentially growing DeFi lending and exchange protocols
Editor's Note: This article comes fromChain News ChainNews (ID: chainnewscom), published with permission.
Editor's Note: This article comes from
Chain News ChainNews (ID: chainnewscom)
Compiler: Zhan Juan
, published with permission.BanklessOriginal title: "Aquaponic Yield Farming"bankless.substack.com
By: Dan Elitzer, IDEO CoLab Investor, MIT Bitcoin Club FounderCompiler: Zhan JuanMore than a year ago, in the
Source: DeFiPulse
Source: Dune Analytics, @sassal0x
Super Liquidity Collateral in Open Finance
"In the article, I elaborated on some ideas: the over-collateralization required by DeFi lending agreements will cause capital inefficiency, which may be solved by allowing assets to be used for multiple purposes at the same time. The fact that the title of this article says “Open Finance” rather than “DeFi” speaks volumes about how far the ecosystem has come in this time. The two graphs below illustrate this dramatic change:
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Many specific concepts proposed in the article "Super Liquidity Mortgage" were later realized, including the creation of Compound cToken, the use of cToken in the Uniswap pool, and the use of Uniswap pool shares as collateral for loans.
Even so, I still believe that we have only just begun to scratch the surface of the hyperliquidity of DeFi assets. Fortunately, one of the hottest trends is emerging in the crypto space — incredibly powerful incentives for profit seekers to get their assets into as many protocols as possible.
Understand SAFG / Liquidity Mining / Yield Cultivation
On May 27th, Compound Labs, the original designers of the popular Compound lending protocol, announced that they intend to distribute 42% of the COMP governance tokens to the protocol’s users over the next four years, giving them the opportunity to fully decentralize the protocol. A major step forward in the vision.
It's a simple, reasonable, well-intentioned concept. However, how things work in theory and in practice rarely seem to line up perfectly. In the cases we’ve seen so far, the value of governance tokens distributed has far exceeded existing market prices for various forms of behavior, with hundreds of millions of dollars of capital pouring into these protocols to exploit the opportunity.
Source: DeFiPulse
This phenomenon is known as "liquidity mining", or "yield farming" (yield farming), the latter term is becoming more and more popular.
Henry He predicted this behavior before COMP began distribution. He pointed out that the disclosed valuation of Compound’s last round of private placement showed that its initial distribution of subsidies had reached $43,000 per day, a figure that was more than 25 times the daily interest paid in all previous markets. As Henry predicted, incentives quickly spiraled out of control, with yield farmers earning higher returns on borrowed assets than on lending assets, a problem that became exacerbated the following week as COMP traded more than 1,000%.
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Source: DeFiPulse
Compound is not the only case, we can also cite other examples of revenue cultivation to promote the growth of the agreement:
In April, Futureswap, a decentralized futures exchange protocol offering up to 20x leverage, did an alpha launch that included distributing its governance token, FST, to users of the protocol. They attracted over $17 million in transaction volume in three days before closing the alpha early to ensure the safety of user funds while they completed an additional round of audits.
Balancer, a Uniswap-like exchange protocol that supports liquidity pools with arbitrarily allocated shares of up to 8 assets, announced shortly after launching on March 31 that future distributions will be based on the amount of liquidity provided to their pools Its governance token, BAL. They went from zero to over $55 million in liquidity in less than three months.
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Clearly, we are entering a phase where there will be an all-out scramble for liquidity based on extremely large subsidies in the form of governance tokens whose holders may or may not one day will decide to use these governance rights to enable itself to capture some of the value flowing through the various protocols.
Is this a zero-sum game? Liquidity providers need to choose where their assets are parked, and will they be free to move between different protocols based on where they capture the highest subsidy returns? When subsidies are reduced to a somewhat sustainable state, will the savvy supply side slip away, leaving a pile of dismal gains?
Is there a more short-term evolution of this phenomenon, such as creating enough unsubsidized capital efficiencies to allow assets to stay in these agreements for a long time? I think a certain type of modern breeder might be particularly well suited to answer this question.
Farming Symbiosis and Symbiosis
In my 20s, I was briefly enamored with the idea of urban farming. What started as community gardens like Red Hook Farms in Brooklyn, then evolved into vertical farming, using space efficiently in dense urban areas to provide healthy, locally grown food.
The concept of aquaponics in particular caught my attention. The system combines aquaculture (raising aquatic animals such as fish or crayfish) with hydroponics (growing plants such as tomatoes or lettuce in water rather than soil). The two activities are symbiotic, with waste from the aquaponic system being decomposed, providing nutrients to the hydroponic system, and purified water being recycled back into the aquaponic system. Bringing the process together yields benefits for both. In addition, hydroponic systems provide farmers with two income streams, both increasing potential income and allowing income diversification.
I think, you can see why I mentioned this...
Lending protocols and exchange protocols, especially those utilizing pooled liquidity and automated market makers, are inherently symbiotic. Lending protocols like Compound and Aave want to have a large amount of assets deposited into their liquidity pools to maximize loan availability while minimizing borrowing costs. Exchange protocols such as Uniswap and Balancer want to have a large amount of assets deposited in their liquidity pools to maximize the potential transaction size and transaction volume while minimizing slippage - they don't care about the amount of assets in their pools. Assets are not loan collateral receipts and can be withdrawn on demand as long as there is sufficient unused liquidity in the lending pool.
Under normal circumstances, in the lending agreement, the liquidity provider earns fees based on the length of the asset loan; in the exchange agreement, the liquidity provider earns fees based on the asset transaction amount. All other things being equal, two or more assets in a liquidity pool are unlikely to earn the same interest rate when they are available for lending, so their proportions in the pool will naturally deviate from their targets. This creates opportunities for arbitrageurs who can enter the pool and trade to bring the pool back into balance, which in turn generates transaction fees. So, under normal circumstances, proceeds from lending encourage proceeds from trading, which in turn goes into lending... It's a beautiful, logical, natural symbiosis.
But instead of the wonderful, reasonable, natural age, this is the beginning of a crazy age of mega-industrials, GMO biofuels, and helicopter subsidies.
Yield breeders are already in the water when this new era of crypto farming is barely a week old. Take a look at the picture below, a Balancer pool with the most liquidity.
Farming and symbiosis is not easy
What's next?
It is important to note that lending and exchange protocols are sometimes structured in ways that are not conducive to the cultivation of farming symbiosis benefits. For example, astute readers may have noticed that the pool in the graph above contains 2% COMP. why? A standard public pool on Balancer with a fixed asset allocation at launch and no administrative controller. If a pool does not contain COMP as one of its constituents, any accumulated COMP will be irretrievably locked into the protocol. This can be solved on Balancer by using Smart Pools, but this may introduce an additional attack surface and is currently not manageable through the Balancer interface.
Curve has been the protocol that benefits the most from the externalities of COMP coin distribution (yield breeders are doing a lot of USDT and other stablecoin transactions to leverage, and they often use InstaDApp's COMP maximization tool). On Curve, all COMP accumulated into existing pools will be stuck there forever, with no way for LPs (Liquidity Providers) or Curve creators/admins to withdraw. While I've heard they're working on how to fix this in a future upgrade, it also shows that unexpected challenges can arise at the intersection of the protocols.
If you want to see how crazy these cross-protocol yield breeding opportunities are, check out this mashup curated by OG liquidity subsidy agency Synthetix: BTC Yield Nurturing Pool. It features three different flavors of Bitcoin (wBTC, renBTC and sBTC) on Ethereum and offers yield breeding opportunities on four crops: SNX, REN, CRV and BAL. It simply leaves Monsanto in the dust.
What's next?
Remember, symbiotic relationships can take many forms. In the short term, yield cultivation ensures compatibility between lending and exchange protocols is mutually beneficial, with both protocols benefiting due to excess accumulated yield. But once the yield-cultivating subsidy drops to a more sustainable level, we don't know whether the connection will be commensalistic or parasitic, and whether the benefits of one agreement will come at the expense of the other.
In the long run, I suspect that a protocol capable of doing this may evolve to have both lending and trading to create a DeFi prime brokerage protocol, by making assets available simultaneously opportunities to generate the greatest possible return in a given risk profile. If I can comfortably hold a fixed percentage of various assets in my wallet and want them to yield the highest yield passively, why don't I put them all in a private Balancer pool to earn transaction fees? ? And if the pool includes, say, ETH, DAI, REP, and ZRX, why would I not want to lend all of my assets, as long as the loan is over-collateralized by other assets that include my asset class? Of course, under the premise of charging a small fee, should the assets in the pool also be used for flash loans? Maybe I'm willing to take more risks and offer them to traders who want to do 20x leveraged perpetual contracts, like Futureswap? In short, it can be regarded as the ultimate evolution of passive investment and personalized investment.
If this type of institutional brokerage agreement approach does become a viable dominant strategy, one of the most noteworthy topics in the next few years will be: is it easier for Balancer to become Compound, or is it easier for Compound to become Balancer.
Yield nurturing is not for the faint of heart
Let me be clear: I think we are almost certainly entering a period of speculative mania. We will see capital cultivation gains based on token valuations reach billions of dollars, an unsustainable level, and symbiotic return cultivation will push the situation to even higher levels.
