The cryptocurrency space is quickly evolving. We are seeing all kinds of ways for traders to earn cryptocurrencies that don’t involve traditional means. Liquidity mining is one of those ways. Liquidity mining is the predecessor to yield farming. Both methods reward traders for holding a particular cryptocurrency.
Before liquidity mining existed, traders would hold their tokens and crypto on hardware wallets or exchanges. The need to reward these holders came in the form of liquidity mining. Since exchanges depend on liquidity, they reward holders for providing liquidity to a particular token. Without liquidity, there is no way for an exchange to thrive.
As such, we are entering an era of marketplace liquidity. As to what liquidity mining is and how it works, stick around as we will paint the full picture. With all that out of the way, let’s begin.
What is Liquidity Mining?
Crypto mining is booming at the moment. Apart from GPU and ASIC mining, we’re seeing the emergence of other methods such as HDD mining and staking, yield farming, and liquidity mining. All of these work very similarly. The DeFi space is full of methods that reward traders for holding tokens and currencies. Before DeFi, these methods were unheard of.
- Liquidity mining exists because of DeFi (Decentralized Finance).
- Liquidity mining is a core principle of DeFi.
- Staking and yield farming are a form of liquidity farming.
Liquidity mining is the very first core principle of DeFi projects. DeFi protocols rely on liquidity to work. As such, liquidity mining means locking your crypto assets in DeFi protocols. Traders receive governing privileges in return. These rewards are usually trading fees. A trader must provide liquidity to a pool large enough to accommodate the needs of an exchange. As such, liquidity mining is usually on a greater scale. Staking, on the other hand, is a very similar method where traders also lock crypto assets but get rewarded in crypto. The only difference is that you don’t need to open a liquidity pool or contribute to one.
You can stake a very small amount and don’t have to enter a pool. While you certainly can, and we’re seeing that pool staking is much more rewarding than solo staking, it isn’t a must. Liquidity mining must be done in a pool. A single holder will likely fail to meet the liquidity demands for the exchange. Rewards typically range between 0.3% and 0.5% per swap.
And the last is yield farming. Yield farming is a popular method to get passive income. Yield farming works through a liquidity pool. When entering a liquidity pool, other users can borrow your crypto assets and you get rewarded in the form of APY. Staking vs liquidity mining is an ongoing topic of discussion as to which method is better for earning passive income.
Why is Liquidity Mining Good?
To summarize everything we’ve outlined in the previous point, here are the reasons why liquidity mining is good for everyone.
- Liquidity mining is essential for DeFi protocol
- It is the first form of passive income in the crypto mining space besides HODLing.
- Yield farming and staking emerge from liquidity mining.
- For liquidity mining to work, you need to join a liquidity pool and get rewarded per swap (usually 0.3%).
- Exchanges benefit from liquidity mining by receiving liquidity, while participants receive LP fees. The users who use the exchanges can trade thanks to the liquidity provided by the exchange.
In addition to all that, liquidity farming is becoming as good of a method to earn passive income as staking. However, with liquidity farming, holders also get an additional set of benefits.
Liquidity Farming Provides A Fair Way to Distribute Native Tokens
If you’ve ever taken an interest in ICOs, then you’re surely aware of their many drawbacks. An ICO is the very first form of cryptocurrency crowdfunding. While it does have its flaws, it is the most popular way to fund projects. With the popularity of ICOs emerged a need to make cryptocurrency funding better. For that, we have DAICO. While we won’t get into what DAICO is, what you should know is that the DAICO crowdfunding method is more secure for investors. You can read about DAICOs and ICOs here.
The funding issue with ICOs is that tokens are not distributed equally. ICO projects value institutional investors over retail investors. So one way to even the playing field is by investing through a liquidity mining pool. Even if liquidity farming makes token distribution fairer, the concept of ICO rewards still works on the principle of the higher the stake, the higher the reward.
Liquidity Farming Is Innovating the DeFi Space
The whole point of liquidity farming is to reward participants. It incentivizes holders to join liquidity pools and provide liquidity to DeFi projects. As such, both developers and innovators benefit by introducing liquidity mining pools to holders.
But developers must also provide security to protocols. Otherwise, holders will not join liquidity pools due to the risk of losing their tokens. Because of security fears, developers are innovating the DeFi space by coming up with new and better ways to provide security. Not only that, but DeFi projects must be sensible for holders to provide liquidity. If a project makes no sense, and the rewards make no sense, then there is no incentive for holders to join and provide liquidity.
As such, the DeFi space benefits by introducing to holders interesting and innovative projects to invest in and earn passive income.
Liquidity Farming Comes With Risks
Despite the benefits of liquidity farming to both DEXs and holders, it isn’t a flawless system. Holders should be familiar with some of the risks associated with liquidity farming.
- Investors should perform their due diligence before joining a liquidity mining pool. Even if a protocol looks promising, it doesn’t mean technical risks won’t lose your investment.
- Despite the security the blockchain provides, investors are still susceptible to rugpull scams. These scams occur whenever a developer of a protocol or liquidity pool shuts down the protocol or pool and leaves with everyone’s money.
- High gas fees, a prime example being Etereum, can discourage smaller investors from joining liquidity mining pools.
As crypto farming becomes more popular, liquidity farming will be the go-to method of providing liquidity to protocols. On top of that, liquidity farming is a very popular method of earning passive income. However, staking and yield farming are quickly becoming more popular. As the DeFi space grows, liquidity farming will be at the center of it all.
Partner at Vega Capital Management - a private funds management company.
An experienced portfolio manager with 10+ years of proven and reputable track record in investment management and financial analysis. Currently, a partner at one of the fastest-growing private fund management companies in southeast Europe, Kiril has been tending to a loyal international base of client-investors and partners. When he is not crunching numbers and increasing his client’s wealth, he reminisces about his Michelin-star restaurant cheffing years and fondness of the culinary arts.