Decentralized finance (DeFi) is one of the most widely used applications of blockchain technology. Mining for liquidity is a popular way for crypto investors to participate in DeFi. This guide will explain what DeFi liquidity mining is, why it’s important, which platforms let people mine for liquidity, the benefits it offers, and the risks associated with this investment strategy.
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Introduction to DeFi and Liquidity Mining
Staking your assets, lending them, and yield farming on DeFi (decentralized finance) platforms are all ways to earn passive income, which is one of the best ways to invest in cryptocurrencies.
Using decentralized networks like blockchains, a new fintech application called decentralized finance aims to disrupt conventional financial markets. DeFi platforms allow market participants to interact peer-to-peer (P2P) by eliminating centralized financial intermediaries.
The term “yield farming” encompasses all approaches taken by investors to generate passive income from lending out their cryptocurrencies. They might get interested, in a portion of the fees they pay on the platform to which they lend their tokens or brand-new tokens that these platforms issue.
One of the more common methods of yield farming in which investors can generate a consistent passive income stream is liquidity mining. We will talk about what it is and the risks and benefits it offers to investors in this guide. In addition, we highlight some of the best liquidity mining platforms for individuals wishing to make use of their accumulated cryptocurrency.
What Is DEFI Liquidity Mining?
Definition:
Liquidity mining is an investment strategy in which DeFi protocol participants contribute their crypto assets to make trading on a platform simpler for others. Participants receive tokens or a portion of the platform’s fees as recompense for their contributions.
The ease with which an asset can be spent is referred to as its liquidity; consequently, the easier an asset is to spend, the more liquid it is. On the other hand, mining is a bit of a misnomer in this context because it refers to the more common way to be compensated for contributing to the verification of transactions on Proof of Work (PoW) networks like Bitcoin.
However, the use of the term “mining” in this title suggests that these liquidity providers (LPs) are seeking compensation in the form of fees and/or tokens.
Yield Farming vs. Staking vs. Liquidity Mining
Staking, yield farming, and liquidity mining are all ways to make money passively by using an investor’s crypto assets.
Staking is a broad category that encompasses all activities and various methods of earning rewards from owning particular cryptocurrencies. By authenticating blockchain transactions, its primary objective is to safeguard the blockchain network.
On the other hand, yield farming is a broad category of ways crypto traders and investors lend out their cryptocurrencies in exchange for interest or new tokens to earn compensation in the form of annual percentage yield (APY).
As a result, it brings us to liquidity mining, one common method of yield farming. Investors engage in liquidity mining with the intention of generating passive income by supplying liquidity to the DeFi protocols of decentralized exchanges (DEXs).
How Does DEFI Liquidity Mining work?
Depositing your assets into a common pool known as a liquidity pool makes it easy to join these liquidity pools. The procedure is comparable to transferring cryptocurrency between wallets. A trading pair like ETH/USDT typically makes up a liquidity pool. An investor could choose to put either asset into the pool as a liquidity miner (also known as a provider).
The (LPs) make it simpler for traders to enter and exit positions by depositing their assets onto the Defi platforms, with the trading fees partially serving as rewards.
An LP’s share of rewards will be greater the more they contribute to a liquidity pool. Liquidity mining’s fundamental concept can be applied in a variety of ways on various platforms.
Benefits of DEFI Liquidity Mining
- The liquidity providers, DeFi platforms, and the blockchain community as a whole stand to gain greatly from liquidity mining. How to do it:
This does not apply to all DeFi protocols, but to those that do use governance tokens to reward liquidity providers. Fair distribution of governance tokens Most platforms reward LPs according to the proportion of their contributions to the liquidity pool. More tokens are awarded to LPs with higher contributions in proportion to the risk they face. Tokens for governance can be used for:
- Vote on proposals for development
Vote on important protocol changes like the fee share ratio and user experience, among other things.
Even if governance tokens are distributed fairly, this system still suffers from inequality because a small number of large investors can take over governance.
Passive income: Liquidity mining is a great way for LPs to earn passive income, similar to how stakeholders in staking networks earn passive income.
The liquidity protocols win-win result: this interaction model helps all parties in a DeFi marketplace. The platform benefits from a vibrant community of users from LPs and traders to developers and other third-party service providers and traders benefit from an efficient and highly liquid marketplace. The LPs are compensated for lending their tokens.
Liquidity mining has a low barrier to entry because most platforms allow investors to deposit small amounts, and investors can use their earnings to increase their stakes in the liquidity pools.
Open governance: since anyone, regardless of the stake, can participate in liquidity mining, anyone can also claim governance tokens and vote on project-affecting development proposals and other crucial decisions made by stakeholders. As a result, the model becomes more inclusive, allowing even small investors to contribute to the growth of a market.
Risks of DEFI Liquidity Mining
Before making an investment, every investor must take into account the risks associated with any investment strategy, and liquidity mining is no exception. Mining for liquidity comes with a number of risks, including:
Impermanent Loss: Liquidity miners face one of the biggest risks because they could lose money if the price of their tokens falls while they are still in the liquidity pool. This is referred to as an impermanent loss because it can only be experienced if the miner withdraws tokens at low prices. The gains from the LP rewards can sometimes make up for this unrealized loss; However, the price of cryptocurrencies is highly erratic and highly volatile.
Exit scam: the very real possibility that the core developers of a DeFi platform will shut down their business and steal investors’ money is sadly common in various blockchain markets. The Compounder Finance rug pull, which resulted in investors losing close to $12.5 million, is the most recent incident that has taken place within the DeFi industry.
Security Risks: specialized weaknesses could make programmers make the most of DeFi conventions to take assets and cause destruction. Since the majority of cryptocurrency projects are open source and the underlying code is accessible to the public, such security incidents are common. Theft of tokens held in liquidity pools or a decline in token prices as a result of negative publicity can result from security breaches.
Information asymmetry: In decentralized networks with open protocols like DeFi marketplaces, the most significant obstacle for investors is that information is not distributed fairly to the public. Community problems like distrust, corruption, and lack of integrity are brought about by information asymmetry.
Best DEFI Liquidity Mining Platforms
Now that you know what liquidity mining is, you might be interested in learning where the strategy is most effective. When choosing a platform from which to mine for liquidity, there are a few things to keep in mind. These are some:
Level of Decentralization: You must determine whether the community is at risk of centralization from one or more parties. Check the project metrics, such as the total value locked (TVL), the number of liquidity providers, and the available liquidity, to accomplish this. You can also check the GitHub repository for the protocol’s source code if you’re technically inclined. You want to know how many developers contribute to the project, how often, and who they are by looking here.
Security: Because blockchain networks and protocols are frequently hacked, you should choose a secure platform to reduce your chance of losing your investment. Check the history of any DeFi platform you’re considering for security breaches. Make certain that the platform conducts independent third-party security audits on a regular basis. Last but not least, think about the platform’s age and who its core developers are. To eliminate potential exit (rug pull) scams, this final step is necessary.
Functionality: most DeFi platforms only support tokens based on Ethereum. You should look for a DEX that supports the token you are interested in if you need to provide liquidity for a token that is not hosted on Ethereum. You should also think about how profitable it is to participate in various liquidity pools on rival platforms and within the same DEX.
Consider these three of the most well-known DEXs for your liquidity mining endeavor:
- PancakeSwap
- Balancer
- UniSwap
Conclusion: Is it worth it to mine liquidity?
There’s a good reason liquidity mining is getting more and more popular with crypto investors.
- It provides an excellent means of passive income generation;
- It helps the blockchain market become more decentralized;
- It gives investors a choice about how to use their reserve coins.
Liquidity mining remains to be seen as a viable long-term crypto investment strategy due to the expanding blockchain industry.
