DeFi Liquidity Mining and What You Need to Know about It
DeFi has no doubt become the rave of the moment in the finance sector. It is steadily revolutionizing and transforming finance in more ways than one. Following its recent tremendous growth, new blockchain tech developments continue to rise as well to facilitate DeFi’s continuous growth. One of such new developments is liquidity mining.
What is Liquidity Mining in DeFi?
Liquidity mining is fast becoming one of the most popular investment techniques in the DeFi ecosystem. In simpler terms, liquidity mining means providing liquidity to an smart contract via locking or staking cryptocurrencies and earning or “mining” rewards in return. While it may appear similar to crypto staking for Proof of Stake (PoS) blockchains, liquidity mining is quite different.
PoS Staking occurs when validators lock their crypto assets as a form of collateral on the blockchain platform or wallets in order to earn rewards by validating transactions on-chain. As opposed to the Proof of Work (PoW) consensus mechanism that had been adopted in previous years for legacy blockchain protocols, PoS provides a better means of ensuring network security while requiring less computational resources.
Liquidity mining on the other hand, involves liquidity providers earning a percentage of fees paid by traders who swap tokens, usually on a decentralized exchange. In liquidity mining, users provide their assets (for example ETH and DAI pairs) as liquidity to a DEX or protocol. This way, when other users of the same DEX or protocol desires to exchange say DAI tokens for ETH, there will be enough liquidity available for the trade.
For instance, let’s say you want to provide liquidity to an AMM (Automatic Market Maker — a smart contract that regulates DEX swaps). You will deposit your tokens in pairs (e.g. DAI/ETH) to a liquidity pool provided by the DEX platform. This way, other users will be able to use your tokens as a reserve pool to swap the desired token pairs. These users are called token swappers who pay a swap fee which is in turn distributed to the liquidity provider. The fees are usually proportionately split among all of the liquidity providers in that pool, based on the total amounts of liquidity each person provides.
Decentralized exchanges are faced with a major challenge of liquidity, hence liquidity mining helps to provide capital to the platform to increase trading volume whilst generating rewards for the liquidity providers. It is a win-win situation for both parties. This is why the DeFi practice has become very popular and a passive means of income for crypto users worldwide
Benefits of Liquidity Mining
Today, liquidity mining has become one of the most popular forms of passive income in the crypto world. In general, the higher the liquidity provided or assets locked in, the higher the rewards earned for transactions. These passive rewards remain the main point of attraction for investors.
On another note, liquidity mining boosts liquidity for DEXs which is very crucial to the growth of DeFi and mainstream adoption. DEXs have struggled to gain higher liquidity in the past which has hindered their growth when compared to centralized exchanges. However, with liquidity mining, gaining higher liquidity appears to be a stronger possibility.
Major platforms that currently support liquidity mining include Uniswap, Curve, SushiSwap and several others. CDzExchange will launch liquidity pools alongside its DEX in the initial phase.
Risks with Liquidity Mining
One of the foremost risks associated with liquidity mining is impermanent loss. Usually liquidity providers are required to deposit an equal amount of value for both tokens (say 50% DAI/50% ETH).
Impermanent loss happens when the market price of one of the token pairs locked in goes up against the other pair. This would require arbitrage to balance the value of both tokens.
The liquidity provider stands a chance of making a loss on the value of the tokens initially deposited if they choose to withdraw, which realizes the loss permanent. This loss is compared to the amount the liquidity provider could have gained if they simply held their asset and didn’t provide liquidity in the first place. It is referred to as an “impermanent” loss because the loss could cancel out if the liquidity provider chooses to hold on longer till the prices perhaps return to the initial value. However, some users may not have the patience to hold on that much longer.
There’s also the security risk. Users could lose some or all of their assets in case of smart contract hacks.
The Road Ahead
Certainly, liquidity mining is a plausible way to earn rewards for users and provide liquidity for DEX platforms. This is why its recent growth does not come at a surprise. However, it is quite important for users to consider the risks involved with liquidity mining and conduct due diligence before jumping on the train. More hands still need to remain on deck to develop better ways of mitigating the risks involved.
Image Source: Pixabay