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?

Source: Freepik Before delving further into liquidity mining, let's explore decentralized exchanges and decentralized finance (DeFi), the backbone enabling liquidity mining endeavors. Traditional financial exchanges typically adhere to an order book model. Within this framework, an order book functions as a centralized repository housing buy and sell orders or digital assets at various price points, submitted by users. Transactions are executed when a match occurs between buy and sell orders from different users. DeFi revolutionized this paradigm by introducing an innovative order book mechanism known as automated market makers (AMMs), spearheaded by protocols like Uniswap. AMMs facilitate permissionless trading of digital assets among users by leveraging a liquidity pool, obviating the need for centralized intermediaries to match transactions. These pools, governed by smart contracts and algorithmic protocols, operate autonomously. By pooling the digital assets or participants who provide liquidity, these liquidity pools ensure increased liquidity depth, enabling more efficient capital swaps with minimized slippage and expanded cryptocurrency accessibility for users.

What Is Liquidity Mining in DeFi?

Source: Freepik DeFi (decentralized finance) apps use the liquidity mining term to describe the process when users provide liquidity to support the liquidity of decentralized financial institutions, receive liquidity pool tokens, and receive fee rewards from validating transactions, along with other benefits depending on a platform.

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?

Source: Freepik DeFi can be called the future of passive index investing. It has every chance and potential to disrupt the passive investing industry by lowering fees, increasing competition and innovation, and providing more choices and exciting opportunities to savers and 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

Source: Freepik Even though liquidity mining can be called a win-win solution for projects and participants, it also has a dark side. Therefore, everyone should consider the following benefits of liquidity mining and its potential risks before participating.

Benefits of liquidity mining

Source: Freepik Now that we have a grasp of liquidity mining, let's delve into its myriad benefits as an investment strategy. When you as a liquidity provider provide liquidity to liquidity pools, you can anticipate reliable returns on your investment. Here are the key advantages associated with DeFi 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

Source: Freepik Despite the benefits of liquidity mining, it's crucial to acknowledge the inherent risks before diving in. Understanding these potential pitfalls empowers you to adopt proactive measures to mitigate their impact and safeguard your investments.

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

Source: Freepik Before finalizing your investment approach, it's prudent to compare DeFi liquidity mining against alternative passive investment avenues.

Liquidity mining vs. staking

In tandem with liquidity mining, staking presents itself as a passive earning mechanism wherein users collateralize their cryptocurrency within proof-of-stake (PoS) algorithms. By locking up their holdings, users contribute to transaction validation and blockchain security, a passive endeavor akin to liquidity mining. Rewards scale with staked amounts, mirroring the dynamics of liquidity mining. Staking boasts relatively lower risks compared to liquidity mining, with project failure posing a primary concern, whereas liquidity mining grapples with market volatility and heightened exploit vulnerabilities.

Liquidity mining vs. yield farming

While liquidity mining and yield farming are often conflated, it's crucial to discern that liquidity mining constitutes a subset of yield farming. The former yields native tokens, while the latter generates interest by locking crypto assets across diverse blockchain protocols. Both strategies share analogous benefits and risks.

Assessing the Viability of Liquidity Mining

Despite grasping the mechanics of liquidity mining, its suitability hinges on individual investment strategies. A thorough examination of the pros and cons is essential to gauge its alignment with your financial goals. Noteworthy among liquidity mining benefits is the proportional relationship between yield and risk tolerance, accommodating a spectrum of risk profiles. Additionally, its user-friendly nature renders it accessible to novices. However, prudent consideration of associated risks is imperative, with potential hacker breaches or rug-pull fraud constituting remote yet plausible threats. Engaging in liquidity mining mandates robust risk mitigation strategies to avert costly investment pitfalls. While liquidity mining represents a contemporary cryptocurrency investment paradigm, its enduring presence underscores its resilience. For those seeking a robust investment strategy poised to endure beyond 2023, liquidity mining may offer a viable option. Prioritize meticulous research and commence with modest transactions to glean insights into potential outcomes before scaling investments.

What is a liquidity mining example?

Liquidity-mining arrangements, for example, allow cryptocurrency to be lent to cryptocurrency platforms. Tokens consisting of two units in the native cryptocurrency are given out in exchange for reward tokens. The reward tokens were worth $400.00 at the time of issuance.

What is the risk of liquidity mining?

Several other risks exclusive to yield farming and liquidity mining are liquidation aka impermanent loss, as well as rug pulls. DEX will liquidate tokens when their value loses a certain amount of value due to liquidity loss or impermanent loss.

Learn more about liquidity mining

If you want to learn more about liquidity mining, you should read about liquidity pools, trading fees, crypto assets, governance tokens, liquidity mining risks, liquidity miners, liquidity tokens, favor institutional investors, crypto liquidity mining, automated market makers, liquidity mining scam, lending crypto assets, liquidity mining protocol, liquidity pool developers, and the cryptocurrency market in general.

Conclusion

As you can see, liquidity mining has become increasingly popular among traders, investors, and crypto enthusiasts for many good reasons. However, the rapidly growing crypto industry is still at the very beginning of its exciting journey, and it remains to be seen if liquidity mining will prove to be a worthwhile long-term crypto investment strategy. Do you want to start investing in the most promising crypto projects? Learn how to invest with BullPerks, the fairest and most community-oriented decentralized VC and multichain launchpad! Source: Freepik

FAQ

Is liquidity mining legit?

Real liquidity mining is legit. It is an investment strategy used to earn passive income with crypto. However, crypto scammers and fraudsters like using official terminology to make their schemes and scam opportunities sound legitimate and more appealing. Terms can be used incorrectly and conflict with each other. Unfortunately, there are a lot of DeFi liquidity mining scams out there.

What is liquidity mining vs. staking?

Liquidity mining is a form of yield farming and another DeFi lending protocol, where you can stake your crypto into a pool to be used by others. It focuses on providing liquidity to the DeFi protocol. Staking refers to locking up your crypto for a defined or undefined period to get rewards (interest). Staking is more straightforward and more accessible to novice traders and crypto enthusiasts.

Is liquidity mining worth it for liquidity providers?

Even though liquidity mining has proven to be highly popular among crypto investors because it earns passive income, it is difficult to say whether it's worth it. Everything depends on your investment opportunities and goals.

How to learn more about liquidity mining and crypto in general?

To become more tech-savvy and learn more about liquidity mining and crypto, you should be interested in the DeFi ecosystem, how to swap tokens, consensus algorithm, risks of liquidity mining, a liquidity miner, fair distribution, how to claim governance tokens, total value, DeFi protocols, equitable distribution, voting power, how to create passive income, peer-to-peer transactions, decentralized transactions, centralized financial intermediaries how to supply liquidity, existing assets, and more. Moreover, consider reading about such topics as facilitating trades, centralized exchanges, primary benefits in crypto, transaction fees, equal distribution, blockchain network security, how to validate transactions and earn rewards, blockchain transactions, consensus mechanism, crypto market, volatile markets, cryptocurrency assets, which risks involved, how to find the best decentralized ecosystem, supplying liquidity, low capital investors, yield mining, idle crypto assets, various liquidity pools, and how not to lose money when working with DeFi platforms and yield farmers.