The Basics of Liquidity Mining
Discover Liquidity mining as an investment strategy for earning additional yield. Read on to find out what liquidity mining is, how it works, and who it is suitable for.
What is liquidity mining?
Essentially, liquidity mining is the process of providing liquidity to a DEX (decentralized exchange) or other DeFi (decentralized finance) platform in exchange for rewards. By staking your cryptocurrency assets as part of a liquidity pool, you help to facilitate trades on the platform and earn a share of the fees generated by the network.
- Liquidity mining refers to lending your assets to a liquidity pool in exchange for yield
- Each transaction in the liquidity pool charges a fee, those fees are redistributed to the liquidity providers
- DeFi platforms incentivize users to provide liquidity with token incentives as a part of the yield
- Liquidity mining is suitable for users holding multiple coins on the same chain
- Drawbacks include impermanent loss, volatile yield, and smart contract risks
- Disclaimer: This article is for educational purposes only and should not be considered investment advice. Please consult with a licensed investment professional before making any investment decisions. -
How does it work?
Liquidity pools are an essential component of many decentralized exchanges and other DeFi platforms. A liquidity pool is a smart contract that contains funds from users who have staked their cryptocurrency assets on the platform. These funds are then used to facilitate trades between different cryptocurrencies, allowing users to buy and sell assets without having to rely on a centralized exchange.
Liquidity mining is the process of providing liquidity to these pools by staking your cryptocurrency assets. In exchange for providing your assets, you earn a share of the fees generated by the platform. The more liquidity you provide to the pool, the larger your share of the rewards will be.
Where is the yield coming from?
The yield that liquidity miners earn by providing liquidity to a decentralized exchange or other DeFi platform comes from two main sources:
- Trading fees: When users trade on the platform, they pay a fee that is then distributed to liquidity providers in proportion to their share of the liquidity pool. The fees automatically add on top of your share of the pool which means your share is growing constantly.
- Token rewards: Many platforms also offer token rewards to liquidity providers as an incentive to participate in the network. By providing liquidity to the pool, you earn a share of these rewards, which can be sold or held. Token rewards can usually be collected anytime independently from the liquidity pool.
It's important to note that the specific yield that liquidity miners can earn varies widely depending on the platform and the current market conditions. Some platforms may offer very high yields in the short term, but these yields may be unsustainable over the long term. As with any investment, it's crucial to evaluate the risks and rewards carefully before participating in liquidity mining.
Should You Get into Liquidity Mining?
Liquidity mining can be a useful strategy for putting your assets to work while you hold them. By providing liquidity to a pool on a decentralized exchange (DEX), you can earn a yield on your assets, often by pairing them with other tokens on the same blockchain. Popular DEXs like Uniswap, Curve, and Balancer offer many options for liquidity pools.
Liquidity mining does not require a minimum investment, making it accessible to a wide range of investors. However, it's important to consider the gas fees associated with using the Ethereum mainnet, which can impact the profitability of liquidity mining.
Flexibility also plays a big role. In most cases, investors are able to exit the liquidity pool at any time with no locking period. Although some projects like Osmosis have integrated lock schedules into their liquidity pool, which users can choose in exchange for higher yield.
Reasons for Staying Aside
Liquidity mining is still quite new and experimental model and it definitely has its flaws. There is an active discussion about whether the liquidity mining model is sustainable or not with no clear conclusion at this time.
- Impermanent Loss - a phenomenon that can occur when providing liquidity to a pool. It happens when the price of one token in the pool changes significantly compared to the other token(s), resulting in a net loss for the investor. Essentially, the investor is exposed to the price risk of both tokens in the pool, and if the price of one token changes more than the other, the investor will experience a loss when they withdraw their funds.
- Volatile APR/APY - the amount of yield for providers depends on the trading volume of the liquidity pool. High trading volume means a lot of fees and therefore higher yield. Furthermore, token incentives are usually emitted by the platform and are not of long-term nature. High incentives serve mainly to bring attention to the project and will decrease over time.
- Smart contract risks - same as with any other dApp (decentralized application), there will always be the inherent risk of bugs or exploitation points. These risks can be mitigated by security audits and bug bounties. Big DeFi protocols have their code regularly audited by independent organizations.
Some protocols have developed solutions to these problems, however, it is still a trade-off situation, where the problem ultimately comes back in a different form.
During bull market conditions many projects provide attractively high yields, causing the capital to shift frequently to where the yield is the highest. As the market cools down, most of the yield dries out and DEXs suffer from the lack of liquidity. These kinds of swings definitely don't add up to a sustainable model and only time will tell if liquidity ming will continue to be used.
Can you make money with liquidity mining?
In theory, yes. But it has become increasingly more difficult to do so. The majority of people lose money on liquidity mining. It takes an experienced DeFi investor to be profitable in liquidity mining due to the many complexities of the field.
Is liquidity mining a good idea?
Liquidity mining is quite an advanced procedure. It is generally not recommended for crypto beginners, as the majority of people end up at a loss.
How do I start liquidity mining?
First make sure you understand very well the basic concepts of DeFi and can use tools, such as wallets. Also, get acquainted with all the risks and shortcomings of the liquidity mining model. Once you are confident enough, find a trusted DEX platform - it is best to stick to the verified ones. Deposit your assets into a liquidity pool and you will start collecting yield.
What is a liquidity mining example?
Think of a pool on the Uniswap DEX. This pool contains ETH and DAI in equal proportions. Users, who swap in the pool use the liquidity provided by other users and reward them with a fee (usually around 0.3 %). Part of those fees is redistributed to so-called liquidity stakers on the platform, who earn yield by lending their assets to the DEX platform.
Is liquidity mining risk-free?
There are many risks that anyone wanting to participate in liquidity mining should consider. These include impermanent loss, volatile APR, smart contract bug or a rug pull.