By Larry Wright
With each new development, conventional ideas about technology and money are challenged on an everyday basis. Recent years have seen a huge increase in the usage of blockchain technology and cryptocurrencies, which has had a profound impact on a variety of industries. At the same time, the most popular strategy for investing in cryptocurrencies is to acquire and hold them until their value increases. There are plenty of other methods to make money passively. These include yield farming, lending, and staking your assets on DeFi (decentralized finance) networks.
Decentralized finance, or DeFi, is becoming increasingly popular among these due to the increased options it provides for generating passive income through techniques like liquidity mining. To get a better understanding of liquid mining, let’s first take a quick look at decentralized finance or DeFi.
Introduction to Decentralized Finance
Decentralized finance, or DeFi, manages financial transactions using cryptocurrencies and blockchain technology. The majority of banking, lending, and trading activities are controlled by centralized systems that are run by regulating organizations. To obtain everything from home loans and vehicle loans one must interact with a variety of financial intermediaries. DeFi opposes this centralized financial system by making peer-to-peer trades more accessible to the general public and disempowering intermediaries and gatekeepers.
As stated above as well, the DeFi application utilizes blockchain and cryptocurrency technology, which means that each transaction is recorded in an encrypted form on the computer by resolving challenging mathematical equations and adding new blocks of transactions to the chain with every new transaction.
This not only gives users anonymity, payment confirmation, and a record of asset ownership but also protects the system and makes financial transactions safer and more transparent than those conducted through the private, secretive mechanisms used in centralized finance.
Now that we are familiar with the fundamentals of decentralized finance. We’ll continue and go into further detail on liquidity mining, starting with some basic terminologies that you’ll come across.
Basic Terminologies
Decentralized Exchanges: Decentralized exchanges or DEX for short, are trading platforms where digital assets from liquidity providers are added. These are networks that operate independently without close oversight from a third party, such as a bank. This type of deal is often controlled by algorithms and smart contracts and is not held by a single party.
Yield: When it comes to other DeFi platforms, yield refers to the interest rate that investors receive for supplying liquidity or owning interests in these initiatives. It can be in the form of trading commissions or LP tokens.
CeFi: Also known as Centralized financial institutions, is the opposite of DeFi. It is organizations operating in the bitcoin market that provide financial services.
TradFi: Traditional finance refers to conventional financial institutions, such as banks, stock exchanges, and hedge funds. TradFi and CeFi are different because TradFi refers to conventional financial markets, and CeFi refers to blockchain technology.
Liquidity Pools: it is a set of funds secured in a smart contract. A market is created when two tokens of equal value are added to a pool by users known as liquidity providers (LP). Each liquidity provider receives a portion of the transaction fee when a trade is made.
AMM (Automated Market Maker): AMM is a smart contract. All decentralized exchanges (DEXs) are driven by an automated market maker (AMM).it is a trading mechanism that links users directly without the involvement of a third party. The AMMs are where LPs deposit their assets and where traders transact while exchanging cryptocurrency.
What is Liquidity Mining?
Liquidity mining is a method of investing that enables participation in decentralized networks by contributing liquidity to a network’s liquidity pool. Participants contribute funds to a decentralized exchange’s liquidity mining pool and, in turn, receive a portion of the platform’s fees or tokens in return for their contributions. Each liquidity provider gets paid according to the aggregate sum of money they put into the pool.
This method of investment creates passive income, which means you can profit from it without making active investment decisions. Back in 2020, when the compound originally introduced the DeFi liquidity mining idea, it was well received. The total value locked (TVL) for liquidity mining has been constant since then at roughly $97 billion. That is why liquidity mining is rather more popular among investors.
Working Mechanism of Liquidity Mining
Let’s take a closer look at how liquidity mining operates. Liquidity mining is the process of using cryptocurrency to provide liquidity to decentralized exchanges. It is based on the Automated Market Maker, or AMM, system architecture, which enables efficient trade regulation. Participants contribute their assets to a large group known as a liquidity pool.
A trading pair, like ETH/USDT, is frequently the basis of a pool. The assets would subsequently be collected by the AMM and given to the liquidity providers as a reward. An LP’s share of the rewards will increase in proportion to how much they contribute to a liquidity pool.
The outcome is a mutually beneficial partnership in which each side gains something from the other. One of the key factors contributing to this method’s popularity among traders is the fact that anybody may use it.
Liquidity Mining Protocols
According to DeFipulse, there are already 120 DeFi platforms with more than $80 billion in TVL, demonstrating the growth of liquidity mining since its beginnings. In light of this, the many sorts of protocols would be brought up as another crucial point in any discussion on liquidity mining.
Protocols for spreading liquidity are distributed in a certain way. The following are the three standout categories among liquidity farming protocols:
Fair Decentralization Protocols
The fair decentralization protocol is an approach that seeks to provide each participant with an equal chance of success. Fair decentralization procedures aim to level the playing field for all stakeholders. As a result, by adhering to several requirements to ensure token distribution, fair decentralization techniques have a better possibility of allocating native tokens fairly.
Programmatic Decentralization Protocols
The DeFi liquidity mining techniques also have another key characteristic called progressive decentralization. Progressive decentralization protocols enable a gradual transfer of power to the community. The idea of programmatic decentralization aims to stop an uneven distribution of governance tokens. Although the process of distributing tokens is long, it avoids the potential of an unbalanced distribution of governance tokens.
Growth Marketing
Unlike the other two protocols, the third kind of liquidity mining employs a method to reward community members who spread the project’s word. To get governance tokens, interested parties must advertise the DeFi platform or protocol. The road map of the growth marketing model is only released a few weeks before the launch date.
Advantages and Risks Associated with Liquid Mining
Now that liquid mining has been covered in great detail, it is time to learn about some of the benefits and dangers associated with it. Starting with the advantages first.
Advantages
Here are a few of the prospective benefits of mining or growing liquidity.
It is an excellent approach for any investor since your income is related to your investment. Your rewards often come in the form of trading commissions that build up whenever trades take place on the exchange. Your rewards will match your dedication if you make a big investment. This also allows you to essentially forecast your returns too.
Before the invention of cryptocurrency liquidity mining, the developers of the DeFi protocol frequently preferred institutional investors over small-capital investors. DeFi liquidity mining put an end to this and now allows investors with both low and large money an equal opportunity to buy local tokens. The benefit of DeFi liquidity mining is that it enables equitable governance distribution using native tokens.
As a result, you could get a lot of comfort from any concerns about bias.
DeFi liquidity mining offers a low entry barrier and a fair distribution of profits to investors. Since most platforms accept minimal deposits, it is simple for novice investors to get involved in liquidity mining. They can also use their gains to buy more interest in the liquidity pools. Therefore, this investing strategy may be advantageous for everyone.
Liquidity mining has the advantage of establishing a loyal and trustworthy community. A protocol might create a community that believes in and supports the new enterprises on the platform with the aid of liquidity farming initiatives.
Risks
Liquidity mining has already brought the DeFi community more advantages than we can imagine, but every successful investing approach also carries hazards that should be taken into account before investing. Risks associated with extracting liquidity include:
One of the main risks for liquidity miners is when the tokens you contributed to a liquidity pool can become worth less than you did when you first deposited them. This is referred to as an impermanent loss. The profits from the LP rewards may occasionally be able to offset this unrealized loss, but cryptocurrency assets are extremely volatile and have dramatic price swings. This is one of the major setbacks that no investor would appreciate.
Liquidity mining is associated with technical concerns like coding flaws and a lack of vigilance a. This might encourage hackers to utilize the DeFi protocols to steal money and wreak havoc. As a result, there may eventually be losses from token theft that occur within the liquidity pools or a decline in token value as a result of the negative publicity.
Another important disadvantage associated with liquidity farming is the concern of increasing gas prices. Higher gas prices may drive away small investors, providing benefits from liquidity mining to those who can afford to pay hefty fees.
Rug pull scams, a type of fraud in which the key developers behind a DeFi platform shut down their businesses and vanish with investors’ money, are also a major entry among the risks associated with liquidity mining.
The greatest issue for investors in decentralized networks with open protocols, like DeFi marketplaces, is that information is not equitably disseminated to the public.
Factors to Consider Before Choosing a Liquidity Mining Platform
Before selecting a liquidity mining platform, there are a few things to keep in mind. These includes
Centralization Risk
One needs to check the level of decentralization provided by a certain platform they are opting for. To do this, examine the project parameters, such as the number of liquidity suppliers, the total value locked (TVL), and the available liquidity.
Security Concerns
Hackers regularly target blockchain networks and protocols. Double-check the DeFi platform you are selecting to reduce the risk of losing your money. You can check its security history by taking into account the platform’s age and the identities of the platform’s primary developers.
Functionality
Given that the majority of DeFi platforms only allow Ethereum-based tokens, you should search for a DEX platform that supports the tokens you want to invest in.
Best Platforms for Liquidity Mining
Here are a few of the noteworthy entries from the best crypto liquidity pools for 2022, along with a summary of their salient features.
Uniswap
When you take into account its trading volume, UniSwap is probably the biggest decentralized cryptocurrency exchange. The platform uses ERC-20 and Ethereum tokens. An investor must deposit Ethereum to a liquidity pool of their choice using a compatible Ethereum wallet. The fact that Uniswap runs an open-source exchange gives it a competitive edge because anyone may use it to build new liquidity pools for any token without paying any fees.
Uniswap also stands out for its 0.3% exchange charge. All you have to do to get Uniswap tokens is deposit crypto assets. A portion of the exchange charge goes to the liquidity providers.
Balancer
The next entry on a list of the best crypto liquidity pools would be Balancer. Ethereum, the liquidity pool, acts as a non-custodial portfolio manager and price sensor. Undoubtedly, it is the best UniSwap substitute available. It offers better conditions for both traders and liquidity providers. The balancer is more flexible than UniSwap because the platform supports up to eight different tokens within a single pool, as opposed to UniSwap’s two-token maximum.
Curve Finance
Curve Finance is a DeFi exchange created specifically for trading Stablecoins, and it is based on the Ethereum network. Because it exclusively uses stablecoins, there is less volatility for temporary loss and less slippage when lending and borrowing money.
On the platform, there are seven various pools, each with a unique ERC-20 pool pair. Therefore, it offers exchanges for several pools of cryptocurrency assets and stablecoins, including Compound, PAX, and others. However, the platform’s native token is called CRV.
PancakeSwap
PancakeSwap is a native decentralized exchange built on the more modern Binance Smart Chain. Due to its usage of the Proof of Staked Authority (PoSA) process, this blockchain is quick, inexpensive, and environmentally friendly. Its liquidity pools, in general, offer higher yields. All you have to do is set up your MetaMask wallet to communicate with BNB Chain-based decentralized applications like PancakeSwap.
DeversiFi
DeversiFi is one of the leading liquidity pools that are famous for being quick and noticeable. Through the use of a layer 2 scaling engine, it provides the highest TPS, or transaction per second. DeversiFi has some impressive features, like support for pooled liquidity pooling and almost no exchange fees because of how quickly transactions are processed. Traders can use the DeversiFi STARKEX smart contract to enable off-chain transactions while maintaining the balance on the on-chain, as it enables both public and private cryptocurrency wallets.
Bancor
Another popular Ethereum-based liquidity pool is bancor. This network uses smart tokens and algorithmic market-making techniques to provide liquidity and precise pricing. Bancor maintains a constant ratio among the numerous linked tokens in addition to altering the number of tokens.
The Bancor stablecoin is made available by the Bancor Relay liquidity pool. Bancor charges 0.1% to 0.5% of the transaction as opposed to a fixed exchange fee, per the pool. Also, it supports liquidity pools using the USDB stablecoin, ETH, or EOS tokens.
Convexity Protocol
It is another decentralized liquidity pool that provides a fungible ERC-20 tokenized option contract or a broader base for tokens. It helps users build collateralized option contracts, which may then be sold as tokens. Convexity liquidity pool uses liquidity insurance in a special way that gives traders and liquidity suppliers peace of mind and assurance of security.
Conclusion
Liquidity mining is a vital component of maintaining the DeFi ecosystem’s expansion. It is a great way to generate passive income for cryptocurrency holdings that would have otherwise been hoarded without the added advantages through liquidity mining. By acting as a liquidity provider an investor in cryptocurrencies can contribute to the development of the emerging Decentralized Finance industry while also making some money.
Though liquidity farming or mining offers numerous opportunities for DEXs and DeFi to thrive, it also has significant drawbacks. Liquidity mining may or may not turn out to be a profitable long-term cryptocurrency investment strategy depending on how quickly the blockchain industry expands, and the results are still awaited.