When you deposit money in a bank, you’ve basically lent those funds to the bank. In return, the bank pays you interest. With liquidity mining (also called “yield farming”) you lend cryptocurrency to a start up cryptocurrency platform seeking to raise capital. In return, the lender will often receive interest payments or share in a cut of the platform’s transaction fees.
But even more important: the lender usually receives units or tokens of the platform’s native cryptocurrency. These tokens reward the lender for injecting liquidity into a budding cryptocurrency platform. Some reward tokens allow their owners to vote on the cryptocurrency platform’s protocols, such as value-capture mechanisms. Of course, the reward tokens can themselves be traded. So, many liquidity providers wager their loan on the likelihood that the new platform will take hold of cryptocurrency markets, thereby causing the platform’s native cryptocurrency tokens to soar in value and allowing the investor to bank a significant payoff when selling the reward tokens.
Earning passive income is one of the best ways to invest in cryptocurrencies, and there are several ways to do that, including staking your assets, lending them, and yield farming in DeFi (decentralized finance) platforms.
Decentralized finance is a new fintech application that seeks to disrupt traditional financial markets using decentralized networks such as blockchains. DeFi platforms work by eliminating centralized financial intermediaries allowing market participants to interact in a peer-to-peer (P2P) manner.
Yield farming is a broad categorization for all methods used by investors to earn passive income for lending out their cryptocurrencies. They can receive interest, a portion of fees accrued on the platform they are lending their tokens or new tokens issued by these platforms.
Liquidity mining is one of the more common ways 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 to investors engaging 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 packed crypto.
What Is Liquidity Mining?
Liquidity mining is an investment strategy in which participants within a DeFi protocol contribute their crypto assets to make it easy for others to trade within a platform. In exchange for their contributions, the participants are rewarded with a share 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 for an asset to be spent, the more liquid it is. Mining, on the other hand, is a sort of a misnomer in this situation that refers to the more common way of getting rewarded in Proof of Work (PoW) networks such as Bitcoin for contributing towards verifying transactions.
However, the use of the term mining in this title alludes to the idea that these liquidity providers (LPs) are looking for some rewards – fees and/or tokens – for their efforts.
ards a liquidity pool, the larger the share of the rewards they will receive. Different platforms have varying implementations, but this is the basic idea behind liquidity mining.
Key Terms and Concepts (Explained)
To effectively participate in a DeFi protocol as a liquidity provider, there are terms and concepts with contextual meaning that you will need to be aware of and understand. Some of these include:
- DEX – this is a short form for decentralized exchange, which is a platform that runs autonomously without direct intervention from a centralized party such as a company. 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, yield is the interest rate accrued to participants for providing liquidity or holding stakes in these projects.
- CeFi – stands for centralized finance, and it refers to the institutions within the cryptocurrency market that offer financial services. It is the opposite of DeFi.
- TradFi – in full, this term stands for traditional finance, and it refers to the conventional financial institutions such as banks, stocks exchanges and hedge funds.TradFi is different from CeFi even though both terms refer to centralized 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 the liquidity reserves within a pool. It is the AMMs to which the LPs deposit their assets and traders interact to exchange their crypto.
Benefits of Liquidity Mining
Liquidity mining presents a lot of benefits not just to the liquidity providers but also to the DeFi platforms and the blockchain community at large. Here’s how:
Fair distribution of governance tokens – this doesn’t apply to all DeFi protocols but to those that do reward liquidity providers with governance tokens. Typically, most platforms will reward LPs by the ratio of their contributions toward the liquidity pool. The LPs with higher contributions are rewarded with more tokens commensurate with the risk they have to bear. Governance tokens can be used to:
- Vote on development proposals;
- Vote on crucial changes to the protocols, such as fee 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 capable of usurping the governance role.
- Passive income – liquidity mining is an excellent means of earning passive income for the LPs, similar to how passive stakeholders within staking networks.
- The win-win-win outcome in liquidity protocols – all parties within a DeFi marketplace benefit from this interaction model. The LPs get 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 third-party service providers.
- Low entry barrier – it is easy for small investors to participate in liquidity mining as most platforms allow for the deposit of small amounts, and investors can plough back their earnings to increase their stakes within the liquidity pools.
- Open governance – given that anyone can participate in liquidity mining irrespective of their stake, anyone can also claim the governance tokens and therefore vote on development proposals affecting the project and other critical decisions determined by the stakeholders. This leads to a more inclusive model where even the small investors get to contribute to the development of a marketplace.
Risks of Liquidity Mining
Every investment strategy that has benefits comes with risks as well, which every investor needs to 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 in the event that the price of their tokens falls while they are still locked up in the liquidity pool. This is called an impermanent loss since it can only be realized if the miner decides to withdraw the tokens with depressed prices. Sometimes this unrealized loss can be offset by the gains from the LP rewards; however, crypto assets are highly volatile with wild price movements.
- Exit scam – the possibility that the core developers behind a DeFi platform will close up shop and disappear with investors’ funds is very real and, unfortunately, a common occurrence across various blockchain markets. The most recent incident that is experienced within the DeFi space is the Compounder Finance rug pull that saw investors lose close to $12.5 million.
- Security risks – technical vulnerabilities could cause hackers to take advantage of DeFi protocols to steal funds and cause 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 theft of tokens held within the liquidity pools or a fall in token price following the negative publicity.
- Information asymmetry – the biggest challenge for investors within decentralized networks with open protocols such as DeFi marketplaces is that information is not fairly distributed to the public. Information asymmetry breeds community ills such as mistrust, corruption and lack of integrity.