In recent years, the use of blockchain and cryptocurrency has increased. While the primary investing strategy for crypto is to purchase and hold cryptocurrencies until they rise in value, there are several additional methods you can use to earn passive income.
One such strategy involves liquidity mining, which takes the advantages of the immense hype behind decentralized finance (DeFi) while allowing investors to use their holdings to generate additional income.
What is Liquidity Mining?
Liquidity mining is a DeFi investment strategy wherein participants supply their crypto assets into various liquidity pools to make it easy for others to trade within a platform. These pools consist of liquidity in pairs of coins or tokens accessible via Decentralized Exchanges (DEXs).
In exchange for the suppliers’ contributions, they will be rewarded with fees and newly issued tokens based on their share of the total pool liquidity. Fees average 0.3% per swap, and the total reward differs based on one’s proportional share in a liquidity pool.
How does liquidity mining work?
Users simply deposit their assets into a pool to participate in these liquidity pools, similar to sending assets from one wallet to another. A pool typically consists of a trading pair such as ETH/USDT.
Crypto holders must contribute equal portions of tokens (in terms of value) in the case of Uniswap and all DEXs using the same AMM mechanism.
A user wants to provide 5 ETH, each worth $2,000 into the ETH/USDT pool.
He has a total of $10,000. As a result, financing 5 ETH requires him to also provide 10,000 USDT (priced $1 each token).
The liquidity provided to the pool will be granted to clients who trade assets from the ETH/USDT pool. Following that, the fees are then collected and distributed to the LPs.
The end outcome is a mutually beneficial connection in which both parties receive something in return. End-users can easily trade with different assets, and exchanges gain liquidity and fees from LPs.
Benefits of Liquidity Mining
Liquidity mining is beneficial not just to the liquidity providers but also to the DeFi platforms and the blockchain community. Some of which are mentioned below:
- Potential for high yields: The yield is proportional to traders’ overall risk. If traders want to make a significant investment, their reward matches their contribution proportionately.
- Distribution of governance and native tokens: Most protocols will reward LPs with governance tokens compensated in proportion to their contributions to the liquidity pool. Higher-contributing LPs are paid with more tokens, which corresponds to the risk they face. This leads to a more inclusive model where even the small investors contribute to developing a protocol.
- Low entry barrier: Small investors can easily participate in liquidity mining because most platforms allow for small deposits, and investors can stake their profits by expanding their shares in liquidity pools.
- Passive income: Liquidity mining, comparable to passive stakeholders in staking networks, is a brilliant way for LPs to make passive income.
- The win-win-win outcome in liquidity protocols: This interaction approach benefits all parties in a DeFi protocol. The platform benefits from its community, from LPs and traders to developers, and other third-party service providers, who are compensated for providing their tokens.
Risks of Liquidity Mining
Despite numerous advantages, there are some hazards to liquidity mining.
- Impermanent Loss: This can occur when the price of the LPs’ tokens in liquidity pools changes compared to what it was when they were first provided. A more substantial price difference makes users more likely to encounter an impermanent loss. However, the cryptocurrency market’s volatility means that traders should be at least somewhat cautious when depositing their money into DEXs.
- Project risk: When a protocol is advanced in technology, the source code it operates on becomes more complicated, leading to a slew of technical liquidity mining concerns. Cybercriminals may be able to abuse the protocol and the assets within if the project does not do an in-depth audit of the code. This could result in a significant loss for the LPs involved in the project.
- Potential rug pulls: Despite the many benefits of decentralized investing, the system’s mechanism includes a few inherent hazards that could happen. One of these is the risk of “Rug pull”, a type of fraud that occurs when liquidity pool developers and protocol developers decide to shut down the protocol and withdraw all of the money invested in the project.
- Information asymmetry: The most significant issue for investors in decentralized networks is that information is not appropriately disseminated to the general public. Mistrust, corruption, and a lack of integrity are all symptoms of information asymmetry that can lead to a heavy loss for traders.
Liquidity Mining vs. Other passive investment strategies
Liquidity Mining vs. Staking
Staking is a consensus algorithm that allows users to pledge their crypto assets as a form of collateral within proof-of-stake (PoS) algorithms. Users that stake larger sums usually get more returns, which is comparable to what happens with liquidity mining.
Another obvious benefit of staking is that the risks are comparatively low. While project failure and liquidity risks are possible, the risks associated with liquidity mining are far more severe.
Liquidity Mining vs. Yield Farming
While some investors may use the terms liquidity mining and yield farming interchangeably, it’s necessary to remember that liquidity mining is a subset of yield farming, which entails locking crypto assets in various blockchain protocols to produce passive income.
While investors who participate in liquidity mining get native tokens, those who participate in yield farming gain interest. Both mechanisms have similar benefits and risks.
Is liquidity mining a long-term investment?
The essential advantage of investing in liquidity mining is that the yield is proportional to the risk LPs take, allowing them to be as risky or safe as they want with their investment. This technique is also relatively simple to implement, making it excellent for novices.
However, there are a few risks that users need to be aware of. Although unlikely, a hacker could get access to the project they’re working on, resulting in the loss of assets. The same is true if there is an instance of rug pull fraud. If LPs engage in liquidity mining, they should constantly concentrate on risk-mitigation measures to prevent costly investing mistakes.
While liquidity mining is a recent investment strategy for crypto assets, it looks like it’s here to stay.
Liquidity mining is a passive income approach that allows crypto holders to profit from their existing assets rather than storing them in cold storage. And it’s hard to deny that liquidity mining is gradually becoming a helpful tool for crypto traders.
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