The rapid growth in cryptocurrency and blockchain over the years has been shocking. One reason for this electrifying growth is Decentralized Finance (DeFi), a blockchain-based finance platform that eliminates centralized financial intermediaries.
Before the emergence of decentralized finance, crypto-assets were actively traded or stored on exchanges and hardware wallets. There was no option in between and it limited the community to either learning how to day trade or learning how to stay satisfied with HODL profits.
DeFi's arrival changed the game by allowing users to earn passive income by deploying their assets as liquidity on decentralized exchanges, lending protocols, and liquidity pools on other kinds of protocols. In DEXs and AMMS, DeFi specifically made it possible to increase one’s capital by lending it to newly built trading platforms.
What is liquidity mining, and how does it benefit DeFi?
In this article, you’ll learn everything you need to know about liquidity mining. Without further ado, let’s dive in!
The term “Decentralized Finance”, better known simply as DeFi, encompasses financial services that are provided on a blockchain and don’t require the involvement of any central authority, like banks, credit unions, or insurance funds. DeFi involves taking conventional elements of the traditional financial system and replacing third-party services with smart contract functionality.
Simply put, DeFi is like a bridge between multiple traditional banking services built on solid blockchain technology. Most DeFi protocols run on the Ethereum blockchain, although other options are available.
What is Liquidity Mining?
Liquidity mining is a process in which crypto holders lend assets to a decentralized exchange for rewards. These rewards commonly stem from trading fees that are accrued by traders swapping tokens. Fees average at 0.3% per swap and the total reward differs based on one’s proportional share in a liquidity pool.
Depending on the farm, it may also reward a user in the native token or governance token of the protocol, which allows you to vote and contribute to the protocol’s future.
Liquidity mining is important because a DEX needs liquidity to enable the trades between different token pairs and this incentive strategy enables users to contribute liquidity to facilitate those trades. This means that most liquidity pools are between trading pairs where users can deposit the two different cryptocurrencies depending on the pool.
Benefits of Liquidity Mining
Although liquidity mining is a means of earning a passive income, it has even more benefits. This section will discuss some relevant benefits of liquidity mining to both providers and decentralized exchanges. Without further ado, let’s talk about the benefits of providing liquidity to DEX.
A Win-win Situation for Liquidity Providers and Decentralized Exchange Platforms
Just as we already know, liquidity is the fuel on which decentralized exchanges run. So, as providers add liquidity to smart-contract protocols, the DEXs that run the liquidity pools become more liquid. And, as a result, DEXs continue to be liquid by making it possible for trustless individuals to transact securely.
Overall liquidity improvement
The liquidity of funds is considered to be the vital element of the liquidity of the entire economic system. Compared to conventional industries, DeFi doesn’t possess a self-built capital pool that would grant stable liquidity. As a result, designing a viable and innovative decentralized fund pool model along with comprehensive user incentives via an interest rate mechanism that would inject better liquidity has become a primary and well-thought-out objective of DeFi projects.
"Since liquidity mining motivates participation through rewards, the DEXs native token can usually see some appreciation from the inflow of capital into the protocol. This participation strategy becomes increasingly attractive to developers and their innovators in the space of DeFi.
Start-ups were usually limited to bootstrapping their projects, but this sort of community incentivisation provides an interesting way to gain traction. As long as rewards make sense and protocols provide more than adequate security, more participants will come and so will innovation in the space.
Although the primary goal of liquidity mining is to create income for liquidity providers, it also helps develop active community members and a large user base for a project. In most cases, providers are likely to be token holders and users of the protocol after launch."
Risks of Liquidity Mining
Liquidity mining has, so far, offered more benefits to the DeFi community than we can imagine. However, there are always two sides to everything.
To reap the rewards of liquidity mining, it is essential to avoid focusing on benefits and ignoring the risks. In this section, we’ll explain the risk associated with liquidity mining. Without ado, let’s dive in!
High Gas Fees
The Ethereum network is currently the premier blockchain that supports smart contracts. Although it’s planning to transition to the proof-of-stake (POS) consensus, it uses the proof-of-work (POW) consensus, which requires processing fees aka gas fees.
Higher gas fees can price out small capital investors which leads to liquidity mining rewards accrued by those who are able to pay high fees to play. With Eth2.0 on the horizon, these issues on Ethereum should level the playing field and let more retail participants transact on the network and thus reap incentive programs like liquidity mining.
Impermanent loss happens when the price of the tokens you’ve contributed to a liquidity pool changes compared to when you first deposited them. The greater the price difference, the greater the chance of impermanent loss.
This results in less value in $USD when you decide to withdraw compared to the value when you decided to provide liquidity. This risk can usually be offset by the gains made through rewards like trading fees, but cryptocurrency market volatility makes liquidity providers a bit more cautious of their deposits.
The more advanced a protocol is, the more complicated the source code that runs the protocol. That means protocols are susceptible to technical risks. Without a careful code audit, unscrupulous individuals can take advantage of a protocol and its assets.
All projects are susceptible to exploitation, no doubt. So, as an investor, be sure to perform your due diligence before staking your assets into liquidity pools. That will protect you against any form of hacks and exploitation of protocols. Also, ensure that you invest in projects constantly audited by independent individuals and agencies.
Liquidity mining is simply a passive income method that helps crypto holders profit by utilizing their existing assets, rather than leaving them inactive in cold storage. Assets are lent to a decentralized exchange and, in return, the platform distributes fees earned from trading to each liquidity provider proportionally.
Liquidity mining is the first yield use case in DeFi. It existed during the very beginning of DeFi’s rise. However, as the market gradually strengthened, the market shifted to a different yet similar passive investment method: yield farming.
Although yield farming is based on liquidity mining, we will use the next lesson to figure out the differences between them and discover which method is more profitable.
NB: Before providing liquidity for a DeFi project, do extensive research. Always test the water with small transactions before going all-in. Doing so will minimize your losses, maximize rewards, and protect you from unscrupulous individuals.
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