The blockchain ecosystem offers endless opportunities for profit-making and wealth preservation on Web3. Liquidity mining is one popular way to make crypto investments that reap passive rewards. How does liquidity mining operate in practice, and what exactly do investors stake? What are its benefits and associated risks? Is liquidity mining a safe option for ethical investors?
What is Liquidity Mining?
Liquidity mining is an investment strategy where participants aim to earn passive income from supplying liquidity to decentralized finance (DeFi) protocols.
In simpler terms, it is a form of yield farming that lets crypto investors earn compensation for lending out their tokens to crypto exchanges. This strategy is popularly used by Automated Market Makers (AMMs) to incentivize users to become liquidity providers in exchange for rewards such as a share of transaction fees or free tokens.
In its essence, liquidity mining is a type of yield farming that creates win-win scenarios for both crypto investors and decentralized exchange (DEX) platform owners. It helps participants put their idle digital assets to work in facilitating exchanges on DeFi protocols.
How Does Liquidity Mining Work?
The basic idea behind liquidity mining is to create liquidity pools that facilitate the peer-to-peer exchange of digital assets on a DeFi project. When participants lock their crypto assets in a shared pool, they are contributing towards the day-to-day functioning of an exchange. This is because the liquidity provided by asset pools is needed for verifying transactions on a crypto network. Let us understand this process and its related concepts in detail.
What is a DEX?
DEX or Decentralised Exchanges are self-contained, autonomous platforms that facilitate crypto transactions without intervention from intermediaries. They provide trading platforms where liquidity providers can deposit their assets for rewards.
What are Liquidity Pools?
A liquidity pool is a collection of digital assets such as cryptocurrencies or virtual tokens locked up in a smart contract to facilitate transactions on a DEX. These pools serve as asset reserves that provide essential liquidity to speed-up crypto-based exchanges on a DeFi market.
What is Yield?
Yield is the passive reward earned by liquidity providers for depositing their tokens in a liquidity pool. This can be distributed as the interest rate on their investments, a percentage of trading fees, or new tokens on the platform.
What is an AMM?
Automated Market Makers or AMMs are smart contracts developed to hold liquidity reserves in an asset pool. The underlying protocol automates direct trade between DEX users and eliminates centralized exchanges.
Benefits of Liquidity Mining
Liquidity mining can be beneficial for all parties involved in a DeFi network be it liquidity providers (LPs), traders, or the larger blockchain community.
1. Earning passive income
Liquidity providers can earn good profits by investing their digital funds in liquidity pools. This gives more comprehensive exposure to crypto assets that could otherwise be lying dormant in owner wallets. So, liquidity mining works as a source of passive income for many crypto enthusiasts all over the world.
2. Aiding in the distribution of governance tokens
Many DeFi programs reward LPs in ratio to their contributions towards the liquidity pool. More tokens deposited also imply that a contributor bears more risk, and thus must be compensated with a bigger reward ratio. Governance tokens can be distributed among investors in proportion to their investments in the liquidity pool. So, participants with more tokens will be able to have a stronger voting power over the future development of the DeFi platform.
3. Low entry barrier
As most platforms welcome small deposits, there is an opportunity for newcomers and small investors to engage in liquidity mining. Becoming a contributor in liquidity pools allows people to make profits from crypto tokens without being experts in the field. At the same time, exposure to DeFi markets lets them interact with the larger blockchain community and learn more about this arena.
4. Inclusivity and open governance
Since liquidity mining is open to everyone irrespective of their stake, more people can participate in the blockchain network because of it. This creates an inclusive model of crypto investments, where anyone who buys into a liquidity pool can have a say in the growth of a DeFi platform.
Risks involved in Liquidity Mining
Now that we know about the advantages of liquidity mining, let us learn about the risks involved in it.
1. Security risks
As blockchain code is open source, most DeFi projects are exposed to security risks. Cybercriminals can exploit the technical vulnerabilities of a crypto platform to steal funds or hack user accounts. Security hacks cause loss of investments as well as reputational damage for the exchange platforms that are attacked.
2. Information asymmetry
Decentralized networks and digital asset pools can be challenging to navigate because very little information about their projects is made public. This can breed corruption, mistrust, and confusion among investors who wish to find reliable options to deposit their money. Still, a certain level of uncertainty is inevitable for all stakeholders who contribute to a liquidity pool.
3. Exit scams
Since the existence of a DeFi protocol depends on its core developers, investors put all their faith in the integrity of these few individuals when making a deposit. If the developers are dishonest, they can shut down their platform and disappear with investors’ funds without any notice. This can result in serious losses for liquidity providers who have no way to recover their tokens.
4. Impermanent loss
It is possible that the price of a crypto token falls while your funds are locked up in a liquidity pool. If investors panic and withdraw their tokens in fear of further loss, they would only get returns at a depressed price. This is called an impermanent loss as the LP loses profits due to the volatile price changes of the crypto market.
Is Liquidity Mining Different from Yield Farming?
Yield farming is the process of earning passive returns on cryptocurrency assets by lending them out to DeFi protocols. Investors are incentivized to deposit their digital assets for timely yields or profits such as interest, governance tokens, and other rewards.
Liquidity mining is a subset of yield farming where investors are rewarded with cryptocurrency tokens for providing liquidity to a particular DEX platform.
While a yield farmer lends their tokens to a centralized liquidity pool, a liquidity miner invests in an exclusive, platform-centric liquidity pool. So, yield farming lets your investments interact with multiple blockchain networks, but liquidity mining limits itself to a single DEX chain. This means that the rewards received through liquidity mining will only comprise native tokens and protocol-specific governance tokens.
MRHB Liquidity Harvester – EMPLIFAI
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