What is liquidity mining?
Before the advent of decentralized finance (DeFi), holders of cryptoassets had three options — they could trade them, keep in hardware wallets, or store on exchanges. Aside from day trading and HODLing, there was no other way to profit. Then, DeFi liquidity mining revolutionized the game. Discover its benefits for retail and institutional investors in the cryptocurrency market.
What is liquidity in cryptocurrency?
Decentralized finance borrowed the term liquidity 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 crypto assets speeds up the transactions.
What does providing liquidity mean?
With DeFi, came a passive investment strategy – earning through lending to new platforms. Today, users can deploy their assets as liquidity on DeFi exchanges, lending protocols, or liquidity pools on other protocols. This passive income method is called liquidity mining.
Typically, a a liquidity mining program 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 governance tokens and fees paid by traders.
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. This is a win-win situation for DEXes and the crypto investor community.
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, liquidity miners provide two tokens of equal value for its trading pairs. 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. Crypto investors take advantage of liquidity mining to reap rewards. DEXes acquire liquidity. Meanwhile, other users can trade in a decentralized environment without delays.
Impermanent loss in liquidity mining
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.
In the first place, they should be aware of impermanent loss (IL). Despite being one of the key terms in liquidity mining, it is often misconstrued.
- IL measures the opportunity costs for LPs as crypto assets lent to DeFi liquidity pools can gain or lose plenty of value rapidly.
- When users add their assets to a crypto market liquidity pool, they miss out on other benefits — mainly, profits from HODLing for speculative purposes.
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%).
How bad is impermanent loss?
For liquidity miners, these 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.
Technical risks in liquidity mining
Any protocol has inherent technical risks. The more advanced it is, the more complex the source code, and the higher the chances of its exploitation. Before placing their digital assets into a pool, investors should not neglect due diligence. Independent code audit is a must to minimize the risk of interference. Additionally, common investment advice mentions these risks:
Extreme processing fees
Ethereum, which is still powered by the unsustainable proof-of-work (POW) consensus, is notorious for its high gas fees. Despite being the go-to platform for smart contracts, it deters small capital investors. Its liquidity mining benefits are only accessible to those who can afford the gas. Eth2.0 should level the playing field, enabling new incentive programs for retail investors.
Rug pull fraud
This is the situation when liquidity pool developers close the project and vanish with the investir funds. This risk is also inherent, as DeFi protocols are anonymous. In 2020, the creators of Compounder Finance shut down the protocol and fled away with $10.8 million. This shows why capital investors should do extensive research before committing to a project.
Liquidity mining vs. yield farming
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.
How yield farming works
Yield farmers profit by putting cryptoassets in decentralized applications. Dapps, which are based on self-executing contracts, range from crypto wallets to entire DEXs. These investors can earn interest and speculate on market swings in a number of ways:
- Providing liquidity: depositing two assets to a DEX to get a passive income – a share of the trading fees.
- Lending: earning yield from interest paid on a crypto loan.
- Borrowing: collateralizing one asset to borrow another one and farm yield with it.
- Staking: pledging tokens to proof-of-stake blockchains for interest, or staking LP tokens earned from adding liquidity to a DEX.
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.
In recent years, liquidity mining programs have become overshadowed by yield farming. This investment strategy lets institutional and retail investors profit from lending, borrowing, and staking. It prioritizes personal gain over support of decentralized finance.