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DeFiNovember 5, 2020

What is Compound's Liquidity Mining ($COMP)?

Shubham Goyal
Product Specialist
November 5, 2020

Within the DeFi world, liquidity mining is the process through which a cryptocurrency exchange platform can reward the pool of users who provide the platform with liquidity. Essentially, it’s a market making strategy that allows anyone from any corner of the world to lend out their cryptocurrency on a particular platform, and earn some passive income.

The Compound Finance protocol is a decentralized lending application on the Ethereum blockchain. It lets any user withdraw assets or provide liquidity in one of their liquidity pools so long as they have an Ethereum wallet and hold a supported cryptocurrency. These users earn rewards that- as is par for the course with Compound’s basic principles- start compounding right away.

Very recently on June 16, 2020, Compound launched its governance token- COMP, and ever since then, the term ‘liquidity mining’ has been doing the rounds within the cryptocurrency world- owing to the factor that Compound now rewards all users who lend and/or borrow digital assets with COMP tokens. The protocol divides the rewards by 50% between both of the groups.

So, How Does Compound Liquidity Mining Work?

Before getting into the workings of the Compound liquidity mining process, let’s talk a little about liquidity mining in general. The process begins with a lender, also known as a liquidity provider (LP), who lends their own crypto assets to a liquidity pool. Now, these liquidity pools are essentially smart contracts that are programmed to store the money for borrowing purposes, and generate interests for the liquidity providers. Users can lend out, exchange, and borrow cryptocurrency through liquidity pools. The returns generated are more often than not shared in the form of said platform’s native token.

The generated interest comes from other users who borrow funds, and in the process, pay interest for the loans to the exchange. So far, liquidity mining sounds like the same thing traditional banks do with stored money too, right? But with a bank, once you withdraw your funds, they don’t produce interests anymore.

However, when you deposit a particular cryptocurrency on Compound, it gives you cToken versions of the same in return. For example, if it’s ETH (Ethereum) you have deposited into a Compound pool, you’ll get a proportionate amount of cETH in return. These cTokens can now be used as collateral for a loan, which signifies that you can still spend your funds even while they’re earning interest.

The rate of interest generated is decided based on supply and demand through the underlying smart contracts on Compound. When there’s a large number of lenders depositing a particular asset in a liquidity pool, it means there’s more money for borrowers to withdraw on loan. Which in turn means borrowing gets cheaper, so if there’s a significant number of people now borrowing that same asset, the pool’s underlying smart contract will now increase the interest rate and generate relatively greater amounts of returns for lenders.

With the launch of the COMP token, though, Compound brought a significant twist to its liquidity mining process.

The COMP Token

Initially launched as Compound’s governance token, COMP revolutionized the way cryptocurrency exchanges reward their users. To earn COMP, all a user would have to do is provide liquidity to the protocol as a lender, or borrow from the same.

Everyday, as per the estimations, 2,880 COMP tokens will be distributed to both borrowers and lenders on the platform. This token distribution will be proportionate to the interest being accumulated in every one of the markets on Compound. The distribution would be so that in every market, 50% of the tokens would be given to the lenders, and the other 50% would be allotted to the borrowers.

So, now the whole point of Compound’s liquidity mining is that you can earn COMP tokens as both a lender and a borrower on the platform. This distribution of COMP is an advantageous strategy on the Compound network’s part- because whenever any of the sides of the pool gets incentivized, it would increase Compound’s value as a protocol, since it would now contain more assets.

Currently, Compound supports nine of the crypto assets provisioned on Ethereum, including USDT, USDC, DAI, WBTC (Wrapped Bitcoin), and BAT (Basic Attention Token).

Cool! But What Do I Get out of It?

As the title suggests, governance tokens give token holders the power to vote in the governance polls held on an exchange platform. So through liquidity mining on Compound, as mentioned before, you now get COMP- which comes with its own set of benefits. To begin with, since COMP was primarily launched to let the governance of the Compound platform be truly decentralized, the holders of COMP get the right to propose, discuss, and vote on the changes and upgrades that can be made to the protocol, and also on the way the protocol is managed right now.

The COMP token has largely incentivized activities on the network and increased user interaction by a considerably wide margin. Compound has announced that from the speed of distribution, COMP will be rebated to the users for the next four years. Now depending on the value and sustainability of COMP, lending/borrowing on Compound could translate into heightened yields.

Speaking of yields, the COMP token has so far proven to be quite valuable- with the price of a single token fluctuating between $50 and $100. So along with getting the opportunity to have a say in the future governance decisions, you’d potentially get to enjoy fairly high returns if you decide to act as a liquidity miner on Compound Finance.

What are the Risks of Compound’s Liquidity Mining?

Along with all the usual risks you run when trading in cryptocurrency – like a platform getting hacked into or an asset losing value due to market volatility – with Compound’s liquidity mining, you might also have to face the risk of liquidation.

As mentioned above, along with earning interests by staking your assets on Compound, you can also borrow against your staked assets, which means that the larger amount of assets you stake, the greater your borrow limit. Now, the borrow limits for different cryptocurrencies are of course, varied, but if somehow your account exceeds its borrow limit, you will be risking liquidation.

Compound Liquidity Mining: The Future

What happens next with Compound’s liquidity mining yet remains to be seen, because just like the rest of the DeFi world, it honestly could go either way. With that being said, though, it’s undeniable that the Compound Finance protocol has opened up a bunch of new opportunities with its liquidity mining procedure.

It’s safe to say that the yields are quite great, as of right now; and getting to present your opinion in future governance decisions doesn’t sound too terrible either- especially seeing how Compound is gradually becoming one of DeFi’s most influential platforms and hence might impact the entire crypto world on a larger scale in the near future. If you’re an experienced crypto investor with the funds to spare, it only seems reasonable to try out liquidity mining on Compound.

For further information on the workings of Compound Finance’s liquidity mining and the COMP token, do check out their official Twitter page!

Happy liquidity mining!

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