What is Liquidity Mining, and How Does it Work?

Liquidity mining has sometimes taken a back seat to other crypto narratives, but it’s time to break down what liquidity mining is, whether it’s profitable, and what are the liquidity mining risks you should consider. 

Key Takeaways

• Liquidity mining is a process of locking your tokens in return for rewards
• Liquidity mining plays a big role within the decentralized finance ecosystem
• Liquidity mining profitability may vary depending on a token pair, the platform, and market conditions
• Impermanent loss and the platform’s credibility [rug pulls, insider trading, etc.] are two most common liquidity mining risks affecting liquidity mining profitability

What Is Liquidity Mining? 

As of 2023, liquidity mining remains a cornerstone mechanism in the decentralized finance (DeFi) landscape. Essentially, liquidity mining is a practice where users provide liquidity to a decentralized exchange (DEX) or lending platform by depositing their crypto assets into a liquidity pool. In return, they receive rewards, usually in the form of additional tokens or a share of the transaction fees generated by the platform.

The basic principles of liquidity mining haven't drastically changed since its inception, but the methods, complexity, and types of rewards have evolved. Given the growing number of DeFi platforms and tokens, there is an increased array of options for liquidity mining.

What Is Liquidity Mining: The Core Terms

Let’s break down core concepts pertaining to liquidity mining one by one.

Decentralized exchanges. As the name clues, these are exchanges with no centralized power behind them. Instead, people trade with smart contracts, algorithms, and pools. No single entity holds a decentralized exchange. As a result, such exchanges do not require involvement of a third party like a bank.

Liquidity Pools. Crypto holders stack up their assets within concentrated pools for profits. Think of a hub, a place where an independent logic concentrates as many holdings as possible. Decentralized exchanges play a towering role in such a logic, while users provide liquidity for pools. The exchange controls assets to allow smooth operations for all participants, who in turn, get rewards for temporarily sharing their assets. Liquidity providers are usually eligible for the transaction fees split among suppliers within the pool. 

Yield. Think of a reward in fees or tokens. Each liquidity provider gets an incentive for unlocking extra liquidity for the platform. The term also addresses DeFI economies, where it means the interest rate accrued. Similarly, users may provide liquidity for yields. 

Some more terms are less important, yet worth mentioning.

CeFi. Centralized Finance systems with centralized power in charge. As opposed to Decentralized Finance with no single entire controlling operations. 

• TradFi. Traditional finance refers to banks, stock exchanges, and hedge funds. Synonymous to CeFi, but the context is majorly focused on financial markets rather than blockchain. 
• AMM. Automated Market Maker is a smart contract responsible for liquidity operations and a smooth trading experience. Liquidity providers lock their assets within an automated market maker contract to further the trades within the exchange. 

What is Liquidity Mining and How Does It Work 

Once you have a basic knowledge of what liquidity mining is, let’s break down the working principles and ideas behind them. Liquidity abundance is the first and foremost criterion for any feasible liquidity mining model. Let’s define liquidity first and dive into liquidity mining right after. 

What is Liquidity Mining: Understanding Liquidity

In broad strokes, liquidity relates to tradability of an asset. How fast and easily users can trade the asset for various purposes. Liquidity is determined by three bullet points described below.

Execution Speed. It determines how fast orders are executed. If liquidity is low, delays occur: limit orders can take hours, days, or even weeks to get executed. Highly liquid pairs don’t require lots of time, but seconds. The overall liquidity and the liquidity for each specific pair are two different concepts. Think of Binance [one of the most liquid crypto exchanges] and a third echelon coin there. 

Spread. The high spread, or gap, between Bid and Ask orders in the order book signals low liquidity. The low spread indicates that you can buy and sell an asset with minimal losses almost instantly. If liquidity is high, the spread usually does not exceed a tenth of a percent of the asset’s market value.

Slippage. The essence of slippage is that low-liquidity pairs do not guarantee not only that orders will be executed quickly but that they will be executed at all. Having an order placed (e.g., Stop-Limit order) does not guarantee its execution in case of high trading activity on the exchange, especially during sharp price fluctuations. The paradox is: at first, orders are not executed for a long time, but then there is a sudden influx of traders, which prevents demand or supply from getting satisfied.

How Liquidity Mining Works?

Decentralized exchanges need liquidity to stay afloat, otherwise users can’t trade. Thereby, implying liquidity acquisition by all means possible. Users serve the purpose the best when exchanges offer the facility of rewards in return to liquidity provided. 

Instead of traditional order books [the list of buy and sell orders reflecting the current liquidity], decentralized exchanges rely on smart contracts commonly known as automated market makers [AMM]. Users lock in their assets, so the contracts have full access over liquidity. AMM facilitates effective trading and regulates all the transactions within the exchange. 

Think of a bank loan, whereas a bank borrows your money for a smaller rate. You basically lend your money to a bank, and the bank guarantees you’ll get your money back later, + the interest rate for lending the money. The bank accumulates money from its customers via deposits and uses the money to generate more profits. 

Say your banker has promised you a 3% return rate for a fixed-year deposit. Assuming a negligibly low credit risk [an institution unable to pay back] and relatively short duration, you agree on terms and deposit the money. The bank lends your money at 5% to someone else and makes 2% profits for intermediary services. AMM works pretty much the same, paying out rewards in the form of trading fees. All contributors get a share of the overall fees generated.

What is Liquidity Mining & Pairs?

Liquidity mining was initially intended to allow effortless token swaps for Bitcoin and other cryptocurrencies. Token swaps allowed trading one token for another within a pool. Users paid a small fee to access trades. As a result, liquidity farming refers to liquidity mining pools and associated trading pairs. Pools may include several tokens, usually two. The proportion of these tokens may also vary, but most pools stick to a 50/50 ratio, keeping an equal amount of tokens. 

What is Liquidity Mining: Incentives for Liquidity Providers

Decentralized exchanges offer a unique governance mechanism that allows for user engagement via voting. Ownership of the platform's governance tokens permits users to vote, and core developers typically guarantee equitable distribution of governance tokens to protect decentralization.

Governance tokens are an important aspect in liquidity mining since they may be used to identify another type of reward with governance capabilities. Many systems have compensated liquidity providers with standard yield rates in addition to governance tokens. As a result of the extra revenue stream for liquidity providers, liquidity mining profitability improved even higher.

Participating in the governing process may bring liquidity providers even more benefits, as they can benefit indirectly from shaping the project’s future. Say you hold substantial tokens to initiate a vote on adding a new trading pair. As a result, you may provide liquidity for this newer pair with higher return rates over the short run. 

What is Liquidity Mining: Providing and Mining Liquidity

Liquidity mining profitability lies in the details. First of which is the difference between providing and mining liquidity. If you deposit crypto in a pair, you earn a shared fee other users pay to swap tokens within this pair. All providers share the fee. Consider this your passive income on liquidity provided. 

Liquidity mining is pretty similar to providing liquidity, as both address you supplying liquidity for the exchange. Yet mining involves LP tokens you get as a reward. You can use LP tokens for various purposes, including staking, further liquidity providing, and special programs sporadically offered by the exchanges. Consider this a more active form of income on top of earning passive income.

Some exchanges offer governance tokens on top of LP rewards. Once the governance tokens turn viral, you can use them to add liquidity outside of the platforms for major trading pairs featuring Bitcoin and beyond. An alternative would be simply swapping your gained tokens to Bitcoin, Ethereum, or any other token available and traded for profits. You can automate your trading with a trading software provider like 3Commas.

What is Liquidity Mining and Its Benefits

Now that you know what liquidity mining is, you can learn about the advantages of using it as an investing technique. Here’s the list of some awesome benefits you can get engaging in liquidity mining. 

Liquidity Mining Profitability

Profits can be pretty solid, considering the number of decentralized exchanges, the growing demand, and each exchange craving a tiny bit of liquidity. Your benefits typically come in the form of trading fees accumulated. The bigger the exchange is, the more you can potentially make. You should keep the pie share concept in mind, though. Sometimes smaller exchanges attract fewer providers, and you get a bigger share of a smaller reward, resulting in higher profits compared to the likes of Uniswap. 

Native Tokens and Governance Distribution Affect Liquidity Mining Profitability

Several years ago, liquidity mining was a loud thing, but the token allocations were mainly unfair. With institutional investors having access to more money than small investors, DeFi protocol architects often favor institutional investors over retail investors. 

Yet things bend to change for the better, and some liquidity mining programs offer both low-capital and high-capital crypto investors an equal chance to acquire tokens. Even if the fair distribution is not common yet, you can compete with majors using staking and local loans for practical yield farming.

Low Entry Barriers Affect Liquidity Mining Profitability

Liquidity mining fosters a minimal entry barrier and an equitable distribution of rewards. Everyone, small to big, can benefit. For those who have always wanted to be a part of the decentralized ecosystem, all doors are now open for further expansion toward Web3. Cryptocurrency liquidity mining allows you to supply liquidity for a greater purpose and rewards simultaneously.

Communities May Shape Liquidity Mining Profitability

In the wake of blockchain adoption, many liquidity mining investments occur on newer exchanges. One benefit of liquidity mining that is sometimes overlooked is that it builds a trustworthy and dedicated community. When a liquidity mining system is implemented, liquidity providers frequently become more active in the community while the exchange expands. Individuals who provide liquidity are more likely to use the system and maintain tokens after investing in digital assets. The benefits of liquidity mining extend beyond the money earned as a liquidity provider. Once you stick to the protocol, you will keep reaping the rewards.

What Are Liquidity Mining Risks

In this part, we’ll go through the risks associated with liquidity mining.

What is liquidity mining and Insider Data?

Insider trading is a big problem across multiple markets, including crypto and liquidity mining in particular. The issue grows exponentially if you’re jumping around newer exchanges lacking credibility. 

The team can use insider knowledge to create unequal investment strategies and leverage on retail traders without the direct access to data. It’s not necessarily the decentralized exchange itself, but also questionable infrastructure it relies upon. Compromised data oracle team members may harm you equally as hard as the exchange itself. 

Those who are aware of joining newer exchanges or untrusted pools always act out of risks. The degree is what varies, but it always stays on the board. You may stick to reliable exchanges to exclude the reputation component out of the equation.

What is liquidity mining and Impermanent Losses?

Impermanent loss is a temporary loss caused by the price gap. It occurs when the price of tokens in a liquidity pool varies compared to when they were deposited. Greater price difference inflates your chances for a loss. As a result, the withdrawal value is lower than when you supplied liquidity. Gains usually cover the losses, but the volatility may play a nasty trick, leaving you with negative returns. 

What is liquidity mining and Security Hacks?

Blockchain market is a magnet for hackers willing to capitalize on cryptocurrency platforms. Some of them are white ones [find breaches and co-operate to fix those, return hacked funds if any] others are not. If a platform loses funds due to a hack, it will barely compensate you. To limit the risk, you can work with a trusted cryptocurrency platform, or insure some of your deposits. Insurance rating is an important factor when evaluating the platforms you’re willing to use. Age of the platform also plays a big role reducing the security risks. 

Best Liquidity Mining Platforms 

UniSwap — DeFI Marketplace

Given its current trading volume, Uniswap is one of the most prominent entries on a liquidity pool list. The decentralized ERC-20 token exchange supports a 1:1 pairing of Ethereum contracts with ERC-20 token contracts.

Uniswap is an open-source exchange providing limitless opportunities to build new liquidity pools for any token. No extra fees are charged. You can adjust the pools and pick the reward structure, with 0.3% being the most popular option across pools. All liquidity providers get a share in the exchanging fees according to their share in the liquidity pool. When you offer liquidity to the platform, you must deposit crypto assets and get Uniswap native tokens as a reward.

Balancer — DeFI Platform

Another Ethereum platform with some features to offer. You can effectively track and manage your assets here, which is a valuable feature many other exchanges lack. Users can customize pools and access the modular pooling benefits. Each user can capitalize on either private, smart, or communal pools.

Owners of liquidity pools can only have entire power over offering liquidity and altering parameters in addition to making changes in the private pool. Unlike private pools, the setup and specifications of a shared pool are fixed. On top of trading fees, you can get native BAL tokens to further your returns.

PancakeSwap — DeFi Protocol

PancakeSwap is a fast decentralized exchange targeting the Binance Smart Chain decentralized network and associated tokens. Investors and traders here can benefit from BEP-20 pools coming packed with lower gas fees [compared to ERC-20 on Uniswap and Balancer]. Most pools offer higher rewards and lower gas fees. However, the liquidity suffers a bit as the network is less popular than its originator Ethereum.

Final Thoughts

Liquidity mining allows the monetization of bitcoin and other crypto assets passively. However, such an investment approach entails some industry-specific risks you should consider in advance. We advise getting prior knowledge about what liquidity mining is, how it works, all ins and outs of providing liquidity, and more details before actually diving into pools on decentralized exchanges.