What is DeFi Liquidity Mining?

If you are a crypto trader, you may have heard of the concept of liquidity mining, but are not sure what it is or how it actually works. Some traders claim to have great yields and passive income generated through liquidity mining, and in this article, we will have a look into this. 

We will show what liquidity mining actually is, how it works, explain the importance of liquidity pools, and analyze the benefits and potential drawbacks of this concept.    

What is liquidity mining? 

Liquidity mining is a yield farming method performed with the help of an automated market maker (AMM). An example of an AMM is Uniswap. 

This is how it works: it activates a protocol that offers trades between traders and a liquidity pool. Liquidity providers maintain this liquidity pool, and in the case of a decentralized exchange (DeFi), the traders themselves provide liquidity. It basically revolves around using your assets to work for you and earn money. We willingly put our funds into the pool, which then charges other traders for fees. A part of it comes back to you and earns you interest over time.    

Yield Farming vs. Staking vs. Liquidity Mining 

All of these actions have some common points and are interrelated. Staking, in the most general sense, is having a specific cryptocurrency and earning rewards from it. Why are there rewards? Because in staking, each active member helps the network stay safe by providing a proof of stake for each transaction. 

Yield farming is any method of investing funds and getting interest – an annual percentage yield (APY). This means that DeFi liquidity mining is a kind of yield farming, in which you earn passive profit by providing liquidity to decentralized exchanges. If you are still up for regular mining, 2022 brought a number of phone mining apps, and we recommend having a look at this guide, describing the best apps to mine crypto right now. 

How Does Liquidity Mining Work  

We put our crypto funds into the market maker to help boost liquidity, and we earn a part of the trading fees that are charged from other traders. The amount that we earn depends on the portion of the trading pool we are providing, and the overall trading volume for that trading pair. For example, for a BTC and USDT pair, there is a $1 million liquidity, and your yield here is 5%-10% APY.

Remember that these rewards are not fixed, and the percentages are based on recent statistics of the trading volume. Since trading volume will change over time, your APY will be affected.  

Liquidity pools 

Crypto liquidity mining pools are pools where traders can put their assets to provide liquidity to each other, swap currencies, and earn interest. Liquidity makes transactions faster, and each pool is secured by a smart contract. 

Benefits 

Fair system with governance tokens 

Everyone can participate and get a hold of government tokens. This gives them a say in the future of projects and the decisions creators make. This is an inclusive and overall democratic system to be a part of. 

The importance of DeFi 

You probably know that DeFi revolutionized the market by bringing a symmetrical, fair game for investors, rather than an asymmetrical, bank-centered relationship. For our topic, the most important thing DeFi brought to traders was putting their crypto on exchanges, liquidity pools and other protocols, and allowing the traders to earn passive income. 

Right now, DeFi is transitioning into a new phase called 2.0, with thousands of new coin opportunities and improved technology. You can learn about some of the best new coins and get in touch with new DeFi 2.0 projects here. 

Low barrier 

Everyone can participate, even small investors. No matter how slight your contribution is, you can be a part of the community and get decent rewards.

Risks 

Impermanent Loss 

This is an inherent characteristic of every AMM, and it occurs when the price of the coins in the trading pair changes. There is a ratio or balance between the coins in a pair, and when that ratio gets affected, you as a trader experience impermanent loss. 

Why is this loss called impermanent? Because you are really losing money only if you take your crypto funds out of the liquidity pool. Your total profit can be seen as the total trading fees you earned minus the impermanent loss. You can use online calculators for this, where you see your potential impermanent losses based on how you think the coin would move. Also, volatility increases impermanent loss; that’s why having a stablecoin in your pair is always a good idea.

Leverage 

There is the option of leveraging when liquidity mining on some exchanges. By activating leverage, you increase your represented amount in the liquidity pool. 

This can increase your APY drastically, but it also greatly increases your risk. Leveraging introduces a liquidity price and increases volatility, which means all your investments will be closed if the price drops enough, and you won’t have enough to cover the loss. 

Rug pulling 

Rug pulling occurs when a coin creator bails out of the project, stealing all the investments. Unfortunately, this is not rare, so always make sure to invest in a legit and stable project.

 

Author: Sviatoslav Pinchuk, COO of TradeCrypto is a crypto journalist who simply bought some BTC for domestic needs in 2014 and then forgot about it till 2017. He got Etherium in 2017 by misclick and sold it in 2018 “just to try”. After losing 1 Florida house on XEM in 2018, Sviatoslav finally decided to trade reasonably. He is one of the most analytical and data-driven traders in the crypto industry.

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