What´s liquidity mining?
In mid-2020, the crypto industry saw a rise of a trend that changed the way people use digital currencies. The trend in question was decentralized finance (DeFi), which opened new doors to crypto users. DeFi offered a form of digital banking through the use of cryptocurrency, which offered equal opportunities to everyone. Unlike regular banking, which leaves many areas of the world unbanked or underbanked, DeFi is accessible to everyone. Among many services that this decentralized ecosystem has to offer is liquidity mining.
This guide will explain what liquidity is, how it works and how to mine it. It will look at the benefits and risks of mining liquidity.
What's liquidity?
In the context of cryptocurrency, liquidity is a term describing the ease of buying or selling coins and tokens. It refers to trading cryptos on exchanges without significantly affecting the assets’ prices.
That way, assets with high liquidity can be sold or bought quickly. If an asset has high liquidity, that typically means there are many buyers and sellers. If you wanted to buy or sell your coins, there would always be someone who could match your order.
Low liquidity would mean that the bid-ask spread is tight, there are fewer offers, and fewer people are trading. In this scenario, large orders could affect the asset’s price. As such, liquidity is an important aspect that traders must consider when trading a specific crypto. Due to the mentioned benefits, assets with high liquidity are more attractive and less risky.
What does providing liquidity mean?
After DeFi became mainstream in mid-2020, decentralized exchanges (DEXs) started becoming more popular. These are crypto exchanges that operate in a decentralized ecosystem and are not controlled by a centralized entity. They act more autonomously, using smart contracts. These platforms have been trying to replace centralized exchanges (CEXs) for years. However, they were unable to do so, due to their lack of liquidity.
This meant that DEXs couldn’t complete their traders' orders. Traders, therefore, avoided them, which meant that liquidity stayed low. This changed around the time when DeFi emerged due to a new method of securing liquidity — Automated Market Makers (AMMs). Automated Market Makers are exchanges that don’t use order books to match buyers with sellers and secure a token exchange. Instead, they use liquidity pools.
These are smart contracts that serve as pools of assets. They can store cryptocurrencies paired against one another on an exchange. Then, when someone wants to swap one asset for the other, the funds are drawn from the pool. That way, there is no waiting period and the swap is completed instantly.
Of course, these pools need to get the funds from somewhere in order to serve their purpose. The funds in the pools come from investors who own the coins/tokens in question. They provide them to the pool in exchange for rewards, and the assets are then used to provide liquidity to traders. Investors who offer their tokens this way are called liquidity providers (LPs).
What is liquidity mining?
Keeping everything explained above in mind, we come to liquidity mining. This is a process that is closely connected to liquidity providers. To put it simply, it’s a term used for getting rewards in exchange for providing liquidity.
While providing liquidity is useful for DEXs and traders, no one is expected to do it for free. Instead, users who provide their coins and tokens to liquidity pools, do it in order to earn rewards. That way, liquidity providing comes with an earning potential, as users accumulate passive income.
This is a great way to earn passive income in the crypto industry. Let’s say that you are interested in a token and believe it will become highly valuable in the future. Naturally, you would purchase it with the intention of storing it until its price rises. However, instead of locking it up in your wallet, you could lock it up in a liquidity pool.
You would still own the asset, and are free to withdraw at any time, however, by lending the asset to the DEX, not only do you keep your investment but you’d also regularly receive rewards from the DEX for staking your coin or token. Thus maximizing profits and achieving the full earning potential of your coins.
Not only will the coin or token (presumably) grow in value someday, but they could also earn you passive income. Getting started is simple; you must pick a cryptocurrency of your choice, then select a DEX and become its liquidity provider.
What are the benefits of liquidity mining?
Liquidity mining is a very rewarding activity in the DeFi sector and one of the best opportunities to earn passive income within the space at the moment. It can be performed by anyone with a handful of cryptos. Apart from that, it has a number of other benefits, such as:
- Potential for high yields
One important detail is that your yield is proportional to the risk you take by investing. This means that larger investments bring back larger yields. Of course, this also means that you need to be certain about wishing to invest in your token of choice.
- Fair distribution of governance and native tokens
The tokens you receive as a reward could be those you locked up. In many cases, providing liquidity grants you tokens that provide voting power for the project. That way, you can vote on various proposals involving the project or make your own proposals. In any case, it is a way of distributing the project’s tokens fairly to those who truly believe in it.
- Low entry barrier
As mentioned, DeFi functionalities like liquidity mining are available to everyone. Getting started is extremely simple — If you purchase only a few tokens, you can still lock them up. In time, they will make more money for you, and you will get passive income without doing anything.
- Growing a loyal, trusting community
One of the benefits of liquidity mining is actually for the project itself. Allowing users to mine liquidity and earn rewards creates a strong, loyal community. Doing this is simple — take care of your community members, and they will support your project.
- Passive income
It goes without saying that passive income is the main reason why community members provide their tokens. After all, the crypto industry is about money and business. It allows crypto users one of the best opportunities for maximizing profits. It is among the simplest strategies that newcomers can understand and use.
- Supporting a decentralized exchange
On the other hand, liquidity mining is also a way for crypto users to support a DEX. In doing so, crypto users ensure the existence of an alternative to centralized exchanges. This gives industry members a true, decentralized financial industry that many investors dream of.
What are the risks of liquidity mining?
While the previously mentioned benefits seem very attractive, you must also remember the risks.
The crypto industry is full of them, and those who ignore them and only chase profit tend to experience losses. The same is true for liquidity mining, and some of the biggest risks include the following:
One of the main risks standing between you and success is impermanent loss. This is something that can occur when the price of tokens dramatically changes while they are locked up. Essentially, you could buy the coins for a price of $10 per piece, and lock them up. Then, the coin’s price crashes to $1. If you bought 100 coins, you paid $1,000 for them. Now, they are only worth $100 in total. This does not include any coins you may have received as a reward, of course. If you decide to withdraw the coins before their price recovers, you will experience impermanent loss. You can offset this risk with the gains you obtain from liquidity mining. However, it’s worth remembering that this risk is very real. This is why it is best to lock up only those coins you intend to keep locked up as a long-term investment.
- Potential rug pulls
Another risk comes from rug pulls. Most people are likely familiar with this type of fraud. Essentially, it happens when the developers decide to shut down the protocol, and not return the funds. So, you found the project that you liked, bought its tokens, locked them up, and then everything shut down. The devs are gone, your money is gone, and there is no explanation or refund. This is another very real danger that you must be aware of.
- Project risk
Lastly, there is a risk to the project itself. As you know, crypto projects tend to be very complex. Some are more complex than others. However, while this might mean greater utility, it also means greater risk. With higher complexity comes a greater chance of flaws in the project’s code. That also means that there’s a greater chance that someone might exploit those flaws.
Is liquidity mining worth it?
The decision of whether liquidity mining is worth it or not depends on multiple factors. You need to consider the project in question, the amount you are investing, your investment goals and risk tolerance. While this can be a great way to earn additional crypto profit, it does come with numerous risks. The crypto value is highly volatile, and LPs are always at risk of impermanent loss.
FAQs
How to earn money in DeFi?
DeFi offers many ways to earn money. You can do it by getting staking rewards, yield farming rewards, or those that come from liquidity mining. There are even loans to consider, which are similar to liquidity mining, only the funds you provide are used differently.
Is liquidity mining profitable?
Liquidity mining’s profitability depends on a number of factors. The deal offered by the project is one, and the amount you invest is another. However, given enough time, it is easy to build up a sizable profit from it.
Is liquidity mining a risk?
Liquidity mining does have several of its own risks. Impermanent loss, fraud, or hacking attacks are the main ones. Investors can never be risk-free in the crypto industry.
What is DeFi liquidity mining?
Liquidity mining in DeFi means providing your tokens to liquidity pools and getting rewards in exchange. These tokens are then used by decentralized exchanges to settle transactions.
Can you lose money doing liquidity mining?
You can lose money during liquidity mining if the crypto price of the token goes down, and you withdraw. As long as you don’t withdraw, you are, technically, not experiencing losses, as the price can still recover.
How does liquidity mining work?
Liquidity mining requires a project’s crypto community to deposit their tokens in liquidity pools. These tokens are then used by decentralized exchanges to settle token swaps. Meanwhile, token providers get rewards for offering their crypto, which come from swap fees.
