What Is Liquidity Mining?
Liquidity is a finance method in which individuals provide a portion of their crypto assets into various “liquidity pools” within the DeFi marketplace. By doing so, these individuals receive tokens and fees.
The incentive behind liquidity mining, also known as liquidity farming, is to encourage participants to offer some of their liquidity to decentralized exchanges. Decentralized exchanges are a type of cryptocurrency trade where direct one-on-one transactions occur online securely and without any need for a mediator.
You can typically find liquidity pools with trading pairs that permit independent liquidity miners to deposit two cryptocurrencies. These miners will feed two trading pairs into the system, such as BTC-DFI, for example. Liquidity miners deposit their cryptocurrencies into the pools of the marketplaces.
Liquidity pools serve as a base for individuals to borrow, lend, and exchange tokens, and users will pay fees for these operations.
Fees are distributed among liquidity miners depending on their share in the pool as a whole. The rules regarding distribution vary from one protocol to another; however, the main goal is clear: Liquidity miners receive rewards based on the total amount of liquidity they have provided to the pool(s) in the marketplace.
Read on to learn more.
Summary of Important Points
- Liquidity pools exist within the marketplace
- Miners are allowed to contribute their assets to these pools
- These contributions help crypto holders profit by utilizing their existing assets
- By providing some of their liquidity to decentralized exchanges, participants receive tokens and fees
- Liquidity mining is a popular way to earn passive income
- Mining scams and impermanent loss are legitimate risks of DeFi liquidity mining
Liquidity Mining vs. Other Passive Investment Strategies
The DeFi industry is undoubtedly growing, and the reason for this is that enterprises and individuals want to capitalize on its numerous benefits. Decentralized finance has opened countless doors to providing equal and improved financial inclusion across the globe and has also supported the use and management of digital assets.
One topic that will likely surface when discussing DeFi trading would be the differences between liquidity mining vs. staking and yield farming. These options are practical and popular solutions for obtaining plausible returns on cryptocurrency assets. Although, each approach varies slightly regarding how participants go about pledging their crypto assets.
The goal of yield farming is to gain the highest yield possible. On the other hand, staking focuses more on helping blockchain networks maintain security. In comparison, liquidity mining provides liquidity in exchange for fees or tokens.
Crypto liquidity mining is typically a popular choice because it allows users to earn passive income without making active investment decisions. The number of rewards you receive depends on your particular share in a liquidity pool. The option to pledge more gives you the freedom to make more; if you have the means (or liquidity) to do so.
Advantages and Disadvantages of Liquidity Mining
Advantages
Liquidity miners earn fees from transactions on the DeFi pool to which they provided their assets. Transaction fees are distributed proportionally to all providers in the liquidity mining pool.
It’s important to note that fees aren’t distributed equally. Depending on how much of your crypto assets you’ve provided, the more of those fees you will pocket. If you barely put any liquidity into the pool, don’t expect much out of it.
Some benefits of liquidity mining are:
- Potential for high yields
- Low barrier to entry
- Facilitates a trusting and supportive community
- Distribution of governance and native tokens
Disadvantages
While there’s always the possibility of something going wrong in compound liquidity mining, the most common risk that liquidity miners could deal with is impermanent loss (IL). Impermanent loss is the risk that liquidity miners take in exchange for fees that they’ve earned in certain liquidity pools.
Impermanent loss means that the value of a user’s crypto assets within a pool could decline with time. The price of your deposited assets may change compared to when you deposited them, and the more significant this change is, the more you will be exposed to impermanent loss.
Suppose IL exceeds the fees that have been earned by a user when that user decides to withdraw; that user suffers negative returns compared to holding their tokens outside the pool. In other words, the dollar value is less than it was when you deposited it.
Impermanent loss, mining scams, and risks are something to remember when deciding whether to contribute to a pool.
Should You Invest in Liquidity Mining?
In liquidity mining, assets are lent to a decentralized exchange in the marketplace, known as a pool. In return, these liquidity miners that contributed to the pool receive fees distributed by the platform in proportion to whatever they gave.
The more you contribute to the pool, the more you earn. So while liquidity mining is a personal choice, it can be an effective way to earn passive income if you understand what you are doing and the risks involved.