Before the advent of DeFi, holders of crypto assets had three options — trading them, keeping them in hardware wallets, or storing them on exchanges. Aside from day trading and HODLing, there was no other way to profit. Then, DeFi liquidity mining revolutionized the game. Discover its definition and benefits in our guide.
What is Liquidity in Cryptocurrency?
The term liquidity was borrowed from conventional markets like the currency exchange. It describes the ease of swapping one asset for another. Higher liquidity translates into faster swapping of tokens on an exchange in the crypto context. As platforms receive orders from buyers and sellers, the ready availability of assets speeds up the transactions.
What Does Providing Liquidity Mean?
With DeFi, came the opportunity to profit passively through lending to new platforms. Today, users can deploy their assets as liquidity on the DeFi exchanges, lending protocols, or liquidity pools on other protocols. This passive income method is called liquidity mining. Typically, it is limited to a set number of months or years — the time needed to get the protocol up and running.
LPs (liquidity providers) lend assets to DEXes in exchange for predetermined rewards. These usually include fees paid by traders and governance tokens. The rewards are proportionate to the user’s share in the liquidity pool. LPs get between 0.05% and 1%, with stable assets and exotic pairs at opposite ends of the spectrum.
Specifics of Cryptocurrency Liquidity on AMM
Sourcing liquidity from users is part and parcel of the automated market maker (AMM) system. DEXes like Uniswap do not match buyers and sellers, unlike conventional exchanges. Instead, they ensure the liquidity of cryptocurrency through incentivized lending. Contributors get a share of the trading fees in return.
On Uniswap, sources of coin liquidity provide two tokens of equal value. A user intending to contribute 5 ETH worth $12,500 must add a crypto equivalent — 12,500 USDT. After gaining liquidity crypto, Uniswap will offer it to traders tapping into the ETH/USDT (or another) liquidity pool. The fees from swaps are distributed among contributors to crypto liquidity.
This creates a mutually beneficial relationship between the parties. DEXes acquire liquidity, providers get rewards, and other users can trade in a decentralized environment without delays.
Significance of Impermanent Loss
Every operation with crypto is inherently risky, whether you mine, trade, or invest. The volatility of the assets makes profits inconsistent. Every crypto liquidity provider should be aware of potential challenges and keep an eye on the market. Impermanent loss (IL) is particularly important.
IL is often misconstrued, although its purpose is relatively simple. This indicator measures the opportunity costs for LPs. When users add their assets to crypto market liquidity pools, they miss out on other benefits — mainly, profits from HODLing for speculative purposes.
Assets lent to the DeFi exchanges can rapidly gain or lose plenty of value. For example, tokens like Ethereum may grow twofold in just a few days! In this scenario, the opportunity costs for LPs are substantial. Their rewards could be much lower than potential earnings from HODLing (typically, less than 50%).
However, negative financial results are only temporary — hence the impermanent aspect. Losses are not realized until LPs withdraw their liquidity cryptocurrency. If their assets rebound to their original price while still in the pool, they can make a profit. Otherwise, they must withdraw their assets from cryptocurrency liquidity services and realize their IL.
This phenomenon is nearly unavoidable due to the high volatility of the market. The most challenging aspect of IL is not defining but calculating and predicting it.
To Sum Up
Liquidity mining is a method of earning a passive income in the crypto market. This symbiosis of traders, liquidity providers, and exchanges has existed since the dawn of DeFi. Instead of trading their assets or keeping them in cold wallets, users add them to DEX liquidity pools and earn rewards. The platforms reward their LPs using governance tokens and fees paid by other users.
Today, the crypto market has largely shifted to yield farming — another passive investment method. This successor of liquidity mining is also based on asset deployment. However, it is focused on maximizing APY rather than supporting the functioning of the DeFi protocols.
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The information provided by CoinLoan (“we,” “us,” or “our”) in this text is for general informational purposes only. All investment and financial opinions expressed by CoinLoan in this text are from the personal research and open information sources and are intended as educational material. All outlined information is provided in good faith. However, we make no representation or warranty of any kind, express or implied, regarding the accuracy, adequacy, validity, reliability, availability, or completeness of any information in this text.