The DeFi Industry Needs To Address Inflation Without Compromising Liquidity

May 24, 2021 4 min read

This story originally appeared on ValueWalk

Yield farming is an essential part of decentralized finance. Enthusiasts want to put their crypto assets to work to generate a passive revenue stream. However, the inflationary nature of yield farming may not be sustainable for much longer.

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The Current State of DeFi Yield Farming

The main appeal of yield farming is how cryptocurrency enthusiasts can stake their assets into lending pools with other users. As other participants borrow from these pools, their repayments and fees go back to the pool. For lenders, this equates to receiving decent compensation regardless of how quickly the loan is repaid. It is a viable concept on paper, but there are certain inflation risks to take into account.

The inflation problem in this industry occurs when more investors join the liquidity pool. As all participants receive tokens depicting their investment, the token also represents the market value of the liquidity pool. When tokens rise in value, there is a new revenue stream for investors. However, it is impossible to remove tokens from the liquidity pool without reducing the overall liquidity itself.

Solving this aspect will require a very different approach to yield farming compared to current projects. Introducing a deflationary aspect to the platform’s tokens is one option to explore, although it can be difficult to introduce such a change. Burning a supply of the existing tokens while maintaining overall liquidity is a big hurdle to overcome.

The Multi-Pronged Approach To Inflation

To introduce a deflationary aspect to an inflationary token, there are multiple options to explore. Most tokens opt for a “burning mechanism”, in which the developers reduce the overall supply by buying back tokens from the secondary market and sending them to a wallet for which no one has the private key. Another option is to introduce a “transaction tax”, for every sale or trade, reducing the circulating supply and giving back to those who prefer to hold the asset for longer periods.

It is often better to attempt a multi-pronged approach instead of focusing on one option that may have little to no impact. For example, Cafeswap employs a total of five different burn mechanisms to address the inflation issue.

The core aspect of this burning method is how Cafeswap will burn tokens from its dev fund and lottery. Additionally, the goal is to buy back tokens via the fees from the decentralized exchanges and the smart vaults. With continuous pressure on the token supply, it becomes possible to reduce the supply without removing liquidity from the pools.

All yield farming platforms must come up with ways to help address inflation without being detrimental to pooled liquidity. If decentralized finance is to be taken seriously by the mainstream, issues like these need to be taken care of as quickly as possible. Even platforms such as bZx, PancakeBunny, Ferengi Vaults, and other providers of yield farming and AMM DEX solutions will need to step up their game. The current rate of inflation in DeFi has become problematic, and introducing additional burn mechanisms will become a necessity, rather than a luxury.

It is interesting to see how DeFi projects aim to tackle the inflation problem. Projects acknowledging this problem can gain a competitive edge over those who are not too bothered by it. Cafeswap is heading in an interesting direction to help deflate its current token supply. There aren’t many details on how this will all work, however, leaving some questions unanswered.

Closing Thoughts

The current generation of decentralized finance solutions will need to cope with the concept of inflation in one way or another. It is essential to prioritize liquidity over the supply of one’s native token. Those tokens are an incentive to be earned by investors; having too much of a circulating supply can be counterproductive to yield farming. Token burns remain the most viable way of removing tokens from the market permanently.

Using a combination of different burn mechanisms under the same umbrella can prove beneficial to the industry. Experimenting with various options will give developers insights as to which option works best for specific DeFi platforms. Once that has been established, the developers can look at making the anti-inflation mechanism more fluent and streamlined.