June 26, 2022 - 6 min read
Prior to the development of Decentralized Finance (DeFi), the crypto community had limited means to leverage profits from their assets. The only two options were to be actively involved in day trading or be content with the HODL returns.
However, DeFi introduced a new way of gaining sustainable returns in the form of liquidity mining. DeFi liquidity mining enabled users to use their assets to provide liquidity to a Decentralized Exchange (DEX) in exchange for rewards. As a result, a new passive income source was established among crypto holders.
This article emphasizes the ins and outs of liquidity mining, along with the potential it carries and the risks it poses to the crypto community.
Liquidity mining simply means placing your crypto assets in liquidity pools to reap profits. Before jumping on what Liquidity Mining is, new crypto investors must be familiar with some terminologies. Let’s have a look.
Liquidity, in simple terms, means readily available cash. It can be a cash reserve or an amount of assets that a company can easily convert into cash. Thus, in liquidity mining, crypto investors lend their assets to liquidity pools, as liquidity is important in decentralized exchanges. It helps investors to earn passive income from crypto.
One major benefit of blockchain is that investors and traders can trade their currency without the help of a mediator such as a bank. Decentralized exchanges are platforms where crypto traders can trade their holdings via peer-to-peer transactions. They work on the principle of decentralization and, therefore, without the participation of central authority.
A liquidity pool is a reserve of digital currency that a group of cryptocurrency owners deposits in a decentralized exchange like Uniswap so that other participants can purchase these digital currencies. Cryptocurrency owners inject their currencies into DEXs in exchange for the rewards that the platform provides. They essentially lock the assets within a blockchain-based smart contract.
In essence, liquidity mining is a gateway for users to participate in decentralized networks by providing liquidity in exchange for rewards. It aids in solving market monopolization and the difficulty of verifying by using frequent order book snapshots. It also awards the users for the risks that they bear.
Decentralized financial applications require liquidity to host decentralized exchanges. Thus, users employ their assets to provide liquidity in exchange for stable returns from the liquidity pool. Whenever traders swap tokens in the decentralized exchange, they have to pay a certain fee (about 0.3% for exchanges like Uniswap) to carry out the transactions. These fees will be distributed among users who lent their assets to supply liquidity to the pool. The reward distribution is based on the contribution by the users to the total percentage of the liquidity pool.
Today, users are not limited to day trading and holding in order to make profitable returns from their share of cryptocurrency. They can easily use these assets to fund a passive source of income. They can add liquidity and stake assets on different decentralized exchanges and lending protocols. DeFi has made it possible to raise capital by lending assets to new trading platforms.
Traditional forms of accountability can have many flaws. The foundation of traditional finance is institutions, regulations, and centralization that basically depend on trust and confidence to operate. It can be enhanced and made more effective via decentralization. It is evident how DeFi and liquidity mining has changed the scene for crypto investors. DeFi paints a picture of a future when technology takes the place of institutions. With the use of technologies like AI, big data, cloud, and blockchain, DeFi enables the removal of the traditional centralized institutional arrangements associated with traditional finance. Below are some potential benefits of DeFi liquidity mining:
In liquidity mining, the yield is always proportional to the risks the users undertake. Thus, higher commitments will always bring about greater returns while increasing risks. Every user is compensated proportionately for their supply of liquidity to the decentralized exchange. It must also be noted that the risks are very subtle compared to the possible profits in liquidity mining.
Low Entry Barriers
Entering into the decentralized ecosystem and partaking in liquidity mining have minimal barriers. Users can supply any quantity of liquidity to the decentralized exchange (depending on the dynamics of the platform) and reap the benefits. The equal distribution of profits and low barrier of entry means that this type of investment technique is open to anyone.
Distribution of Governance
DeFi liquidity mining endows all types of investors with a fair opportunity to obtain native tokens. These tokens can be used for governance and to stake for greater returns. In addition, holding native tokens enables the liquidity providers to make changes and vote in the decentralized exchange system.
Crypto can be an extremely volatile market. Thus, there are always risks lurking with any kind of crypto investment. For example, one significant risk in DeFi liquidity mining is impermanent loss (IL).
Impermanent loss is an unrealized loss that happens when your investment in the liquidity pools changes what you first invested in. It happens whenever the price of a cryptocurrency, an asset, or both within the liquidity pool changes. Since it vanishes as soon as the prices of digital assets or currencies return to normal, it is known as an impermanent loss. However, if the liquidity pool investor decides to take his money out before prices stabilize, an impermanent loss could turn into a permanent loss.
Benefits from incentives like trading fees often help to reduce this risk, but the volatility of the cryptocurrency market makes liquidity providers more concerned about their deposits.
Users must also pay the opportunity costs when they deploy their assets to provide liquidity. The user runs the risk of not earning or even losing money if an asset in their chosen liquidity pool loses or acquires too much value after being placed. As an illustration, the value of the cryptocurrency used for liquidity mining may soar the next day. As a result, users may suffer losses that are far greater than the modest profits from liquidity mining.
Moreover, there are also some technical risks in the protocols that users should be concerned about. For instance, protocols are susceptible to technical errors. Rug pulls are also a possibility. When the developers of the liquidity pool and protocol choose to escape with investor funds, it is a form of fraud.
Lastly, it should be mentioned that smooth transactions depend on liquidity mining pools. Liquidity mining pools are the basis for an automated revenue generation platform. They might have a wide range of undiscovered uses as well. Before making an investment in the cryptocurrency market through a liquidity pool, one risk that must be taken into account is an impermanent loss because, if handled improperly, it can result in a significant loss.
By investing in liquidity pools of stable currencies or avoiding currencies with significant volatility, impermanent loss can be minimized.
You can earn cryptocurrency using DeFi liquidity mining and increase your income from interest on deposits. You should be cautious when providing the tokens to the liquidity pool because this method involves its own risks.
To level up and gain a deeper knowledge of all things related to the future of the cryptocurrency industry, check out the latest content in the Supra Academy section.
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