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What is liquidity mining, and how does it work?
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Before the emergence of decentralized finance and DeFi platforms, users could only access liquidity by exchanging some assets for others. But DEX-exchanges presented crypto-holders with a new way to generate revenue by adding their cryptocurrencies to the common pool. In this article, we will explain what liquidity mining is, how it works, how it allows users to make money, and take a close look at the risks of this new scheme.
What is market liquidity?
Understanding the liquidity mining mechanism is important to understand what liquidity is and how it works. Liquidity is a set of all trading offers with exchanges and brokers. That is, liquidity determines how quickly you can buy or sell an asset at the best possible price, with minimal loss.
Liquidity has three main properties:
Speed. It determines how fast orders are executed. If liquidity is too low, delays occur: limit orders can take hours, days, or even weeks to get executed. A vivid example is Dogecoin (DOGE). Try placing a limit order at the current price on some exchange and record the time to check how long execution will take. And then try to sell it again. For highly liquid pairs, the execution of orders takes seconds or even milliseconds.
It is necessary to distinguish between the platforms’ and trading pairs’ liquidity. Binance is one of the most liquid crypto exchanges out there, but it also has weakly traded pairs, for example, DENT/USDT or IDEX/USDT. In other words, even the largest platforms have low-liquidity pairs.
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. Slippage means that even having an order placed (e.g., Stop-Limit order) does not guarantee its execution in case of high trading activity on the exchange: 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.
To summarize, the higher the liquidity, the lower the spread, the faster the orders are executed, and the less likely they are to slip.
So who provides market liquidity?
Depending on the platform’s operating principle, liquidity is provided by traders or organizations – banks or exchanges. They are called liquidity providers. On crypto exchanges, they are usually the users themselves, who place orders to buy and sell. In other words, trading on crypto exchanges is person-to-person or P2P trading. You may have heard of it – Binance has a separate section for P2P trading.
However, this does not mean that the exchange can not interfere with the trading process. For example, if the plan is to open large short positions and turn the market around. In this way, you can manipulate the market, make profits by betting on the fall of rates, and raise revenue through commissions. But this is a dirty game, and legal platforms do not normally resort to this. If the exchange supports OTC trading, then the liquidity provider here is either the exchange itself or other institutional investors.
Brokers do not provide liquidity – they only provide access to trading on various exchanges, and liquidity is supplied to them by exchanges, banks, and other organizations, in particular, private investors. When you exchange currency with a bank, you buy and sell it to that bank. Hence, such high spreads are determined by the organization itself.
It was a lengthy but necessary intro, and now it is time to move on to the main topic: what is the point? The point is that it does not matter who acts as a liquidity provider – an exchange or a trader, the commissions are always earned only by exchanges.
It was the first time in the history of finance when liquidity mining allowed ordinary users to find themselves on the other side of the market.
What is liquidity mining?
Liquidity mining is a way of organizing the market where the exchange and the token issuer reward the community for providing liquidity. Miners generate revenue depending on the share of commissions paid by traders or investors, price spread, and the orders’ lifetime. It is not necessary that the platform only accommodates cryptocurrency trading. The same is applicable to an investment in crypto startups or lending. But most often, this approach is popular among automated market makers (AMM). All participants “drop” their tokens to a common pool, called a liquidity pool.
The figure below illustrates how remunerations are accrued to market makers.
What affects liquidity mining profitability
If you had already heard of liquidity mining and even participated before it became mainstream, you are sure to be aware of how high interest rates were, back in the day. Some places, like Binance, offered a remuneration of between 50% and 100% per annum, and some other platforms offered up to several thousand percent.
Sounds insane? In fact, this was true. The essence is that the yield directly depends on supply and demand, that is, the market balance. Only if, in the case of trading, when the demand for a cryptocurrency increases, its price rises, but in the case of liquidity mining, there is an inverse dependence: the more miners, the lower the yield is, just like with staking.
As a result, there was a high demand for trading in the first days of liquidity mining, while the liquidity pool was tiny. This allowed a small group of people to “skim all the cream off the top.” The number of miners was growing gradually, and the cherished piece of pie was turning too small for everyone to share. People were more willing to freeze their tokens than to trade on exchanges. Why trade when you can just freeze your tokens and receive interest without risk? That’s what they thought, but the main thing here is a high interest rate and a completely passive approach to earning. However, many people are mistaken about the risks: they are not insignificant, but we will talk about that later. As a result, the number of miners was much higher than the number of traders, and interest declined to 10% – 20% per annum, although it’s still quite a high figure, especially compared to the equally risky staking and lending.
Interesting fact: there is a DeFi platform and is an automatic market maker, Cream, the name of which reflects the essence of liquidity mining. This can be interpreted very symbolically:
Earn Cream interest = skim the cream
Liquidity mining risks
So, we’ve covered the principle of liquidity mining. And what about the risks? It’s time to talk about the most important thing. Warning: you may be shocked and discouraged by some things, so get ready.
Since we have previously highlighted this, let’s not test your patience. So, the main risk of liquidity mining is … drum roll …
A smart contract can withdraw any amount of any token from your address at any time.
Unexpected? Yes, and this is encoded in many smart contracts, although not all of them. Cases have already happened where a user opened his wallet and found out that all his tokens had disappeared. In fact, smart contracts can withdraw funds even ten years later, when you will hold thousands of dollars or even more in your wallet. And the users themselves give them such rights, so when investing, always read the agreement carefully.
What’s the solution?
Of course, large AMMs like Uniswap or Maker are unlikely to do such a thing, but fresher and more inconspicuous ones may, which already happened with Cyberchain. Therefore, avoid dubious projects and treat risks consciously, especially if the smart contract has not been audited. Also, read the agreement carefully – there may be a clause on withdrawal of funds, or you might find some other shaky points.
If you added your tokens to the liquidity pool, then after the withdrawal, send tokens to another wallet, which you have not yet used, and do not deposit any funds to the old one. This way, your tokens will stay safe. Be sure to use separate wallets for each new project. You can’t always know what’s in the code of a smart contract and what the outcome may be.
Another risk lies in smart contract vulnerability. Many projects launch their platforms in a rush and don’t spend more than a month on development. This is too little time dedicated to test, detect, and fix all possible vulnerabilities. Because of this, hackers can detect backdoors and simply withdraw all the funds at once.
What can be done?
Unfortunately, even comprehensive outsourcing cannot guarantee that there are no vulnerabilities in the source code. Therefore, you need to follow the basic rules of risk management: invest only the amount you are willing to lose. Also, try not to invest all your funds into a single project. This way, you will save most of your funds if hackers manage to attack tokens of one of the projects.
Another risk is an impermanent loss. These losses occur periodically when the rate of one of the provided crypto assets is unstable; for example, the ETH/DAI pair on Uniswap or BNB/BUSD pair on Binance. The point is that the Liquidity Provider (LP) must provide the pair in the correct ratio, which is 50/50. If this equilibrium is broken because of the rise of one of the cryptocurrencies, the profit is taken away from LP.
Let’s use an example: let’s say a holder provides ETH/USDT for Uniswap at a 50/50 ratio. But if the price of ETH on third-party platforms starts to rise relative to Uniswap, then arbitrators come into the game, notice the difference, and use this opportunity to buy cheaper Ethereum to make a profit. That is, for the same amount of USDT, the arbitrator buys, for example, not 1 ETH, but 1.05 – the balance is broken. And then instantly sells for USDT. The arbitrator’s profit will be taken away from LP. However, this loss is only theoretical for now, and until the liquidity provider withdraws his tokens, he technically hasn’t lost anything. The loss is reset when the ETH price returns to previous levels. That is why the losses are called impermanent.
Liquidity mining allows you to earn cryptocurrencies passively and receive income higher than the interest on deposits and even PoS-staking. However, this method has its own risks, which are not found in other types of mining, so you should be careful while providing tokens to the liquidity pool, especially if the project promises high returns. Always carefully check the platforms and read the agreement to avoid unpleasant surprises.
Disclaimer: The contents of this article are not intended to be financial advice and should not be treated as such. 3commas and its authors do not take any responsibility for your profits or losses after you read this article. The article has been presented to provide readers with general information. There is only personal experience described herein. The user must do their own independent research to make informed decisions regarding their crypto investments.