Looking back on the achievements made in 2021, the development speed of the DeFi (Decentralized Finance) ecosystem is beyond imagination. For example, the amount of borrowed funds has increased by 170 times. The number of users involved has increased by 140 times. The total amount of assets in DeFi's smart contracts has increased by 140 times, and so on.

Concept

Liquidity pools are pools of tokens locked in smart contracts that provide liquidity in decentralized exchanges (DEX) in an attempt to attenuate the problems caused by the illiquidity typical of such systems.

Although the concept and application of DeFi began as early as 2018-19, the real start of its popularity was mainly the introduction of the concept of "liquidity mining".

Liquidity Mining

What is "liquidity mining"? This starts with the concept of AMM (Automatic Market Maker). The general tradition is that when trading cryptocurrencies on stocks or exchanges, most of them adopt the "mixing system". Meaning, if you want to sell Stock A for $50, someone must want to buy it for $50 before the transaction can be "mixed successfully" and closed.

If no one is willing to buy Stock A for $50, your transaction will not be executed. When this situation occurs, we call it "poor liquidity". It is a poor experience for customers because it takes a long time to complete a transaction.

Therefore, in order to avoid this situation, there are organizations called "market makers" which specialize in the role of the "counterparty" in stocks or exchanges. If you want to sell, he can buy. And if you want to buy, he can always sell. This makes transactions smooth, shortening transaction time and perfecting the experience.

The background of liquidity mining is very complicated. In many cases, it works with users called liquidity providers (LP) who are responsible for injecting funds into the liquidity pool. In simple terms, mining can be done by depositing certain token assets. The term "mining" is used as it follows the traditional term used in Bitcoin industry.

Rewards

Liquidity providers (LP) will inject assets into a fund pool and get rewards in return. Other users borrow or exchange tokens, and the DeFi platform will charge some fees accordingly. The fees charged by the DeFi platform will be distributed among the liquidity providers according to their contribution to the liquidity pool. Therefore, the more funds that liquidity providers deposit into the liquidity pool, the more fees they receive. In addition to handling fees, there is another type of rewards for injecting funds into the liquidity pool, which is the acquisition of new tokens. For example, some tokens may not be able to be purchased in small quantities on the open market, but they can be accumulated by providing liquidity to a specific pool of funds. For examples, UNI in Uniswap, CAKE in PancakeSwap, BONE in ShibaSwap etc. These reward tokens can be subsequently deposited into other liquidity fund pools, so as to continue to receive rewards and go back and forth.

Liquidity mining on COMPOUND mainly involves depositing tokens or lending tokens on it, so as to obtain rewards of COMP governance tokens. COMP holders can vote to determine the development direction of the COMPOUND protocol. If the COMPOUND business has value, then COMP has natural governance value.

Liquidity Pools

But what are liquidity pools? This is the core of DeFi. The liquidity pool is a smart contract. The mechanism of a smart contract is a code that will be automatically executed once certain conditions are met, and there is no longer a need for a centralized organization to operate and manage the interaction between parties. By writing the rules of the loan into the smart contract, users can pool the assets through the smart contract, and then distribute these assets to borrowers.

Liquidity mining is usually done using ERC-20 tokens in Ethereum, and rewards are usually issued in the form of some ERC-20 tokens. An example is ShibaSwap which rewards its users with BONE tokens. PancakeSwap, on the other hand, lives in the Binance Smart Chain (BSC) Network. It rewards users with CAKE, a BEP20 token.

Liquidity miners usually transfer funds frequently between different agreements in order to obtain high returns. Therefore, the DeFi platform will also provide other economic incentives to absorb more capital into the platform.

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