One year anniversary of liquidity mining explosion, let's see how DeFi has grown

Source: ChainNews, Author: Pan Zhixiong.

A year ago, decentralized finance (DeFi) began to gain widespread attention in the cryptocurrency community. However, without the influence of the concepts of Liquidity Mining and Yield Farming, the DeFi ecosystem might not have developed as rapidly within this year, and the subsequent DeFi Summer may not have occurred.

Looking back at the achievements of this year, the development speed of the DeFi ecosystem has been astonishing. Just a few examples show growth in hundreds of times: for instance, the amount of borrowed funds increased by 170 times, the number of trading users grew by 140 times, and the total assets locked in DeFi smart contracts surged by 140 times, among others.

Although the term "liquidity mining" was neither invented by Compound nor was it the first to adopt the mechanism, Compound has been the most important promoter of this concept. Most of the information available online about liquidity mining emerged after Compound launched its "Lending is Mining" initiative, which was exactly one year ago from now.

Since then, liquidity mining has become the most worthwhile mechanism for DeFi protocols in their early stages, even evolving into a standard "template" that many projects adjust based on their own characteristics.

Users participating in "liquidity mining" can be divided into two main categories:

• One category consists of "whales" or "gun pools" that directly sell the token rewards they receive for cash;

• The other category includes users who hope to participate in the primary market token distribution through this mechanism, allowing them to grow alongside the projects.

On the contrary, some argue that the "nested" risks brought by this mechanism (such as protocols combining for mining) may increase the systemic risks of the entire DeFi ecosystem, and if the distribution method is not precisely designed, it may prematurely overdraw the protocol's growth potential. For example, Uniswap stopped its liquidity mining activities after several attempts and has yet to launch new initiatives since the release of version V3, possibly in search of a more reasonable plan.

Regardless, this mechanism has effectively mobilized the cryptocurrency community and users to participate in DeFi protocols, and it has become an essential part of all new projects.

On the first anniversary of the liquidity mining boom, we hope to review the achievements of the DeFi ecosystem over the past year through data and the impacts it has caused—it's important to note that the rise of DeFi is not solely due to "liquidity mining," but it is certainly one of the most important factors.

Who invented the term "liquidity mining"?

To trace the earliest origin of the term "Liquidity Mining," the verifiable source is the open-source automated trading tool Hummingbot. The term began to be used in June 2020, while the Hummingbot team had been using it for more than half a year prior.

Hummingbot is a tool aimed at professional users, so ordinary users may not be aware of it.

The team first announced the "launch of liquidity mining features" in a blog post on November 1, 2019, and later added related functionalities in the December 0.20.0 version, opening Beta testing in the 0.23.0 version in February 2020, initially supporting centralized exchanges like Binance and decentralized exchanges like 0x Mesh.

Further reading: Introducing Liquidity Mining

In Hummingbot's earliest definition, "liquidity mining" specifically refers to providing liquidity to exchanges. Later, the DeFi industry further generalized the concept, allowing it to be used in lending or other financial applications, as these services also require a party to provide liquidity. This eventually evolved into another new term: Yield Farming.

Hummingbot's definition of "liquidity mining" is very precise and complete; here is their explanation:

"We call this 'liquidity mining' because its concept is very similar to PoW mining. Compared to using mining machines and electricity, liquidity mining utilizes computational resources and token inventories to run Hummingbot's market-making client. By competing with other participants for economic incentives, their collective efforts can achieve a common goal of providing liquidity for specific tokens and exchanges. In return, they receive compensation commensurate with their work based on an algorithm-defined model."

The Hummingbot team also released a white paper titled "Liquidity Mining," which contains more specific details; the completion date of this version of the white paper was October 30, 2019.

Which was the first DeFi project to adopt liquidity mining?

The first DeFi protocol to adopt liquidity mining mechanisms may be the synthetic asset protocol Synthetix, which launched liquidity incentive activities in February 2020, nearly four months before the DeFi boom that began in June 2020.

Further reading: New Uniswap sETH LP reward system

At that time, Synthetix did not use the term "liquidity mining," instead referring to it as the LP Reward System, where LP stands for liquidity provider. They later also used terms like liquidity incentive experiments to describe liquidity mining activities.

Mechanically, the incentive activities launched by Synthetix were similar to later liquidity mining. The first activity rewarded users who provided liquidity for synthetic assets on Uniswap, with the first supported trading pair being sETH/ETH.

Of course, the complete process to earn rewards was quite lengthy: users first needed to collateralize SNX to obtain sUSD, then trade it for sETH, and finally provide liquidity on Uniswap with an equal amount of ETH to receive "LP tokens." Lastly, they would stake the LP tokens in Synthetix's smart contract to claim SNX as rewards.

Who ignited the liquidity mining craze?

Although early liquidity mining was more related to trading scenarios, the prosperity of liquidity mining can actually be attributed to the decentralized lending protocol Compound.

In June 2020, Compound officially launched the distribution method for its governance token COMP, marking the first large-scale recognition among other DeFi protocols that they could promote liquidity growth through their own governance tokens.

The mechanism is relatively simple: users just need to regularly use Compound's lending protocol to be allocated a certain number of governance tokens COMP based on the amount of funds borrowed. Of course, this mechanism has undergone multiple adjustments since then.

Thanks to Compound being a relatively large and influential project within the DeFi protocols, and having previously kept its native token plans private, when the community learned that Compound was launching a "governance token with no actual value," there was a frenzy of discussion and research.

At that time, Compound and the community did not refer to their mechanism as "liquidity mining," but it indeed prompted other projects to adopt the "liquidity mining" mechanism later on. If you search for the term "liquidity mining" on ChainNews, you will find that it appeared around the time Compound disclosed its token distribution mechanism, which is likely not a coincidence.

For various reasons, this event by Compound is highly significant and led to the DeFi boom in the following months, which the overseas community referred to as DeFi Summer.

Is liquidity mining the same as FCoin's "trading mining"?

I remember that shortly after the concept of liquidity mining was introduced, there were many voices in the Chinese community claiming that it was actually similar to FCoin's "trading mining" launched in 2018, with some even suggesting that FCoin, which introduced "trading mining," was the true originator of "liquidity mining."

In fact, the core differences between these two concepts are quite clear. "Liquidity mining," based on the transparency of trading data enabled by blockchain, ensures that the entire process is auditable and traceable, whereas FCoin's inability to sustain itself was largely due to its chaotic centralized management, and the status of the assets under custody was not transparent enough.

More importantly, although the mechanisms adopted by the three projects (Hummingbot, Synthetix, and Compound) are ultimately referred to as "liquidity mining," they are fundamentally different mechanisms, with Hummingbot's solution being similar to FCoin's trading mining.

Data speaks: DeFi this year

Total Value Locked (TVL): 140 times

Total Value Locked (TVL) is a core metric for assessing liquidity and capacity in the DeFi ecosystem, indicating how much real assets are invested in DeFi smart contracts to scale the entire system.

According to DeBank's data, as of June 1, 2020, the total TVL of all DeFi was $940 million, while the peak was on May 11, 2021, when the total TVL reached $131.4 billion, an increase of nearly 140 times within a year.

Total Borrowing Amount: 170 times

There are protocols in DeFi that specifically provide over-collateralized lending services, and the total borrowing amount reflects the scale of collateral and lending in these protocols.

As of June 1, 2020, the total borrowing amount across all DeFi was $150 million, while the peak was on May 9, 2021, when the total borrowing amount reached $26.7 billion, an increase of over 170 times within a year.

Number of Trading Users: 140 times

Trading protocols are also the most important facilities in the DeFi ecosystem, so the number of users using trading protocols (calculated by unique addresses) reflects the user scale of the entire DeFi ecosystem.

As of June 1, 2020, the number of users of all DeFi trading protocols was over 6,200, while the peak was on May 11, 2021, when the number of trading users reached 850,000, an increase of nearly 140 times within a year.

Trading Volume: 1000 times

For trading protocols, trading volume is also a very intuitive standard. Especially since the launch of Binance Smart Chain (BSC) this year, the trading volume of protocols within its network has seen an astonishing increase.

As of May 31, 2020, the trading volume of all protocols was $22.3 million, while the peak was on May 29, 2021, when the trading volume reached $23 billion, an increase of over 1000 times within a year.

Gas Price: Up to 18 times

In fact, before DeFi Summer, the Gas Price, which indicates the price of the Ethereum network, had already seen significant growth, rising from single-digit GWei levels to tens of GWei. However, after the launch of liquidity mining, Gas Price continued to rise rapidly, only recently showing a downward trend.

According to Blockchair's data, as of June 1, 2020, the median Gas Price was 30 GWei, while the peak was on September 17, 2020, when the average Gas was 544 GWei, an 18-fold increase in three months.

Interestingly, September 17, 2020, was the day Uniswap announced the issuance of governance tokens and conducted an airdrop, resulting in a large number of on-chain transactions for claiming UNI airdrop tokens.

Block Capacity: Increased three times, cumulative increase of 50%

Unlike Bitcoin, Ethereum's block capacity can be adjusted based on miner votes, so as physical network, computing, and storage resources improve, miners can choose to continuously increase the capacity and throughput of the Ethereum network.

Before June 2020, Ethereum's block capacity (Gas Limit) was 10 million GWei, which increased to 12 million GWei in June and July, and again to 12.5 million GWei by the end of July.

By April of this year, the block capacity was further increased to 15 million GWei, representing a 50% increase compared to the same period last year.

Stablecoin Issuance: 10 times

The demand for stablecoins has also grown significantly, increasing from $7.3 billion in stablecoin issuance on June 1 last year to $70.5 billion today, nearly a 10-fold increase in one year.

BTC Cross-Chain Token Issuance: 48 times

With the development of DeFi, the demand for BTC on the Ethereum network has grown rapidly, as it is also a native crypto asset with a large user base and market value.

The issuance of BTC-pegged tokens increased from 5,200 BTC on June 1 last year to 250,000 BTC today, a 48-fold increase in one year.

Oracle Call Frequency: 500 times

Oracles had not seen large-scale application before the rapid development of DeFi, but since last year's DeFi Summer, the demand for oracles has changed dramatically.

As of June 1, 2020, the number of oracle calls was 72, while the peak was on December 18, 2020, when the number of oracle calls approached 40,000, an increase of over 500 times in six months.

How will DeFi continue to grow?

Recently, we have seen a downturn in the cryptocurrency market, with one of the most obvious indicators being the decline in Gas Price, along with various degrees of decline in other data. Does this mean that Ethereum's DeFi ecosystem has hit a ceiling?

In fact, from the data, the current DeFi ecosystem is still in a nascent state. Although Ethereum's TVL has now dropped to $56 billion, more assets have yet to enter the DeFi ecosystem.

A simple calculation shows that if we consider: "Ethereum's market cap + the market cap of stablecoins and BTC on the Ethereum chain + the market cap of the five largest projects on the Ethereum chain (UNI, LINK, MATIC, AMP, AAVE)," this scale is about $400 billion. In this context, $56 billion only accounts for 14% of $400 billion, and this does not even include the thousands of long-tail tokens on the Ethereum chain.

In addition to asset scale, Ethereum is currently limited by throughput constraints, and many trading applications have encountered growth bottlenecks due to being "too expensive" and "too slow." Although the block capacity has increased by 50% this year, there is still a long way to go to be affordable and user-friendly.

Fortunately, various new-generation Layer 2 protocols have recently been launched or are about to go live, which will become the core foundation for the next phase of DeFi growth. Under the new infrastructure, some mechanisms that are even more interesting than "liquidity mining" are expected to emerge, and it will be worth watching.