One of the most popular applications of blockchain technology is decentralised finance (DeFi), and one popular way for crypto-investors to participate in DeFi is to mine liquidity. In this guide, we will introduce the concept of Liquidity Mining, why it is important, which platforms allow users to mine liquidity, its benefits and the risks involved in this investment strategy.
INTRODUCTION
Earning passive income is one of the best ways to invest in cryptocurrencies, and there are a number of ways to do this, including betting your assets, lending them out and performance farming on DeFi (decentralised finance) platforms.
Decentralised finance is a new fintech application that seeks to disrupt traditional financial markets using decentralised networks such as blockchains. DeFi platforms work by eliminating centralised financial intermediaries that allow market participants to interact peer-to-peer (P2P).
Yield farming is a broad categorisation for all methods used by investors to earn passive income by lending their cryptocurrencies. They can receive interest, a share of the fees accrued on the platform where they are lending their tokens or new tokens issued by these platforms.
Liquidity Mining is one of the most common forms of yield farming where investors can earn a steady stream of passive income. In this guide, we will discuss what it is, including the risks and benefits for investors who engage in the practice. Not only that, but we also highlight some of the best Liquidity Mining platforms for anyone looking to make use of their packaged cryptocurrency.
WHAT IS LIQUIDITY MINING?
Liquidity mining is an investment strategy in which participants within a DeFi protocol contribute their crypto assets to facilitate others to trade within a platform. In return for their contributions, participants are rewarded with a portion of the platform’s fees or newly issued tokens.
The term liquidity means the ease with which an asset can be converted into spendable cash, so the easier it is to spend an asset, the more liquid it is. Mining, on the other hand, is something of a misnomer in this situation referring to the most common way of being rewarded in Proof-of-Work (PoW) networks like Bitcoin for contributing to verifying transactions.
However, the use of the term mining in this title alludes to the idea that these liquidity providers (LPs) are seeking some rewards (fees and/or tokens) for their efforts.
HOW DOES LIQUIDITY MINING WORK?
Participating in these liquidity pools is very simple, as it involves depositing your assets into a common pool called a liquidity pool. The process is similar to sending cryptocurrencies from one wallet to another. A pool usually consists of a trading pair such as ETH/USDT. As a liquidity miner (or provider), an investor could choose to deposit any of the assets in the pool.
By depositing their assets on Defi platforms, LPs make it easier for traders to enter and exit positions with trading fees used in part to reward them.
The more an LP contributes to a liquidity pool, the greater the proportion of the rewards they receive. Different platforms have different implementations, but this is the basic idea behind Liquidity Mining.
KEY TERMS AND CONCEPTS (EXPLAINED)
To participate effectively in a DeFi protocol as a liquidity provider, there are terms and concepts with contextual meaning that you will need to know and understand. Some of these include:
DEX: this is an abbreviated form of decentralised exchange, which is a platform that runs autonomously without direct intervention from a centralised party, such as a firm. Dexes are trading platforms to which liquidity providers contribute their digital assets.
Yield: this is the reward offered to liquidity providers in the form of trading fees or LP tokens. In other DeFi platforms, the yield is the interest rate accrued to participants for providing liquidity or holding shares in these projects.
CeFi: stands for centralised finance and refers to institutions within the cryptocurrency market that offer financial services. It is the opposite of DeFi.
TradFi: in its entirety, this term means traditional finance, and refers to conventional financial institutions such as banks, stock exchanges and hedge funds. TradFi is different from CeFi even though both terms refer to centralised financial structures, the contexts vary because CeFi is used in reference to blockchain and TradFi is used in reference to conventional financial markets.
AMM (Automated Market Maker): AMMs are smart contracts designed to hold liquidity buffers within a pool. They are the AMMs to which LPs deposit their assets and traders interact to exchange their cryptocurrencies.
BENEFITS OF LIQUIDITY MINING
Liquidity Mining presents many benefits not only for liquidity providers, but also for DeFi platforms and the blockchain community at large. Here’s how:
Fair distribution of governance tokens: this does not apply to all DeFi protocols, but to those that reward liquidity providers with governance tokens. Generally, most platforms will reward LPs by the proportion of their contributions towards the liquidity pool. LPs with higher contributions are rewarded with more tokens proportional to the risk they have to bear. Governance tokens can be used for:
Voting on development proposals;
Vote on crucial changes to protocols, such as the share ratio and user experience, among others.
Even with a fair distribution of governance tokens, this system is still prone to inequality, as a few large investors are able to usurp the role of governance.
Passive income: Liquidity Mining is an excellent means of earning passive income for LPs, similar to how passive stakeholders within gambling networks.
The win-win-win outcome of liquidity protocols: all parties within a DeFi market benefit from this model of interaction. LPs are rewarded for lending their tokens, traders benefit from an efficient and highly liquid marketplace, while the platform benefits from a vibrant community of users, from LPs and traders to developers and other external service providers.
Low barrier to entry: it is easy for small investors to participate in Liquidity Mining, as most platforms allow small amounts to be deposited, and investors can recoup their profits to increase their holdings within liquidity pools.
Open governance: since anyone can participate in Liquidity Mining regardless of their stake, anyone can also claim governance tokens and therefore vote on development proposals affecting the project and other critical decisions determined by stakeholders. This leads to a more inclusive model where even small investors can contribute to the development of a market.
RISKS OF LIQUIDITY MINING
Every investment strategy that has benefits also comes with risks, which every investor should consider before investing, and liquidity mining is no exception. The risks involved in mining for liquidity include:
Impermanent loss: one of the biggest risks faced by liquidity miners is the possibility of suffering a loss should the price of their tokens fall while they are still locked in the liquidity pool. This is called an impermanent loss, as it can only be realised if the miner decides to withdraw the tokens at depressed prices. Sometimes, this unrealised loss can be offset by gains from LP rewards; however, cryptoassets are highly volatile with wild price movements.
Exit scam: the possibility of the core developers behind a DeFi platform closing shop and disappearing with investors’ funds is very real and, unfortunately, a common occurrence in several blockchain markets. The most recent incident experienced within the DeFi space is the Compounder Finance carpet-pulling that saw investors lose close to $12.5 million.
Note: Compounder Finance is not related to another well-known DeFi protocol called Compound Finance.
Security risks: Technical vulnerabilities could allow hackers to exploit DeFi protocols to steal funds and wreak havoc. Such security incidents are common within the cryptocurrency space because most projects are open source, with the underlying code publicly available for viewing. Security hacks can lead to losses due to the theft of tokens held within liquidity pools or a drop in the price of tokens following negative publicity.
Information asymmetry: the biggest challenge for investors within decentralised networks with open protocols such as DeFi markets is that information is not distributed fairly to the public. Information asymmetry generates community ills such as distrust, corruption and lack of integrity.
THE BEST LIQUIDITY MINING PLATFORMS
Now that you have an idea of what liquidity mining is, you may be interested to know where the best place to apply the strategy is. There are a few factors to consider when choosing a platform you might want to liquidity mine. These include:
Level of decentralisation: you should find out if there is any risk of centralisation of one or a few parties within the community. To do this, check the project’s metrics, including the number of liquidity providers, total value locked (TVL) and available liquidity. If you are technically inclined, you can also audit the protocol’s source code by checking its GitHub repository. Here, you want to see how many developers contribute to the project, the frequency and their identity.
Security: blockchain networks and protocols get hacked on a fairly regular basis, and you want to minimise the risk of losing your investment by choosing a secure platform. For any DeFi platform you are considering, check its history for security hacks. Make sure the platform regularly performs an independent third-party security audit. Finally, consider the age of the platform and the identity of the lead developers. This final step is necessary to eliminate potential exit scams (carpet pulling).
Functionality: most DeFi platforms exclusively support Ethereum-based tokens. If you need to provide liquidity for a token that is not hosted on Ethereum, you should look for a DEX that supports the token you are interested in. You should also consider how lucrative it is to participate in multiple liquidity pools within the same DEX and on competing platforms.
Here are three of the most popular DEXs to consider for your liquidity mining journey:
UniSwap
Balancer
PancakeWap
Let’s consider each in brief.
1. UniSwap
UniSwap is arguably the largest decentralised cryptocurrency exchange with a current trading volume of over $800 billion. The platform supports Ethereum and ERC-20 tokens (Ethereum-hosted assets only).
To participate in liquidity provision, an investor must use a compatible Ethereum wallet and deposit Ether into a liquidity pool of their choice. UniSwap offers a governance token called UNI to liquidity providers which they can use to vote on various issues, as well as claim ownership of:
uni community treasury;
The protocol rate change;
uniswap.eth ENS name;
Uniswap default list;
SOCKS liquidity tokens
Popular liquidity pools on UniSwap include:
ETH/USDT
ETH/USDC
ETH/DAI
ETH/WBTC
Note: Ethereum is currently experiencing high transaction fees and delayed confirmation times, a problem that the blockchain’s core developers hope to fix with the network’s upcoming upgrade from mining to betting.
2. Balancer
Balancer is another decentralised Ethereum-centric exchange that gives UniSwap a run for its money. It is arguably the best alternative to UniSwap out there, offering better terms for both liquidity providers and traders.
A major concern for Balancer is that although the protocol is open and the platform decentralised, the exchange relies heavily on Balancer Labs, the company that created it and runs the DEX website through which traders and LPs can access the DEX application.
With Balancer, liquidity pools are not limited to two tokens, as the platform supports up to eight different tokens within a single pool. It is more versatile and has a more intuitive user interface than UniSwap. Like its main rival, Balancer LPs and merchants will need to use a compatible Ether wallet to access and interact with the exchange.
Popular tokens for LPs on the Balancer platform are:
WETH
BAL
USDC
DAI
WBTC
AAVE
3. PancakeSwap
Unlike UniSwap and Balancer, which are used for trading ERC-20 tokens, PancakeSwap is based on the newer Binance Smart Chain (BSC), which gives traders and liquidity providers access to BEP-20 tokens. It has several advantages over its competition, including:
It is fast;
Transaction fees are much lower;
Most of its liquidity pools offer higher yields;
It is a late entrant to the DeFi scene that benefits from the market experiences of other platforms.
PancakeSwap inherits the advantages of the BSC, which is a fork of the Ethereum blockchain. It is a fast, cheap and green blockchain due to its use of the Proof of Staked Authority (PoSA) mechanism. Apart from its consensus mechanism, the BSC blockchain is almost identical to Ethereum and can even be accessed through the popular MetaMask Ethereum wallet.
FINAL THOUGHTS: IS LIQUIDITY MINING WORTH IT?
Liquidity mining is becoming increasingly popular among cryptocurrency investors for a good reason.
It offers a great avenue for passive income;
It contributes to the decentralisation of the blockchain market;
It provides investors with a choice about what to do with their spare change.
The blockchain space continues to grow and it remains to be seen whether Liquidity Mining will prove to be a worthwhile long-term crypto investment strategy.
FREQUENTLY ASKED QUESTIONS ABOUT LIQUIDITY MINING
What is Liquidity Mining?
Liquidity Mining is an investment strategy whereby crypto investors are rewarded for contributing to the liquidity of an asset within a decentralised market.
How does Liquidity Mining work?
Essentially, liquidity providers (LPs) deposit their assets into a liquidity pool from which traders will access desirable tokens and pay trading fees for exchanging their assets on a decentralised platform. These trading fees are shared between the platform and the LPs.
Which platforms support Liquidity Mining?
There are several decentralised exchanges that incentivise liquidity providers to participate within their platforms. The most popular are UniSwap and Balancer, which support Ethereum and Ether-related tokens in the ERC-20 standard. PancakeSwap is another popular DEX where you can mine liquidity with support for Binance Smart Chain-based assets.
Is Liquidity Mining worthwhile?
Liquidity Mining is an excellent means of earning passive income for cryptoassets that might otherwise have been handled without the additional benefits. By participating as a liquidity provider, a crypto investor aids in the growth of the nascent decentralised finance market while earning some returns.
