What is the purpose of liquidity mining?

Before the development of decentralized finance, crypto holders could profit only from keeping assets on the exchanges, trading them or storing them in cold wallets. Users were limited to either learning how to day trade or profit from HODLing. However, liquidity mining changed everything. Let’s find out more about it.

Definition of crypto liquidity

In terms of cryptocurrency, liquidity refers to how easy it is to convert cryptocurrency into cash or other assets. The higher it is, the faster you can swap a specific token on the exchange. Since platforms obtain orders from sellers and buyers, the high liquidity of assets accelerates and simplifies the transactions. 

How to provide liquidity to cryptocurrency exchange?

Decentralized finance made it possible to obtain passive profits through lending to the newly built platforms. Now, traders can use their assets as liquidity on the decentralized exchanges, lending protocols, or liquidity pools on other types of protocols. This means of passive income is referred to as liquidity mining. Generally, it is restricted to a certain number of months or years — the time required to activate the protocol. 

Liquidity providing involves lending assets to decentralized exchanges in return for specific rewards (such as governance tokens and trading fees). The size of reward differs based on the user’s proportional share in a liquidity pool. The average fee received by liquidity providers is 0.3% per swap. 

Characteristics of cryptocurrency liquidity on the automated market makers

Liquidity providing is an essential part of the automated market maker system. Instead of matching buy and sell orders, decentralized exchanges (for example, Uniswap), provide the liquidity of cryptocurrency by encouraging users to lend assets to the DEXs. In return, traders receive a part of the trading fees. 

On decentralized exchanges, LPs need to provide a pair of tokens of the same value. If you have 4 ETH worth $10,000, you need to add a digital equivalent — 10,000 USDT. After receiving liquidity, Uniswap will distribute it among traders who contributed to the ETH/USDT liquidity pool. The size of the reward will depend on the trader’s proportional share in a liquidity pool.

This contributes to a win-win relationship between all parties: decentralized exchanges get liquidity, LPs obtain trading fees, and end-users receive an opportunity to trade in a decentralized fashion. 

Impermanent loss explained

As well as trading and investing, liquidity mining always entails risks. The high market volatility makes it complicated to stay profitable in the market. Therefore, in order to profit from liquidity mining, you should always monitor the market. Impermanent loss is especially significant. 

Impermanent loss is easy to define but difficult to calculate. It is a loss that the traders have to incur when the value of the assets they have deposited changes between the time of deposit and withdrawal.

If an asset lent to the decentralized exchange gains too much value in a short period of time, the user is at risk of losing profits. For instance, tokens like ETH may double in value in a matter of days. In such case, the opportunity costs for liquidity provider will be high, and the reward will not offset the losses. 

But don’t forget that the negative financial consequences only temporary. Moreover, losses are only realized when you withdraw your tokens from the liquidity pool. Impermanent loss can be avoided if the market rebounds to the initial price. Failing this, liquidity providers are obliged to withdraw their assets from the liquidity pool and realize their impermanent loss. 

Because of the high volatility of assets, impermanent loss is virtually inevitable.

Conclusions

Liquidity mining allows users to earn passive income in the cryptocurrency market. It has existed from the very beginning of DeFi. Liquidity mining helps crypto owners to profit by using their assets instead of leaving them inactive in the hardware wallet. Liquidity providers lend assets to the DEX and in return, the platform distributes trading fees to each of them proportionally. 

However, recently, the cryptocurrency market has shifted to yield farming — a new but already popular means of passive investment. Even though yield farming and liquidity mining have much in common, there are many differences between these two concepts. For example, yield farming is focused on maximizing the annual percentage yield instead of maintaining the functioning of the DeFi protocols.