Liquidity mining allows users to not only earn handling fees and platform reward tokens by depositing cryptocurrency assets into a liquidity pool, but also supports the operation of decentralized exchanges. But liquidity mining is not just a simple process of earning passive income, it involves multiple risks such as market fluctuations, smart contract risks, and impermanent losses.
Therefore, this article (Crypto City) will provide an in-depth introduction to the operation and main risks of liquidity mining to help investors fully understand and make informed decisions before participating.
What is liquidity mining?
Liquidity mining is a decentralized finance (DeFi) mechanism in which participants provide liquidity to a decentralized exchange (DEX) by locking two cryptocurrencies in a liquidity pool. These participants are often referred to as "Liquidity Providers (LP)". They will receive liquidity pool tokens (LP tokens) in return and earn transaction fees or other rewards through these tokens. .
Simply put, a liquidity provider will deposit two or more cryptocurrency tokens of "equal value" into a liquidity pool at the same time. The assets in the pool will be used to provide liquidity to other users and help them in Token transactions are conducted quickly on the platform.
Liquidity provider LP can obtain fee income from other users’ transactions; in addition, some liquidity pool platforms will also issue additional reward tokens. These tokens may include the platform’s governance tokens, allowing users to participate in the platform. governance decisions.
From this point of view, the main difference between liquidity mining and cryptocurrency mining lies in its operation method and source of income. The threshold for liquidity mining is low. Users only need to provide assets to decentralized exchanges and support transactions within the liquidity pool to earn handling fees and token rewards; while cryptocurrency mining relies on computing power for verification. Transact on the blockchain and receive block rewards.
If you want to learn more about other cryptocurrency mining methods, read our mining guide.
How Liquidity Mining Works
Liquidity mining works as follows:
1. Choose a platform and liquidity pool
Users first need to choose a decentralized exchange (DEX), such as Uniswap, PancakeSwap or SushiSwap.
Liquidity pools usually consist of two cryptocurrencies (such as ETH/USDT), and users need to choose the appropriate pool based on their risk appetite and expected returns.
2. Provide liquidity
After selecting a liquidity pool, users deposit two tokens of equal value into the pool. These tokens provide the platform with the liquidity required for trading, ensuring that traders do not encounter illiquidity issues when conducting token swaps. Usually, liquidity providers need to provide equal amounts of two tokens (such as Ethereum and USDT) so that transactions can proceed smoothly.
3. Earn rewards
Liquidity providers can earn revenue in two main ways:
Transaction fees: Whenever a trader trades in a liquidity pool, the platform charges a small transaction fee and distributes it to liquidity providers proportionally.
Platform LP reward: In return for providing liquidity, the platform will give liquidity providers "Liquidity Provider Tokens" (LP Tokens). These tokens represent a user’s share of assets in the liquidity pool and can be used to earn transaction fees or other rewards from the platform.
What are the benefits of participating in liquidity mining?
Financial platform Finbold analyzes that liquidity mining offers investors a relatively simple way to earn passive income on their crypto assets.
Here are some of the main advantages of liquidity mining:
passive income sources
Governance participation rights
Increase cryptocurrency liquidity
Lower threshold for participation
Liquidity mining allows investors to deposit idle cryptocurrency into a liquidity pool to earn transaction fees and reward tokens issued by the platform. This is an effective way to earn stable passive income by providing liquidity, especially in markets with high liquidity needs.
Liquidity mining offers diversified revenue streams and the opportunity to participate in decentralized governance, making it an attractive option for investors looking to create passive income in the DeFi space. However, investors still need to be aware of the risks and carefully manage their investment strategies based on market conditions.
Liquidity Mining vs. Yield Farming
Liquidity mining and yield farming (Yield Farming) are two DeFi strategies that are often confused, but they actually have key differences.
Liquidity mining is a form of yield farming that focuses on providing liquidity to decentralized exchanges; while yield farming is a broader DeFi strategy in which users lend or provide cryptocurrency to various Decentralize the platform and thereby gain benefits, which can include providing liquidity, lending, and even participating in platform governance.
Compared with liquidity mining, the income mainly comes from transaction fees and LP coins; the scope of income farming is wider and the strategies are more diverse. The source of income may come from the returns of other DeFi protocols such as lending and staking.
So don’t get confused when you see these two words next time. (CryptoCity) has organized the differences between the two strategies into the following table:
feature
Liquidity mining
Yield Farming
Conceptual users deposit two tokens of equal value into the liquidity pool of a decentralized exchange and receive transaction fees and platform reward tokens. Lending or providing cryptocurrencies to multiple DeFi protocols to earn yield is broader than yield mining. Revenue comes from transaction fees and additional token rewards provided by the platform (such as governance tokens). Loan interest, staking rewards, liquidity mining income and other sources. Risks include impermanent losses, smart contract risks, and platform security risks. Smart contract risks, impermanent losses, platform risks and market fluctuation risks. Flexibility is mainly targeted at specific liquidity pools and has low flexibility. Assets can be dispersed across multiple platforms, with diverse strategies and high flexibility. The main purpose is to provide liquidity on decentralized exchanges and ensure smooth transactions. Comprehensive application of multiple strategies, such as lending, staking and liquidity mining.
Source: (CryptoCity) Chart Comparison of the differences between liquidity mining and revenue farming
List of popular liquidity mining platforms
The market for liquidity mining will remain active and diverse in 2024. Here are some popular liquidity mining platforms suitable for users to participate and earn income:
Platform name
Main features
Source of income
handling fee
Uniswap is a decentralized exchange that supports a large number of ERC-20 tokens. It charges 0.3% transaction fee, transaction fee, and platform token reward of 0.3%. Curve Finance focuses on stablecoin transactions, with low slippage, and is suitable for stablecoins. Exchange between stablecoins Low slippage handling fee of 0.04% - 0.4% Transaction fee, depending on the pool type Balancer supports custom liquidity pools, allowing multiple token combinations, providing flexibility to customize the trading procedures of the pool Fees and token reward fees are flexible and set according to the liquidity pool. PancakeSwap is based on the Binance Smart Chain, with low transaction fees, suitable for small investors. Low transaction fees and platform token rewards of 0.2%. Transaction fees Bancor uses a smart token system , supports cross-chain asset exchange, reduces volatility risk, smart token transaction fees, cross-chain rewards 0.1% - 0.5% transaction fees
Risks of Liquidity Mining
In liquidity mining, although passive income can be earned, there are many risks in the process. The following are the main risks faced by liquidity mining:
Smart contract risks come from the possibility of smart contract vulnerabilities or hacker attacks, which may lead to theft of funds. Once the contract is deployed, it cannot be changed and the risk is difficult to reverse.
Platform risk means that some unreliable DeFi platforms may shut down suddenly, causing investors to lose funds. Choosing a platform with audit guarantee can reduce this risk.
Market volatility risk is associated with severe fluctuations in the cryptocurrency market, especially when participating in high-volatility token pools, where the value of the asset may be significantly reduced.
Low liquidity risk occurs when there is insufficient liquidity, and you may face high slippage when exiting assets, resulting in trading losses.
Regulatory risks stem from the lack of protection of the DeFi platform by the legal framework, and future regulatory changes may affect the operation of the platform.
But what we want to remind you most is the risk term that you must know when participating in liquidity mining: "impermanent loss".
The impermanent loss of liquidity mining
Impermanent Loss is a risk in liquidity mining, which occurs when a liquidity provider deposits assets into a liquidity pool. Due to changes in asset prices, the value of the assets held decreases.
Specifically, when the prices of two tokens (such as ETH/USDT) in the liquidity pool fluctuate, the proportion of assets will be adjusted accordingly. If the price of one of the tokens rises or falls relative to the other, arbitrageurs will take advantage of this price difference to trade, thereby changing the distribution of tokens in the pool, causing the liquidity provider's holdings to decrease in value.
Impermanent losses are called "impermanent" because such losses may decrease or disappear as market prices recover as long as the liquidity provider does not withdraw from the pool. But if liquidity providers withdraw assets when prices are volatile, the losses become permanent.
Let’s say you deposit 1 Ethereum and 1,000 $USDT into a liquidity pool on a decentralized exchange (DEX). When you deposit these assets, the price of Ethereum is 1 Ethereum = 1,000 $USDT, so you are providing a total of $2,000 $USDT worth of liquidity (1 Ethereum + 1,000 $USDT).
Next, assume that the price of Ethereum rises to 1 Ethereum = 2,000 $USDT. At this point, the liquidity pool will automatically rebalance the ratio of Ethereum to USDT to reflect market demand. Arbitrageurs will buy cheaper Ethereum until the price in the liquidity pool matches the market price. As a result, you will have approximately 0.707 Ethereum and approximately 1,414 $USDT left in your liquidity pool.
If you choose to exit the liquidity pool at this time, you will get back 0.707 Ether and 1,414 $USDT, which totals approximately 2,828 $USDT. Compared to if you simply held 1 Ethereum and 1,000 USDT, their total value would now be 3,000 $USDT. Therefore, you lost 172 $USDT by participating in the liquidity pool, which is the so-called impermanent loss.
Simply put, impermanent losses occur because price changes cause the proportion of assets in the liquidity pool to change, and arbitrageurs take advantage of this price difference to trade, reducing the number of assets you ultimately hold.
How to reduce the risk of liquidity mining?
Strategies to reduce the risk of liquidity mining mainly focus on managing impermanent losses, smart contract vulnerabilities and choosing reliable platforms. CoinGecko, which specializes in information in the cryptocurrency field, proposed that the following specific methods can reduce the risk of liquidity mining:
1. Select a stablecoin pool
Impermanent losses caused by large price fluctuations are one of the main risks in liquidity mining. Therefore, try to choose a liquidity pool with stable coins (such as USDT, USDC), which can reduce the risk of market fluctuations because of stable coins with relatively stable prices. and bring about impermanent losses.
2. Use vetted smart contracts
Smart contract vulnerabilities are another risk. When participating in liquidity mining, you should choose a DeFi platform that has been reviewed by an independent third party to ensure the security of smart contracts.
3. Invest in more than one liquidity pool
Diversifying risks is an effective strategy to reduce losses. Instead of investing all your funds in one liquidity pool, choose to diversify your investments across multiple liquidity pools and platforms. This can reduce losses caused by the failure of a single asset or platform.
4. Choose a pool with high liquidity
Choosing a high-liquidity pool can reduce the risk of slippage and ensure that there will be no drastic fluctuations in asset value due to insufficient liquidity when trading.
In summary, liquidity mining, as an investment strategy in decentralized finance, provides investors with the opportunity to earn passive income while also participating in the governance of the platform and supporting the development of the DeFi ecosystem.
Investors should carefully evaluate various risks when selecting a liquidity pool, and reduce potential losses through diversified investments and choosing reliable platforms. Only with an in-depth understanding of the operating mechanism and good risk management can the benefits of liquidity mining be maximized while ensuring the safety of funds.
