Summary
Liquidity mining is the practice of using personal cryptocurrency assets to earn passive income or yield. Typically, in exchange for rewards, liquidity miners provide liquidity to DeFi protocols, or lend or stake their cryptocurrency assets. Some liquidity miners do all of the above. Like all cryptocurrency investment opportunities, liquidity mining comes with risks. Liquidity miners face risks such as impermanent loss, smart contract or protocol vulnerabilities, and excessive gas fees.
Therefore, before investing funds into liquidity mining, miners must conduct in-depth research. Common research methods include investigating the project team, security, token type, and timelines associated with the investment. Although doing your own research (DYOR) cannot completely prevent cryptocurrency losses, it can help reduce risks.
Introduction
The simplest form of liquidity mining uses idle cryptocurrency assets to earn cryptocurrency interest. Relying on smart contracts, holders can lend their cryptocurrency to others and receive returns. In the decentralized finance (DeFi) ecosystem, users can earn cryptocurrency income in several ways, the most common of which are:
Lend assets using cryptocurrency lending protocols.
Staking cryptocurrency on a protocol.
Become a liquidity provider (LP) for DeFi protocols (such as decentralized exchanges (DEX)) and earn LP rewards (see LP token section).
Many liquidity miners will use one or more of the above methods to establish a passive income stream. However, like other DeFi investment opportunities, liquidity mining also comes with risks. Whether you intend to become a liquidity miner or are simply interested in the mechanism of liquidity mining, it is necessary to conduct due diligence.
The risks of liquidity mining
Impermanent loss
Impermanent loss is perhaps the most prominent risk of liquidity mining and the entire DeFi space. When cryptocurrency holders participate in liquidity mining, they typically lock up their cryptocurrencies for a period of time, reducing the liquidity of these assets.
Impermanent loss occurs if the price of the tokens you hold changes from the price at which you deposited them into the pool. Regardless of which direction the price goes, the greater the change, the greater the loss.
While liquidity mining income can offset this loss, this is not always the case, and liquidity miners may face significant risks from impermanent loss. For more information, please refer to our help article "In-depth explanation of impermanent loss".
hacker attack
Since smart contracts are responsible for controlling DeFi protocols, a vulnerability in the smart contract code could cause the value of the corresponding token to plummet to zero. This risk is exacerbated if hackers exploit the vulnerability or security issue to maliciously manipulate the project.
Fraud
A bad actor with the right skills can create a DeFi platform and pass it off as a legitimate yield farming site. After all, DeFi projects are open source, transparent, and permissionless, meaning anyone can copy the underlying code and create a new project. While early adopters often receive greater rewards, think twice before participating, as high returns come with high risks.
Newly launched liquidity mining platforms can be more difficult to research as there are often limited user reviews and information available. You need to be especially cautious with these platforms as if you change your mind after committing your crypto holdings to such a platform, you may not be able to withdraw or claim your rewards.
Fuel costs are too high
Normally, network congestion leads to higher gas fees. This unprecedented price surge will affect liquidity miners with less invested capital, as the earnings they earn may not be enough to cover the gas fees. Even if they choose to store their assets in a pool, other risks such as impermanent loss and forced liquidation may still affect them.
Common DYOR methods
Securities
Ensuring the security of liquidity mining and DeFi protocols is critical to preventing malicious attacks. To reduce the risk of such attacks, liquidity miners must ensure that the smart contract code has been audited by a trusted source, that is, look for DeFi projects that have conducted a comprehensive audit of their smart contracts.
Countless DeFi projects, such as UniSwap, originated from successful DeFi protocol forks. However, many DeFi projects have failed due to network effects or lack of liquidity. Even worse, some projects are even deliberately created scams. For example, a fraudulent team may create a fork to attract liquidity and then disappear with the newly absorbed tokens.
It is also important to understand the total locked value (TVL) of the project, which refers to the total amount of money currently locked in the protocol. If the TVL indicator is suspiciously low, it means that less funds are currently locked in the protocol, which in turn means that liquidity miners can earn less.
Token
Different pools can provide different investment opportunities in various assets, including stablecoins and blue-chip tokens (i.e. tokens from mature blockchain projects such as Bitcoin and Ethereum). Protocols can also distribute their own tokens to stakers and liquidity providers.
It is important to keep in mind that protocols can use their tokens for services in many ways. For example, a protocol can use its tokens as a marketing strategy to attract more users. Therefore, you should always be clear about the currency you will receive from liquidity mining.
Timeline
To increase liquidity, new DeFi protocols often offer more generous rewards to early adopters. This reward also acts as a risk incentive, which encourages users to earn high rewards by investing in and using new or untested products or services.
However, while early adopters may earn more lucrative returns, they may also face a high risk that the liquidity mining protocol may fail, in which case the money and time invested may not be recovered.
Liquidity miners should carefully weigh their options and take all factors into account with other opportunities. Because token prices may fall due to inflation, new DeFi protocols cannot provide miners with sustained high rewards in the long term, especially when they use native tokens as reward currencies.
team
When browsing project information, please pay attention to major liquidity mining websites for errors. If there are errors, it indicates that the team may be careless or even have fraudulent intentions. Ideally, your website should be well designed, have no typos or broken links, and look professional. Additionally, you can check whether the project team undergoes regular audits by an external independent auditor to assess whether the team is reliable.
A healthy, balanced project team should consist of entrepreneurs, product managers, developers, software engineers, marketing specialists, and financial experts. It would be even better if there are well-known advisors on the project board.
If possible, you can also research individual team members. First, check their social media accounts to learn about their past achievements and activity on platforms such as LinkedIn, GitHub, Reddit, TradingView, and YouTube.
The way they interact on social media can indicate their skills, experience and influence. Generally speaking, established groups with a good reputation are less likely to commit fraud.
Conclusion
For users who are good at effective risk management, liquidity mining can be a viable passive income strategy. However, given the high volatility of liquidity mining and the entire cryptocurrency market, developing a reliable liquidity mining strategy requires both vigilance and a lot of time and effort.
If you are considering participating in liquidity mining, the above methods can be used to reduce risk. In addition, you should thoroughly research and conduct due diligence before investing in any financial opportunity.
Further reading
What exactly is liquidity mining in decentralized finance (DeFi)?
A Beginner's Guide to Decentralized Finance (DeFi)
A Beginner’s Guide to Earning Passive Income with Cryptocurrency
Why and How to Do Your Own Research (DYOR) When Investing in Cryptocurrency
Disclaimer and Risk Warning: The content of this article is factual and for general information and educational purposes only. It does not constitute any representation or warranty. This article should not be construed as financial advice and does not recommend that you purchase any specific product or service. For more information, please click here to read our full disclaimer. Cryptocurrency prices can fluctuate. The value of your investment may go down or up, and you may not get back your original investment. You are solely responsible for your investment decisions and Binance Academy is not responsible for any losses you may incur. This article does not constitute financial advice. For more information, please refer to our Terms of Use and Risk Warning.
