What is Liquidity Mining in DeFi and How Does It Work?

The rapid growth in cryptocurrency and blockchain over the years has been shocking. One reason for this electrifying growth is Decentralized Finance (DeFi), a blockchain-based finance platform that eliminates centralized financial intermediaries. 

The fascinating thing about DeFi is that, apart from being decentralized, it still offers several ways for investors to earn passive income. One of these ways is through liquidity mining. 

What is liquidity mining, and how does it benefit DeFi? 

In this article, you’ll learn everything you need to know about liquidity mining. Without further ado, let’s dive in!

What is Liquidity Mining?

Liquidity mining, also called yield farming, is a network participation strategy that allows you to provide liquidity (capital) to a liquidity pool on a Decentralized Exchange (DEX). In return, you receive a reward from the specific liquidity pool to which you provided liquidity. Depending on the farm, a user may also be rewarded in the native token or governance token of the protocol which allows you to vote and contribute to the protocol’s future.

Liquidity mining is important because a DEX needs liquidity to enable the trades between different token pairs and this incentive strategy enables users to contribute liquidity to facilitate those trades.  This means that the majority of liquidity pools are between trading pairs where users can deposit the two different cryptocurrencies depending on the pool.

However, it’s important to note that there is a difference between liquidity mining and liquidity provision.  Liquidity provision is where a user provides liquidity to a trading pair and reaps rewards from trading fees. So when a user swaps between the two tokens a small fee is charged.  This fee is where rewards for liquidity provision providers come from. You can imagine when several token swaps take place on a DEX that liquidity mining can turn into a great passive income opportunity for many.

Liquidity mining is similar in the sense that you provide liquidity however you’ll then receive a LP token that needs to be staked in order to earn rewards reserved for the mining program.  These liquidity mining rewards come directly from the project’s liquidity provision incentives.  

Aside from earning yield, many protocols offer different types of reward incentives like governance tokens which allow voting rights for the protocol.  If a DEX’s native token becomes increasingly popular due to its utility, it can usually be swapped for even greater profits or swapped for “blue-chip” cryptocurrencies like Ethereum and Bitcoin.

A Brief History of Liquidity Mining

Although it became mainstream in June 2020, liquidity mining has existed since 2017. IDEX, one of the largest decentralized exchanges, pioneered the concept in October 2017. Synthetix then redefined it in 2019 before Compound refined it further in June 2020 to what we know it as today. 

In October 2017, IDEX announced a reward program for market makers, which became the basis of what we now understand as liquidity mining. Instead of locking up their capital in a pool, the exchange rewarded market makers with its token, IDEX, for trading on its platform. There was no need to lock up assets somewhere else. All market makers needed to do was fill a limit order, and they’d receive IDEX as a reward.

After Compound announced the concept in 2020, its adoption rate over the past couple of years has been electrifying. For example, between June and October 2020, the total value locked (TVL) was over $10 billion. According to Defipulse, the TVL (at the time of this writeup) stood at $96.96 billion.

Benefits of Liquidity Mining

Although liquidity mining is a means of earning a passive income, it has even more benefits. This section will discuss some relevant benefits of liquidity mining to both providers and decentralized exchanges. Without further ado, let’s talk about the benefits of providing liquidity to DEX.

Fair and Broad Distribution of Native Tokens

During the ICO-rush in 2017, most retail investors were angry with the methods used in token distribution. There seemed to be no fair playing ground. DeFi protocol developers favored institutional investors over retail investors because of the funds the former had at their disposal.

Introducing liquidity mining created an equal chance for both institutional and low-capital investors. Depending on the protocol and the farm parameters, if you deposit money into a liquidity pool, you may receive rewards in the form of native tokens that you could use to vote.

Although liquidity mining minimizes favoritism, it’s important to note that distributing tokens to liquidity providers doesn’t end the inequality of token distribution. Token distribution is still based on the concept that the higher the stake, the higher the reward. 

A Win-win Situation for Liquidity Providers and Decentralized Exchange Platforms

Just as we already know, liquidity is the fuel on which decentralized exchanges run. So, as providers add liquidity to smart-contract protocols, the DEXs that run the liquidity pools become more liquid. And, as a result, DEXs continue to be liquid by making it possible for trustless individuals to transact securely. 

Nurturing a Loyal Community for a Project

Unlike in the ICO era, where investors only focused on making returns on their investment, a liquidity mining program helps build a community that trusts and supports new projects.

Although the primary goal of liquidity mining is to create income for liquidity providers, it also helps develop active community members and a large user base for a project. In most cases, providers are likely to be token holders and users of the protocol after launch.

Inclusive Governance

Decentralization isn’t just a practice limited to information and value.  Decentralization can also trickle down to how the platform operates and develops in the future. Hence why so many DeFi projects like Matrxiswap are migrating to being community-owned.

Decentralized exchanges accomplish this through an inclusive governance model. The DAO model allows users to participate in voting on protocol changes and future developments through the use of governance tokens.

But how does a user receive a governance token?

DEXs and other projects can list their token on markets where users can choose to invest in them.  Other protocols elect to reward liquidity providers with yield from mining and governance tokens as well.

These extra incentives make liquidity mining even more attractive as users can choose to have voting rights on the protocol and earn even more passive income. The concept also helps reduce regulatory effort and increases community loyalty. It strengthens community engagement, contributes to decentralization, and helps lead the way to successful DAOs.

Allows for More Innovation in DeFi

Since liquidity mining incentivizes participation through rewards, the DEXs native token can usually see some appreciation from the inflow of capital into the protocol.  This participation strategy becomes increasingly attractive to developers and their innovators in the space of DeFi.

Start-ups were usually limited to bootstrapping their projects, but this sort of community incentivization provides an interesting way to gain traction. As long as rewards make sense and protocols provide more than adequate security, more participants will come and so will innovation in the space. 

Risks of Liquidity Mining

Liquidity mining has, so far, offered more benefits to the DeFi community than we can imagine. However, there are always two sides to everything. 

To reap the rewards of liquidity mining, it is essential to avoid focusing on benefits and ignoring the risks. In this section, we’ll explain the risk associated with liquidity mining. Without ado, let’s dive in!

Technical Risks

The more advanced a protocol is, the more complicated the source code that runs the protocol. That means protocols are susceptible to technical risks. Without a careful code audit, unscrupulous individuals can take advantage of a protocol and its assets.

All projects are susceptible to exploitation, no doubt. So, as an investor, be sure to perform your due diligence before staking your assets into liquidity pools. That will protect you against any form of hacks and exploitation of protocols. Also, ensure that you invest in projects constantly audited by independent individuals and agencies.

Rugpull Fraud

Although Blockchain decentralization provides security for decentralized finance, the lack of centralization has also exposed investors to other risks like rug pulls.

A rug pull is a fraud scheme where protocol developers or liquidity pool developers decide to shut down the protocol and run away with investors’ money. The anonymity and openness of decentralized protocols allow anybody to start a project without registration or verification. So, it’s easier for anybody to pull this scheme and vanish unpunished without a trace. An example of a rug pull fraud scheme is Compounder Finance, which rug pulled $10.8 million.

So before going all-in on a project, perform your due diligence to avoid falling victim to unscrupulous acts. Make sure you check the background of the project development team. If you can, study the smart-contract implementation code, and if you can’t, let a developer friend help you with this. Also, make sure that the developers’ vision aligns with your own. By doing this, you can prevent hacks or theft.

Information Asymmetry

DeFi aims to eliminate intermediaries and remove central authority from influencing your finances. However, insider information can still lead to an unfair playing field even when it comes to liquidity mining.

Those who may know when a new liquidity pool is open earlier than others can take advantage of the rewards programs which were designed for fair distribution. One of the best ways to overcome this is through the protocol’s transparency of the mining program and associated liquidity pools. It’s likely that when more protocols transition into DAOs that this solution will look out for the community at large as opposed to individual investors.  

High Gas Fees 

The Ethereum network is currently the premier blockchain that supports smart contracts. Although it’s planning to transition to the proof-of-stake (POS) consensus, it uses the proof-of-work (POW) consensus, which requires processing fees aka gas fees. 

Higher gas fees can price out small capital investors which leads to liquidity mining rewards accrued by those who are able to pay high fees to play. With Eth2.0 on the horizon, these issues on Ethereum should level the playing field and let more retail participants transact on the network and thus reap incentive programs like liquidity mining.

Impermanent Loss 

Impermanent loss happens when the price of the tokens you’ve contributed to a liquidity pool changes compared to when you first deposited them. The greater the price difference, the greater the chance of impermanent loss.  

This results in less value in $USD when you decide to withdraw compared to the value when you decided to provide liquidity.  This risk can usually be offset by the gains made through rewards like trading fees, but cryptocurrency market volatility makes liquidity providers a bit more cautious of their deposits.

Type of Liquidity Mining Protocols

One year post-launch, the adoption rate of liquidity mining has skyrocketed. According to DeFipulse, there are over 120 DeFi platforms with over $80 billion TVL. 

Although these DeFi platforms use the same concept as Compound, there is still variation in how different protocols work. Liquidity mining protocols are divided into three categories.

Fair Decentralization Protocols

As its name implies, the fair decentralization protocol is a model that aims to create an equal playing ground for all interested parties. The protocol equally distributes the native tokens to all active users and early community members. 

Unlike ICOs that require interested investors to buy a governance token, the fair decentralization protocol model does not sell the native currency but uses some criteria for an equal distribution of the tokens. The fair decentralization protocol transitions power to the community instantly after launch.

Programmatic or Progressive Decentralization Protocols

Progressive decentralization protocols allow a gradual transition of power to the community like what we’re planning with NFTperp. With this model, distributing tokens is a gradual process and requires setting up a governance model after the project launch. 

The concept used in programmatic decentralization aims to prevent an imbalance in the distribution of governance tokens. It prevents whales or institution traders from accumulating a high percentage of native tokens. 

Growth Marketing Protocols

This category of liquidity mining protocol is entirely different from the other two. Developers using this model incentivize community members who market the project. To get governance tokens, interested individuals need to advertise the DeFi platform or protocol. 

Unlike others that already have a road map some months before the launch date, protocols using the growth marketing model are only announced a few weeks before the launch date. The projects using this model thrive on hype. 

Conclusion

As learned in this article, liquidity mining programs are an essential part of DeFi and keep the protocols within the ecosystem running. Without liquidity, DEXs cannot survive. 

However, you need to understand that DeFi is still emerging, and liquidity mining is still in its infancy. So we don’t know what may become of it in the future. Although I believe liquidity mining is here to stay, you should still be careful as the direction of the technology is unpredictable. 

Before providing liquidity for a DeFi project, make sure to do extensive research. Always test the water with small transactions before going all-in. Doing so will minimize your losses, maximize rewards, and protect you from unscrupulous individuals.