What is liquidity mining?
Liquidity mining is a term used in decentralized finance (DeFi) applications where users supply liquidity to decentralized financial applications and receive rewards for doing so. In the context of Uniswap, liquidity mining refers to users (Liquidity Providers, or LPs) supplying both assets to a given trading pair market so that the protocol can execute trades.
Whenever liquidity is deposited into a pool, special tokens known as liquidity tokens are minted to the Liquidity Provider’s address, in proportion to how much liquidity they contributed to the pool. These tokens are a representation of a Liquidity Provider’s contribution to a pool. Whenever a trade occurs, the 0.3% fee is levied and is distributed pro-rata to all Liquidity Providers in the pool at the moment of the trade. The user is able to claim the fees when they take their assets back from the protocol.
Beyond receiving trading fees for supplying liquidity, liquidity providers on Uniswap for eligible markets will also receive UNI tokens for providing their service.
Liquidity providers will earn UNI proportional to their contribution liquidity. The UNI and ETH earned through liquidity mining are not subject to any vesting or lock up.
Further reading on DeFi :What is Defi Trading Platform and how to make money with DEFI NEB
Pros and cons of liquidity mining
Liquidity mining can be a very lucrative investment, with annual interest rates often measured in double- or triple-digit percentages.
However, you can only get those stellar APRs by accepting a significant amount of risk. Higher yields are usually attached to pairings that involve smaller crypto projects with short operating histories and limited market caps. Bugs in the DEX system’s smart contracts could also undermine or erase your gains, and significant price changes in one or both of the crypto pairing’s components could also hurt your returns.
Liquidity pools also can be vulnerable to a unique type of fraud known as a “rug pull.” Scammers set up a new cryptocurrency and push capital into the coin through DEX services. The project backer’s quick investment drives coin prices sky-high, inspiring other investors to jump on the bandwagon. The liquidity pools powering these trades can grow to millions of dollars in less than a day, and then the scammer withdraws the entire liquidity pool. The new project collapses while the bad guys walk away with a beefy profit.
Finding the right balance between risk and reward can be difficult, given the large number of liquidity mining options. There are several DEX platforms and hundreds of active currency pairings. There will likely be some trial and error involved in your first liquidity mining investments. Cryptocurrencies are inherently volatile and you should be prepared for big price swings on a daily basis. Your life savings probably don’t belong in a high-yield liquidity mining account. This is a place for smaller investments.
Also, don’t forget that activating or ending a liquidity mining setup is a transaction on one of the major smart contract blockchains, where the processing fees can carve out a large slice of your investment returns.
Final thoughts: Is Liquidity Mining Worth It?
Liquidity mining is becoming increasingly popular amongst crypto investors for a good reason.
- It offers a great avenue to earn passive income;
- It contributes towards the decentralization of the blockchain market;
- It provides investors with an option on what to do with their reserve coins.
The blockchain space is still growing and whether liquidity mining will prove to be a worthwhile long-term crypto investment strategy remains to be seen.