Liquid mining is a popular way to earn investment income in the decentralized finance (DeFi) markets. However, it can be quite daunting to new market entrants. Read on to learn what liquidity mining is and how it works.
What Is Liquidity Mining?
Liquidity mining refers to injecting funds (in the form of digital assets) into liquidity pools, providing decentralized exchanges with liquidity to earn rewards.
DeFi users injecting funds into liquidity pools are called liquidity providers (LPs). Typically, they deposit two tokens into a decentralized trading pool to earn a share of the pool’s trading fees, plus protocol tokens paid out as incentives to LPs to provide liquidity.
Liquidity mining is enabled by decentralized exchanges that deploy automated market makers (AMMs), enabling LPs to contribute liquidity into a decentralized trading smart contract to allow traders to buy and sell the (usually) two tokens held in the trading pool directly from and to the smart contract.
How Does Liquidity Mining Work?
Now, let’s take a look at how liquidity mining works in the DeFi markets.
- A trading protocol, such as Uniswap, provides two tokens, X & Y, in an autonomous liquidity pool for trading.
- Trading requires liquidity in both tokens to ensure users can buy and sell the two tokens without significant price slippage. Liquidity providers deposit equal proportions of tokens X and Y into their liquidity pools to ensure that there’s ample liquidity for that.
- Trading continues within the pool as users swap token X for Y and vice versa. Every trader pays a trading fee (in addition to network fees) for token swapping.
- The protocol then distributes the fees (paid in the liquidity pool tokens) to liquidity providers, proportional to their deposited funds. Additionally, liquidity mining rewards are paid in the protocol’s governance tokens. In the case of Uniswap, that would be UNI.
- If there is an imbalance between the two tokens, the AMM adjusts its prices accordingly to encourage more investors to input liquidity into the pool.
To cash out the fees and rewards, liquidity providers must withdraw their assets from the trading pools back into their personal crypto wallets.
Benefits of Liquidity Mining
Since the relationship between the DEX, liquidity pools, and liquidity providers is symbiotic, liquidity mining benefits all parties involved. Some of the benefits include:
- LPs earn rewards: Liquidity mining rewards liquidity providers with a yield similar to staking. The process is autonomous and on-chain, ensuring equal distribution of rewards.
- Decision-making rights: Since the rewards are in the protocol’s native token, holders gain voting rights within the ecosystem.
- Improves liquidity on the platform: The protocol gets more liquidity while LPs earn rewards. This factor increases the platform’s attractiveness to investors.
- Low entry barrier: The permissionless nature of these protocols allows anyone to participate in liquidity mining.
Risks of Liquidity Mining
Liquidity mining also comes with certain risks, which you should know. Here are some of them.
- Impermanent loss: Impermanent loss (IL) relates to the prices of the tokens held in the liquidity pool. A liquidity provider may have pooled their assets with a certain expectancy that may not be met depending on the volatility. It’s also not uncommon to encounter an overhyped project that doesn’t meet the investors’ standards. All the same, IL can lead to substantial, permanent losses.
- Smart contract risks: Liquidity mining depends heavily on the proper coding and execution of smart contracts. If developers write the smart contract code poorly, it opens doorways to cyberattacks. This factor is especially true for projects that don’t audit smart contracts.
- DeFi scams: Unfortunately, fraudulent activities like rug pulls and exit scams are far too common in the DeFi markets, and liquidity providers are popular targets. For example, a malicious DeFi project’s team can wait for LPs to come and lock their funds into liquidity pools and then withdraw the more valuable token (or all funds held) in the pool, leaving LPs with heavy losses.
Is Liquidity Mining Worth It?
Liquidity mining is one of DeFi’s most popular investment income-earning opportunities. The reason for that is the high APYs often paid (in protocol tokens) by decentralized trading pools. After all, crypto traders and investors are deploying capital in the DeFi markets to make money.
Newer, less established decentralized trading protocols often pay higher liquidity mining rewards than their more established counterparts. However, they are often run by anonymous teams and don’t always have audited smart contracts, opening up the possibility of rug pulls or smart contract hacks.
But even mining liquidity on more established DeFi protocols carries a significant amount of risk, ranging from impermanent loss to the compression of yields, which can result in significant losses.
While liquidity mining can be a very lucrative venture, it requires a deep understanding of the DeFi markets and decentralized trading, making it unsuitable for beginners or crypto investors with a low risk tolerance.