What Is Liquidity Mining? Full Guide
26 Jul, 2022
Earning passive income is one of the generally best ways to invest in cryptocurrencies. There are many exciting ways to do that, including staking, participating in crypto airdrops, direct lending, yield farming, and more.
Yield farming is a broad categorization for all methods used by crypto investors to earn passive income. And today, we want to focus on liquidity mining, one of the most common ways of yield farming where users earn a steady stream of passive income. Want to learn more? So let's start! How does liquidity mining work? The process when crypto holders borrow their tokens to a decentralized exchange platform in return for rewards. Liquidity mining rewards go from fees that are collected from traders.Liquidity Mining Investments Strategy
Liquidity mining is an investment strategy or the practice of lending assets when participants within the DeFi (decentralized finance) protocol deposit their crypto assets to make it easier for other users to trade on the platform. Participants are rewarded as part of the platform fees or newly issued tokens in exchange for their contributions. Liquidity mining seems even more exciting as users can obtain rewards without needing to make active investment decisions. The main benefits associated with liquidity mining include the potential for high yields, distribution of governance and native tokens, low barriers to entry, and nurturing of trusting and loyal communities.What Is DeFi?

What Is Liquidity Mining in DeFi?

History of Liquidity Mining
The rise of liquidity mining surged during the summer of 2020, also dubbed as DeFi summer. This period witnessed the widespread acknowledgment and the rise of the DeFi market, marked by its efficient and permissionless trading architecture, which attracted numerous liquidity providers and other crypto holders. Concurrently, protocols enticed liquidity providers with exceptionally high rewards for the deposited tokens, boasting annualized percentage yields (APY) that sometimes soared into triple digits or beyond, thereby further propelling the growth of DeFi and liquidity mining. Liquidity mining emerged as a highly lucrative endeavor, particularly for liquidity providers who could inject substantial capital into a liquidity pool thereby securing a larger share of a protocol's transaction fee distributions. Consequently, this bolstered liquidity within the pools, rendering them more appealing for trading activities and fostering increased participation on the protocols. Presently, the annual percentage yield offered by most yield farming protocols has substantially decreased. This decline, however, signifies a positive development, indicating the market's maturation and enhancing sustainability for participants. Nevertheless, liquidity provision and activity within DeFi protocols remain robust, with liquidity providers and other participants continuously scouting for the next lucrative opportunity in liquidity mining.How Do Liquidity Pools Work? The Importance of a Liquidity Pool in DeFi
Liquidity pools form the backbone of decentralized exchanges (better known as DEXs) through the use of an automated market maker system. An automated market maker, also known as AMM, is a system in which investors, in this case, referred to as liquidity providers, add equal amounts of stablecoins or cryptocurrencies (such as BTC/USDT) into the pool. Thus, users can exchange one stablecoin for another by exchanging Bitcoins of the same value for USDT (Tether). Liquidity providers (or LPs) provide services to DEX buyers and sellers by supplying them with tokens that are easy to trade on the same blockchain. Liquidity pools with the deposited funds not only supply a lifeline for the core business of the DeFi protocol but also serve as hotbeds for investors willing to take risks and reap big rewards. Liquidity pools are an innovation in the crypto industry that has no direct analog in traditional finance.Why DeFi Liquidity Could Be Interesting for Investors?

How Do You Earn from Liquidity Mining?
Liquidity is essential when investing to access the wealth that investors create. If all assets are associated with long-term investments or highly illiquid investments, users may face a shortage of funds. This can significantly reduce the ability to direct funds into an investment opportunity that comes the way. As for highly liquid assets, they can be immediately turned into cash without friction or other costs.Pros and Cons of Liquidity Mining

Benefits of liquidity mining

Passive income
Liquidity mining stands out as one of the premier avenues for cryptocurrency investors to generate passive income. By supplying more liquidity into pools, a liquidity provider adopts a predominantly passive approach, merely holding onto the protocol's native tokens while rewards are automatically accrued. Moreover, as the pool attracts more participants, increased activity translates into augmented rewards for LP token holders, further enhancing their passive income stream without the need for active management.High yield
It's crucial to recognize that the yield in liquidity mining aligns with the level of risk assumed, making it an enticing strategy for various investor profiles. Whether making a substantial investment or testing the waters, proportional rewards match the contribution. Exchanges incentivize liquidity provision by rewarding each liquidity provider with a share of fees generated from trading activities. Given that rewards correlate with one's share of the pool, prospective yields can be estimated beforehand, especially during periods of heightened market activity, resulting in significantly higher returns than traditional banking options.Distribution of governance and native tokens
DeFi liquidity mining fosters a fairer distribution of governance through native tokens, addressing previous disparities favoring institutional investors. This inclusive approach allows both low-capital and institutional investors equal access to native tokens, endowing them with voting power within the associated decentralized exchanges (DEXs). Holding native tokens empowers investors to influence protocol characteristics, from revising development funds to adjusting fee structures, thereby democratizing decision-making processes within the ecosystem.Permissionless: low barrier to entry
Liquidity mining epitomizes permissionless participation, requiring only a noncustodial wallet like MetaMask and a designated cryptocurrency holding. Rewards earned can be reinvested into the pool, amplifying one's stake and subsequent rewards over time, without any entry barriers beyond ownership of requisite assets. By bolstering liquidity, LPs play a pivotal role in fortifying the DeFi ecosystem, expanding accessibility to capital-efficient swaps and fostering the development of new applications, thereby enriching the broader ecosystem.Nurtures a trusting and loyal community
An often overlooked aspect of liquidity mining is its capacity to cultivate a trusting and loyal community, particularly within emerging exchanges. Participants in providing liquidity tend to engage actively within the community, fostering a symbiotic relationship with the exchange's growth trajectory. Beyond immediate income, continued engagement with the protocol ensures ongoing benefits, underscoring the enduring value proposition of liquidity mining beyond mere financial returns.Exploring the Risks of Liquidity Mining

Impermanent loss
Impermanent loss looms as a significant risk in liquidity mining. This phenomenon occurs when the value of tokens in liquidity pools fluctuates relative to their initial investment value. Greater price disparities amplify the likelihood of impermanent loss. Should the token prices decrease upon withdrawal compared to its initial deposit value, investors incur losses. While trading fees can offset this risk, the volatile nature of the cryptocurrency market warrants prudent caution when engaging with decentralized exchanges (DEXs). Additionally, receiving more of a depreciating cryptocurrency exacerbates losses compared to holding the asset itself, underscoring the need for careful consideration before providing liquidity to prevent significant losses.Project risk
Technical risks inherent in liquidity mining protocols and smart contracts underscore the importance of thorough due diligence. Complex source codes underpinning advanced protocols are the reason for smart contract vulnerabilities and render them susceptible to exploitation by malicious actors. Failure to conduct comprehensive smart contract code audits exposes protocols and their assets to potential breaches. Of the myriad liquidity mining risks, attention must be directed toward safeguarding the protocol, its smart contract, and its underlying project. Extensive research into a project's fundamentals and platform integrity mitigates vulnerabilities to hacks and exploitation. Regular independent audits of the smart contract code further fortify project resilience against security threats.Potential rug pulls
Decentralized investing, while offering myriad benefits, harbors inherent risks such as rug pulls. This fraudulent scheme entails liquidity pool developers and protocol operators abruptly shutting down operations and absconding with investor funds. Decentralized protocols, with their anonymity, facilitate the launch of projects without verification or registration. Instances like the Compounder Finance debacle in 2020, where developers absconded with millions via a backdoor mechanism in a smart contract code, underscore the threat of rug pulls. To shield against liquidity mining fraud, diligent due diligence is imperative. Thorough research into project backgrounds and operational transparency minimizes susceptibility to fraudulent schemes, safeguarding investments against potential losses.Comparing Liquidity Mining with Other Passive Investment Strategies
