What is liquidity mining and how does it work?

What is liquidity mining?

Liquidity mining is a way for users to earn extra income with their crypto through a protocol within decentralized finance (DeFi), by making their crypto available in exchange for rewards. These rewards often consist of additional tokens, paid out as a share of transaction fees or as governance tokens.

Users can provide liquidity within DeFi to help other users trade tokens smoothly within the protocol. Within DeFi, everything operates in a decentralized manner, which means that liquidity is also provided by users rather than centralized liquidity providers and market makers. In return for their help, users receive additional tokens as rewards. Liquidity mining occurs across various DeFi applications, such as decentralized exchanges (DEXs) and lending platforms.

Liquidity mining is part of yield farming, an umbrella term for ways to generate additional income through DeFi. Within yield farming, this can be done, for example, by providing liquidity to liquidity pools (liquidity mining) and by lending crypto (crypto lending).

Key Takeaways

• Liquidity mining is a way to earn additional returns within DeFi by making crypto available to a protocol in exchange for rewards.
• Users who add liquidity to a liquidity pool (liquidity providers) receive rewards in the form of transaction fees and sometimes additional tokens, such as governance tokens.
• Liquidity mining plays a crucial role in the functioning of decentralized exchanges, as liquidity is fully provided by users rather than centralized parties.
• Rewards and returns from liquidity mining can vary and depend on factors such as trading volume, token prices, and the protocol’s incentives.
• Liquidity mining involves risks, such as impermanent loss, smart contract risks, and potential additional costs like gas fees, making thorough research essential before participating.

How does liquidity mining work?

Liquidity mining works through liquidity pools within DeFi solutions. A liquidity pool is a collection of different cryptocurrencies stored in a smart contract. You can think of it as a trading pair, where liquidity is provided by users. Such a liquidity provider is referred to within DeFi as a liquidity provider, also known as an LP provider.

It works as follows:

• A user deposits one or more tokens into a liquidity pool within a DEX or lending platform.
• During this period, the tokens are locked in the smart contract, meaning the LP provider cannot freely access them until the tokens are withdrawn.
• The liquidity pool is used to facilitate transactions, such as swapping tokens or issuing loans.
• In return for their contribution, liquidity providers receive LP tokens, which represent their share of the pool.

As long as the tokens remain in the liquidity pool, users receive rewards. These rewards can consist of transaction fees paid by other users and additional tokens issued by the protocol to incentivize participation.

Examples of liquidity mining

A well-known example of liquidity mining is providing liquidity to a DEX pool such as ETH/USDC, a commonly used trading pair on decentralized exchanges. Liquidity providers deposit both tokens in equal value into the pool and receive LP tokens representing their share. In return, they earn a portion of the transaction fees paid by traders. Additionally, rewards may be paid out in the form of ETH, USDC, or other tokens, depending on the protocol.

Some protocols distribute their own token as an additional incentive to attract liquidity. This is often done with a higher APY to make participation more appealing. A well-known example of this is Uniswap, which previously distributed the UNI token to liquidity providers to encourage platform usage and decentralize governance.

In addition, lending platforms use liquidity mining by rewarding users for making assets available that can be borrowed by other users. When users deposit stablecoins or other crypto assets, they earn interest and sometimes additional rewards in the form of protocol tokens. An example of this is Aave, where users earn interest on lent assets while also receiving AAVE tokens as an incentive.

Role of decentralized exchanges (DEXs)

Liquidity mining is crucial for decentralized exchanges (DEXs). Unlike centralized exchanges, DEXs do not operate with order books but instead rely on liquidity pools filled by users. These users enable DEXs to execute transactions. This is often done through automated market makers (AMMs). AMMs ensure that transactions are executed automatically and determine prices based on supply and demand.

Without sufficient liquidity, transactions would become more expensive and less efficient. This is one of the reasons users are incentivized to lock their tokens in a liquidity pool through liquidity mining, where rewards are distributed.

Advantages of liquidity mining

Liquidity mining comes with several advantages:

• The ability to earn additional returns with crypto through DeFi platforms by making assets available as liquidity.
• Earning extra tokens, such as governance tokens, which can give users influence over the protocol by allowing them to participate in decision-making.
• Contributing to the liquidity and efficiency of DeFi protocols and decentralized exchanges.
• Encouraging a more decentralized and fairer token distribution.

Disadvantages of liquidity mining

Liquidity mining also involves several risks:

• Risk of impermanent loss when the price ratio between tokens in the liquidity pool changes.
• Fluctuations in the value of reward tokens, making returns unpredictable.
• Exposure to smart contract risks, such as programming errors or security vulnerabilities.
• The complexity of DeFi protocols, which can make it difficult for beginners to properly assess risks.
• Possible additional costs, such as gas fees, which can reduce overall returns.

Final thoughts

Liquidity mining is an important part of the DeFi ecosystem and plays a crucial role in the functioning of decentralized exchanges and lending platforms. By providing liquidity, users can earn additional returns and contribute to the efficiency and accessibility of DeFi protocols. At the same time, liquidity mining comes with specific risks, such as impermanent loss, smart contract risks, and unpredictable returns. Therefore, it is important for users to fully understand how liquidity mining works and the risks involved before deciding to participate.