What is Liquidity Mining?

What is Liquidity Mining?

Before the advent of DeFi (decentralized finance), earlier crypto adopters were stuck with few options for maximizing their gains. Investors could either buy a coin and HODL or study charts and place trades. Since not everyone knew technical analysis, most investors had to settle for HODLing their assets until they got a return on investment. When DeFi emerged, traders became aware of other profitable strategies to earn from crypto. DeFi brought various alternatives to earning passive income from crypto by staking your assets and providing liquidity to decentralized exchanges.

One significant investment strategy DeFi offered was liquidity mining. This allowed investors to lend their crypto holdings to decentralized protocols in exchange for incentives. This concept was initially utilized by IDEX in October 2017, but was redefined when DeFi came into play in 2020. Shortly after this, we saw an exponential increase of over 2,800% in total value locked in DeFi protocols on Ethereum and other blockchain networks.

How does Liquidity Mining Work?

When looking into liquidity mining, one significant factor is the presence of decentralized exchanges and liquidity pools. Decentralized exchanges operate under the Automated Market Maker (AMM) structure, which facilitates trading. When a trader swaps on a DEX, a certain percentage of the value being swapped is paid as fees. The AMM collects the fees and distributes them amongst the liquidity pool’s investors. The more traders utilize that pool, the more money liquidity miners make.

The second factor to take note of is the “liquidity pool.” A liquidity pool is a smart contract where tokens are locked for trading or providing liquidity. For liquidity miners, a liquidity pool is a smart contract that stores the capital they are offering to the DEX. Though the scope of liquidity mining goes beyond decentralized exchanges, the use case of liquidity pool applies to all.

Benefits of Liquidity Mining

Liquidity mining significantly benefits the crypto space by incentivizing users to provide liquidity, enhancing market fluidity and accessibility. It rewards participants with tokens or fees, democratizing financial opportunities and fostering a robust DeFi ecosystem. This mechanism not only bolsters trading efficiency but also allows individuals to earn passively, promoting innovation and growth within the sector. Here are some positives of liquidity mining:

1. Low entry barrier: There may be other DeFi mechanisms that offer better yield options than liquidity mining, but when it comes to entry-level difficulty, liquidity mining is the easiest. Liquidity mining makes it easier for anyone to access financial tools that yield passive income.
2. Passive earning: Getting started with liquidity mining only requires the locking up of some crypto assets in a protocol. As the protocol interacts with users, it generates revenue which is distributed to investors as rewards. It is also important to note that your share of the reward is based on how much liquidity you have provided.
3. Distribution of Native and Governance Tokens: Liquidity miners are privileged to get a share of the protocol’s native and governance tokens at zero cost. The governance token gives holders voting power over the protocol. For this benefit, people tend to hold governance tokens for the long term.
4. Helps in Marketing: When gaining public recognition, developers tend to adopt liquidity mining as a marketing strategy for their protocols. When a protocol offers more incentive to whoever may offer liquidity, it accrues more investors.
5. Helps in Building A Community: Liquidity mining helps build an ecosystem of trustworthy and loyal community members. This community would include investors who locked their crypto assets in a protocol, individuals who hold the protocol’s tokens, and users who utilize it. Though liquidity is not the only factor in community growth, it is a key player in nurturing communities.

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Risks of Mining

Liquidity mining entails risks such as impermanent loss, where asset values may diverge from market prices, causing potential withdrawal losses. Reward volatility, especially in platform tokens, can affect incentive values. Smart contract vulnerabilities may lead to asset losses, and regulatory uncertainties could impact DeFi participation. Here are some risks to consider:

1. Impermanent Loss: Cryptocurrencies are volatile assets that experience price fluctuation from time to time. When there is a change in the market price of a token you invested in a liquidity pool, it is considered an impermanent loss. For example,if you invest 1 ETH at a market price of $100, and the next day it drops to $70, you have suffered an impermanent loss. This can only become a “permanent” loss when you withdraw your asset from the pool. Before investing in liquidity mining, you must understand the fundamentals of impermanent loss.
2. Security Risks: Not all protocols are safe for liquidity mining. Some are prone to hacks, which would lead to a loss of funds. While it may be difficult to vet if a protocol is safe or not, it is important to always put the concept of security in mind when investing.
3. Rug Pulls: Rug pulls are projects that are aggressively hyped by the developers and then abandoned when investors provide enough liquidity (enough to suit the scammer’s taste). Developers may decide to entice investors with high rewards that may end up as a Ponzi scheme.

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How to Provide Liquidity

The easiest way to provide liquidity is by using a large and secure exchange like UniSwap or Sushiswap. With this method, you can find a pool or pair that you want to deposit tokens into to provide liquidity and earn rewards. In the guide below, we show an example of providing liquidity with Sushiswap on their SYN/ETH pool, which is paying a 28.51% reward.

Follow these steps to begin providing liquidity: 

1. Visit the Sushiswap Earn page.
2. Select the Liquidity Pool you want to deposit into (SYN/ETH in this example) and click the ‘Deposit’ button.
3. Enter the amount of liquidity you want to provide and stake your tokens.
4. Your rewards will be paid out in real time and can be claimed anytime.

Final Thoughts

In conclusion, liquidity mining offers a unique and accessible way for investors to earn yield on their cryptocurrency holdings. By providing liquidity to decentralized finance platforms like Sushiswap or Uniswap, users can earn rewards in the form of tokens and enjoy passive income. While liquidity mining presents an attractive opportunity for investors, it is crucial to be aware of potential risks, such as impermanent loss, security risks, and rug pulls.