🔍 Curious about liquidity mining? Find out how it works, its pros & cons, and how you can get involved in DeFi in this NFT.EU article! 📈
Thinking of putting your cryptocurrency to work and earning DeFi rewards?
DeFi liquidity mining is one of the top 5 ways to make money using cryptocurrency (without parting ownership of it).
DeFi presents some great peer-to-peer earning opportunities unique only to the blockchain - liquidity mining is one of them.
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But what is liquidity mining in DeFi and how does liquidity mining work? This blog delves deep into what liquidity mining in crypto is, its pros and cons, and opportunities and risks, beginning with liquidity mining definition.
Liquidity Mining can be understood as a practice where users inject or contribute funds to a liquidity pool for rewards. These rewards comprise a fixed yield called Annual Percentage Yield (APY), transaction fees, and platform rewards, if any.
The rewards are directly proportional to the share of the liquidity provider (LP) in the pool. The platform’s governance tokens reward the LPs, which come with additional perks.
Read more about governance tokens and how they work in this article by NFT.EU.
The process of injecting liquidity or depositing tokens in liquidity pools on decentralised exchanges (DEXs) in exchange for platform rewards is known as liquidity mining. Liquidity mining is a great opportunity to earn passive income in crypto.
Note: Liquidity mining and yield farming are not synonymous. Liquidity mining is a subset of yield farming. Yield farming is a much broader term. Read more about yield farming in this NFT.EU article.
Also, find a list of top-yield farming protocols and DeFi tokens on Coingecko.
Liquidity mining started on Compound, a borrowing and lending protocol built on the Ethereum network. Compound encouraged its users by distributing COMP tokens and granting them governance rights within the platform. Compound became the top DeFi protocol in just a day, reaching ~$500 million in staked value.
DeFi platforms use liquidity mining as a crypto incentive to attract investors, temporarily lock their funds, and provide liquidity in a decentralised manner. In return, the LP receives special tokens called LP tokens, which track and represent the share of the LP’s contribution to a liquidity pool.
An LP contributing $5000 to a $25,000 liquidity pool has 1/5th of the pool share and is also eligible for 1/5th of the gas fees and other platform rewards.
In less than a decade, the DeFi sector has seen immense growth, with its TVL (total value locked) reaching a quarter of a trillion.
In DeFi, transactions happen in a peer-to-peer fashion, governed by smart contracts and blockchain technology. It is the users injecting liquidity into protocols and the users again perusing that liquidity to earn an income within a decentralised finance ecosystem.
Liquidity mining is essential for DeFi platforms like DEXs to function. Without enough liquidity, DeFi opportunities like arbitrage, staking, trading, swapping, and farming would be limited, and the risks, such as price slippage, would be higher on DeFi platforms.
Let’s understand liquidity mining using an example. Suppose two groups of kids are selling lemonade and cookies in two separate shops by the roadside. Some of the cookie-selling kids want to try the other group’s lemonade, and some of the lemonade-selling kids want cookies.
So, the two groups decided that one lemonade was equal to two cookies and merged the two shops into one. Now, those with lemonade could exchange cookies for a glass of lemonade and vice versa at any time.
Soon, more customers arrived at their new shop, which sells both cookies and lemonade. To meet the demand, the supply had to be increased. For that, the newly formed group decided to give a lemonade token to anyone who contributed lemonade and cookies.
The kids could use it to buy toys and candies from other shops or be traded for more cookies. The lemonade tokens would be given in proportion to the lemonade kids add to the jug.
This helped the kids never to run short of either lemonade or cookies while earning additional lemonade tokens.
That’s exactly how liquidity mining works.
DeFi platforms like DEXs don’t use order books like centralised crypto exchanges. Instead, they have liquidity pools made up of token pairs. For instance, An ETH and USDT 50:50 pool on UniSwap.
You can also check the list of top liquidity pools on UniSwap on the Ethereum blockchain network.
For trades to happen, both tokens need to have liquidity to allow for swaps without slippage.
Any user can contribute tokens in the given ratio to the pool and earn rewards proportionate to their contribution. In exchange, the liquidity providers get LP tokens, which can be redeemed for the original tokens, staked for additional rewards, or traded on secondary markets. Due to the perpetual liquidity available within the pool, users can instantly swap tokens at any time.
To understand the mechanics of liquidity pools, watch this video from Whiteboard Crypto.
When a user swaps tokens from the liquidity pool, the liquidity provider receives a portion of the transaction fees.
The rewards include transaction fees and a fixed annual percentage yield (APY) paid in governance tokens that are proportionate to the LP’s contribution to the pool.
For instance, LPs would be paid APYs in UniSwap’s UNI token. These governance tokens carry voting rights and can be cashed out by being withdrawn from personal DeFi wallets.
For a detailed breakdown of liquidity mining rewards, check this great piece by
Liquidity mining is beneficial for the LPs as well as DeFi protocols in several ways:
Liquidity mining is a popular way of earning passive income. In return, you can contribute your idle crypto tokens and earn token rewards and transaction fees. Different protocols have different fee structures and reward systems in place for LPs.
Some of the best DeFi platforms for liquidity mining are UniSwap, Balancer, PancakeSwap, and Curve Finance.
DeFi protocols thrive on capital. These protocols incentivise liquidity provision via liquidity mining and other ways to attract liquidity. LPs get governance tokens that grant them voting rights on decisions related to the protocol. LP tokens can yet again be staked for more yields or traded in open markets.
Though liquidity provision may seem lucrative, it isn’t without its risks and challenges. Users need to educate themselves well before they put their crypto assets to work. Some of the potential risks include:
Impermanent loss is the temporary loss in value LPs have to face when contributing funds to a liquidity pool. Liquidity pools are governed by an automated market maker (AMM), an algorithm for rebalancing token ratios within the pool.
As soon as an arbitrage opportunity rises in the market, traders start buying one token from the pool, leading to an excess supply of the other. The price of the token with more supply reduces. This results in fund loss, which can be reversed unless the LP decides to withdraw its contribution.
Read more about the impermanent loss in this NFT.EU article.
Smart contract vulnerabilities are inherent in DeFi earning opportunities, including liquidity mining. Smart contract risks may arise due to poorly written codes that are vulnerable to exploits and hacks.
If you are an LP, platforms with no proper smart contract audit can be given a pass without a second thought.
Price fluctuations can be a boon and a bane in DeFI. New digital assets or tokens will be more volatile and experience extreme price fluctuations. Traders may use price volatility to their advantage and profit from arbitrage. However, slippage is a common risk.
In liquidity pools, LPs are required to lock in their funds for a set period. Price volatility may lead to significant losses for the LPs when they finally sell their tokens. To avoid such risks, choose liquidity pools with the least divergence or pools with stablecoins.
If you own a Web3 wallet with some crypto in it, you can become a liquidity provider, too. That’s the beauty of DeFi.
Here’s a step-by-step guide on how you can contribute liquidity to liquidity pools.
The first step in any investment begins with choosing the right platform. In the case of liquidity mining, this step holds additional significance as every DeFi platform is unique and has different transaction fees and token reward structures.
In that light, here are some factors you can consider while choosing the platform to put your tokens in:
Having a crypto or DeFi wallet is the first requirement to become a liquidity provider. Connect any compatible non-custodial DeFi wallet with the DeFi protocol and get started with liquidity mining.
Deposit equal values of two or more tokens in the pool of your choice. UniSwap allows single token deposits as well, and it auto-generates the pair.
Liquidity mining can be highly rewarding for DeFi users if done in an informed fashion. Since the DeFi ecosystem is open and unregulated, it invites more risks. Liquidity providers must consider all factors before they start depositing their tokens in AMM pools.
Liquidity mining is the lifeblood of the DeFi sector and will evolve with time. Until then, DYOR, don’t FOMO, and diversify in multiple pools. Invest only in audited platforms, and don’t forget to evaluate the performance of the pool you choose regularly.
For more interesting insights on DeFi and blockchain, visit NFT.EU!
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Liquidity mining and yield farming are used synonymously. However, liquidity mining is a sunset of yield farming and involves liquidity provision to pools in return for rewards only. Yield farming is a much broader term.
In liquidity mining, the rewards comprise fixed APY, transaction fees, and other incentives specific to the platform. These rewards are directly proportional to the share of an LP in a liquidity pool.
Leading DEXs like UniSwap, PancakeSwap, SusiSwap, etc., are trusted names where LPs can earn yields by providing decentralised liquidity. Other popular platforms include Curve Finance, Balancer, and Compound, among many others. DeFi liquidity mining protocols have different reward structures and fees. You can check the list of 69 such platforms on Alchemy.
Liquidity mining is a great way to earn passive income by putting your idle crypto to work. Liquidity mining is profitable in the sense that it is more rewarding than staking. It rewards LPs with both transaction fees and yields. However, liquidity mining has some risks that LPs should take note of while investing.
