by Blaise Cavalli,

Decentralized Finance (DeFi), a new investment mechanism, exploded in the financial sector and was certainly the trend to watch in the digital asset industry.

With billions of dollars circulating on public blockchains, it was only a matter of time for digital assets to enter the realm of revenue generation through on-chain banking and financial systems.

Various financial products from borrowing and lending to derivatives have made their way into the blockchain financial industry, fueled in recent months by this experimental trend of bringing traditional financial instruments into the sector. The movement is largely made possible by the Ethereum blockchain as it provides the interoperability required for different money legos to interact.

The governance of these new money protocols was a major concern that introduced the idea of ​​governance tokens, usually generated through yield farming approaches.

What is crop farming?

DeFi platforms open up a whole new range of avenues and business opportunities, and yield farming has become a cornerstone for DeFi in 2020. The excitement started with Compound’s COMP governance token, which was the first to initiate this investment mechanism. On June 15, Compound distributed its governance token in addition to the usual cryptocurrency interest. This concept, which seemed quite lucrative and effective, quickly spread to other applications and created a hype around yield farming and liquidity mining.

As a concept, yield farming or liquidity mining is a new way for users to earn passive income in the DeFi ecosystem. Cryptocurrency farming consists of placing crypto assets on a specific platform in exchange for a return on investment. The trusted platform is then responsible for generating profits and giving them back to their stakeholders.

The main task is to generate governance or reward tokens for everyone who participates in the protocol that implements this system:

  • Liquidity providers put funds into a liquidity pool. This reserve feeds a marketplace where users can offer or take out loans and exchange tokens.
  • When using these platforms, commissions (fees) are incurred, which are paid to the liquidity providers in accordance with their share of the liquidity pool – and thus achieve a return or interest.
  • The interesting thing is that in addition to the fees, another incentive to raise funds into a liquidity pool is the distribution of a new token – a governance token, which gives the holder a right to participate in the decisions of the protocol.

The aim of every application is to generate more liquidity. So the invested money is converted into an investment and a reward generator. Unfortunately, the intensity of income farming skews the value of associated crypto assets, which are in higher demand. It remains a fragile mechanism for the time being and carries a high level of risk for investors. Platforms can be attacked and the value of assets is very volatile as new protocols compete with the most promising initiatives.

Nonetheless, it promises to become yield farming the silver lining of the DeFi universe, expanding the industry and drawing financial capital and new players into the field. As DeFi continues to grow in popularity, more and more financial services companies are looking to take advantage of blockchain and move from their traditional financial systems to a decentralized ecosystem.

Governance token as a differentiator for productive agriculture

DeFi is not yet fully decentralized, with many of the major platforms and projects starting with core teams that control their initial development. This is gradually changing with the rapid emergence of governance tokens as a means of decentralization.

Governance tokens have become an essential part of DeFi applications. It enables new projects to be more decentralized. Most governance tokens function like shareholder votes and allow investors to influence the project development roadmap and operational decisions.

Recently, governance tokens and yield farming have found synergies through liquidity mining approaches, where governance tokens are distributed to the early users who provide liquidity to a particular platform. In this way, liquidity mining becomes a way of distributing the tokens fairly to the platform users.

Despite their popularity, governance tokens come with their own set of challenges. The main problem concerns the concentration of governance tokens in the hands of a limited number of early investors.

A recent report highlighted that many projects, especially those with strong venture capital roots, remain highly centralized. Analysis of projects like MakerDAO and Compound revealed that the voting process appears to be mostly controlled by large owners, as the top 20 addresses hold around 24% (MKR) and an astonishing 68% (COMP) of the total.

It is important to look at the owners of most tokens and how they are managed. Multisig wallets on the core portfolios and value safeguards in smart contracts help, for example, to show the founders’ willingness to work on the project over a longer period of time.

An example of potential problems was already observed in the first governance vote for the leading decentralized exchange Uniswap. The vote took place on a proposal aimed at reducing the number of tokens required to submit and pass proposals. It was submitted by the open source credit protocol and the major UNI token holder Dharma.

This ended in rejection, although the proposal was overwhelmingly supported by 98% of the votes cast. By the end of the vote, it missed the threshold of 40 million votes required for approval by around 1%. If approved, the entire community could have been ruled by its two main investors, significantly reducing the effectiveness of its decentralization.

DeFi craze is driving the demand for stablecoins

In line with yield farming, the demand for Ethereum-based stablecoins exploded during the recent DeFi euphoria, with supply from Dai growing more than 600% and USDC growing 200%. As of July, with a market capitalization of nearly $ 130 million, Dai’s offering has since expanded to around $ 1 billion.

Dai is created when Ether holders deposit their ETH into the MakerDAO protocol, which allows them to create the stablecoin and use Ether as collateral. As an ERC-20 token, Dai can then be used on the Ethereum network to generate income using DeFi protocols.

Demand for Circles USD Coin (USDC) also skyrocketed in the third quarter, with USDC’s market cap tripling from $ 928 million on July 1 to $ 2.79 billion today. USDC is the second stablecoin after Tether (USDT) to grow more than $ 1 billion in a single quarter.

The capitalization of the combined stablecoin sector rose $ 8.2 billion in the third quarter – more than the four previous quarters combined. Of the sector’s $ 20 billion capitalization, 75% has been spent on Ethereum.

In this context, many different DeFi consortia have been formed in recent months, with Ren and Polychain Capital launching the Ren Alliance in March and TD Ameritrade and Cumberland DRW unveiling the Chicago DeFi Alliance in April.

The Open DeFi Alliance initiative has announced the establishment of a western branch and the addition of eight new member companies. The alliance aims to unite leading figures in the DeFi sector by forming a global collaborative consortium focused on innovation, risk management and liquidity strategies.

The new members include the well-known decentralized financial companies Aave, Balancer, BlockScience, DyDx, Ocean Protocol, Outlier Ventures, Quantstamp and SuperRare, with the organization now comprising a total of 16 companies. It now contains four of the 20 largest DeFi protocols by locked capital.

Nyctale is pleased to be indirectly linked to this initiative through our lead investor Outlier Ventures.

Sources:

  • East Meets West When Eight Top Projects Join The Global DeFi Alliance – Cointelegraph; October 27, 2020 [1]
  • Inside Yield Farming 2020: What’s the Trend? – hackers; October 25, 2020 [2]
  • Yield Farming Drives DAI Supply 623% To Grow Nearly $ 1 Billion – Cointelegraph; October 22, 2020 [3]
  • Uniswap’s First Governance Vote Fails … Despite 98% Support – Cointelegraph; 20th October 2020 [4]
  • Everything You Need to Know About DeFi and Yield Farming – Publish0x; October 16, 2020 [5]
  • DeFi governance tokens face three challenges – Cryptonews; October 11, 2020 [6]

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