Decentralized Finance (DeFi) and Liquidity Mining: Opportunities and Challenges

Abstract

The aim of the study is to examine liquidity mining, an innovative application of decentralized finance (DeFi), giving crypto investors opportunities to earn passive income through staking and yield farming. Employing a set of network models including Metcalfe's law and using the data on AAVE and YFI DeFi tokens for the sample period between 10 October 2020 and 3 July 2024 with 1364 daily observations, the study attempts to estimate the relationship between network connectivity and fundamental values of YFI and AAVE tokens. The study examines the price of YFI and AAVE tokens as a function of the network effect, and such an application finds support in the literature on network economics. Overall, the study results provide strong evidence to support the hypothesis that the fundamental values of YFI and AAVE tokens are likely to be determined by the network effect. Additionally, the results show that the on-chain blockchain metrics have an impact on the returns of these tokens. The practical implications of these results for crypto investors, who patronize the DeFi products, are that using a mix of network models and Network Value to Transaction Ratio (NVT), a proper valuation of these tokens is possible. Furthermore, it is possible to extract useful information for trading from on-chain metrics estimated from the blockchain data.

Keywords: DeFi, Liquidity Pool, Yield Farning, Staking, Proof-of-Work, Proof-of-Stake. JEL classification: E32, E51 and E52