Investing
Bybit Learn
Bybit Learn
Beginner
Jan 5, 2022

What Is Liquidity Mining: How to Profit from a Decentralized Ecosystem

In recent years, the use of blockchain and cryptocurrency has grown rapidly. While the main investing strategy for crypto is to purchase and hold cryptocurrencies until they increase in value, there are several additional methods you can use to earn passive income. One such strategy involves liquidity mining, which takes advantage of the immense hype behind decentralized finance (DeFi) while allowing investors to use their holdings to generate additional income.

If you’re wondering, “What is liquidity mining?” the answer is that it’s a beneficial network participation strategy which gives you the opportunity to place some of your assets into liquidity pools available on decentralized exchanges. By lending assets to these liquidity pools, you can earn such rewards as trading fees and governance tokens. This article goes into detail about liquidity mining, including its many benefits and the few risks that might occur when investing.

What Is Liquidity Mining?

Liquidity mining is a decentralized finance mechanism wherein participants provide some of their crypto assets into various liquidity pools, from which they’re rewarded with tokens and fees.

The in-depth answer to “What is liquidity mining?” is much more important to understand if you’re thinking about placing some of your cryptocurrency assets into liquidity pools. Liquidity mining has proven to be highly popular among investors because it earns passive income, which means that you can obtain rewards from liquidity mining of crypto without needing to make active investment decisions along the way. Your total rewards depend on your share in a liquidity pool.

Even though the liquidity mining of crypto became considerably more popular in June 2020, the strategy had been pioneered three years earlier. The concept was initially defined in 2017 by IDEX, which is among the most popular decentralized exchanges. Over the next three years, the concept was further refined by Synthetix and Compound.

When DeFi liquidity mining was first introduced by IDEX, it existed in the form of a reward program which provided certain benefits to participants on the exchange. Instead of locking capital in a separate pool, participants were given IDEX tokens once they made the decision to provide liquidity. In order to obtain IDEX, the only thing participants had to do was fill a basic limit order.

The DeFi liquidity mining concept was adopted at an exceedingly fast rate once Compound announced it in 2020. Since then, the total value locked (TVL) in regard to liquidity mining is at just under $97 billion. One major reason for its popularity among exchange participants is that anyone can use this strategy. Instead of keeping your crypto assets in storage where they don’t earn you any money, liquidity mining makes it possible to earn passive income on your existing assets.

Liquidity Mining: Key Terms and Concepts

Before learning more, you should be aware of a couple of key terms covered throughout this guide.

  • Decentralized exchanges are cryptocurrency exchanges that allow for peer-to-peer transactions, which means that an intermediary such as a bank is unnecessary. This type of exchange is fully autonomous, and is managed by algorithms as well as smart contracts.
  • Liquidity pools provide you with the ability to lock your assets in the form of tokens when liquidity mining with a decentralized exchange (DEX). These assets can then be traded by individuals on the platform without involving a go-between. You can receive native tokens once you provide liquidity to a liquidity pool.

Benefits of Liquidity Mining

Now that you understand what liquidity mining is, it’s time to learn about the benefits of utilizing this investment strategy. When you provide assets into liquidity pools, you can be confident in the returns that your investment will deliver. The primary benefits associated with DeFi liquidity mining are:

  • Potential for high yields
  • Distribution of governance and native tokens
  • Low barrier to entry
  • Nurtures a trusting and loyal community

High Yield

Before you begin to liquidity mine, it’s important to understand that your yield is proportional to the overall risk you take with your investment — which makes liquidity mining a beneficial strategy for any type of investor. If you want to make a sizable investment, the rewards you receive will proportionately match your contribution. The same is true if you want to dip your toes in before fully committing to the liquidity mining strategy.

Decentralized exchanges can’t be operated unless a certain amount of liquidity is in place for traders who want to exchange tokens from different cryptocurrencies. When you provide liquidity in this manner, exchanges are incentivized to give you rewards for your contributions.

Since your investment is essentially used to facilitate decentralized transactions, your rewards usually come in the form of trading fees that accrue whenever trades occur on the exchange in question. Since your share of the liquidity pool dictates what your yields are, you can essentially estimate what your rewards will be before you’ve even invested.

Distribution of Governance and Native Tokens

A core benefit of DeFi liquidity mining is that it allows for the relatively equitable distribution of governance via native tokens. Before liquidity mining of crypto existed, token distribution was largely unfair and imbalanced. In many cases, DeFi protocol developers would favor institutional investors over low-capital investors, due to the amount of funds that institutional investors had at their disposal.

DeFi liquidity mining provides low-capital and institutional investors alike with equal opportunity to obtain native tokens. These tokens give you a certain amount of voting power within the DEXs that you’ve invested in. When you have tokens for a specific exchange, you can use them to influence that protocol’s characteristics. The primary benefits of holding native tokens include the ability to:

  • Revise the development fund
  • Vote to change the fees
  • Implement changes to the UI
  • Change the distribution of fee rewards

Even though tokens are primarily used for governance, they are highly versatile and can also be used to stake, earn money via yield farming or take out a loan.

Low Barrier to Entry

Along with equal distribution of rewards to investors, DeFi liquidity mining also has a relatively low barrier to entry. As mentioned previously, anyone can take advantage of this investment strategy. If you’ve previously wanted to take part in the decentralized ecosystem, but didn’t necessarily have the assets to do so, the liquidity mining of crypto allows you to provide any amount of liquidity and receive tangible benefits.

Nurtures a Trusting and Loyal Community

One benefit of liquidity mining which is often overlooked is the fact that it nurtures a trusting and loyal community, since many investments occur with new exchanges. When a liquidity mining program occurs, the investors who provide liquidity typically become active in the community while the exchange itself continues to grow.

The individuals who provide liquidity also tend to use the protocol and hold tokens well after they’ve invested their cryptocurrency assets. With liquidity mining, the benefits don’t end with the income that you receive as a liquidity provider. By continuing to engage with the protocol, you’ll continue to receive additional benefits.

Risks of Liquidity Mining

Despite the many benefits of liquidity mining, there are also some inherent risks to be aware of before you engage in it. Once you understand the potential risks, you should be able to mitigate these issues and reduce their chance of occurring in the first place.

Impermanent Loss

Before you start investing your crypto assets in liquidity pools, you should know what impermanent loss is and how it can affect you. This can occur when the price of the tokens that you’ve contributed to liquidity pools changes in comparison to what it was when you first invested. A more substantial price difference makes it more likely that you’ll encounter an impermanent loss.

If the tokens have a lower price when you decide to withdraw than they had when you first placed them into liquidity pools, you lose money. You can offset this particular risk with the gains you obtain from trading fees. However, the volatility of the cryptocurrency market means that you should be at least somewhat cautious when depositing your money into DEXs.

Project Risk

There are also some technical liquidity mining risks to be aware of, inherent to any protocol. When a protocol is highly advanced, the source code that the protocol runs on is more complex. This complexity means that protocols are open to technical liquidity mining risks. If you don’t perform an in-depth audit of the code, it’s possible for cyber criminals to exploit the protocol and the assets within.

Of the several liquidity mining risks in this guide, the one to focus on is the potential risk to the protocol and the project. Even though all projects can be exploited, it’s still highly recommended that you perform extensive research on a project and its platform before you decide to place your assets into its liquidity pool. 

The research and due diligence you perform should provide you with a level of protection against hacks and similar exploitation. It’s also important that the projects you invest in are audited on a regular basis by independent agencies.

Potential Rug Pulls

Despite the many advantages that come with decentralized investing, the nature of the system does have a few built-in risks that could arise. One of these involves the potential for “rug pulls,” which are a type of fraud that occur when liquidity pool developers and protocol developers decide to shut the protocol down and take away all of the money that’s been invested in the project.

Since all decentralized protocols offer anonymity, projects can be started without any kind of verification or registration. Compounder Finance (not the similarly named Compound Finance) is one example, when developers closed the project in 2020 and ran away with $10.8 million of investor assets.

If you don’t want to fall prey to liquidity mining fraud, it’s essential that you perform your due diligence to learn everything you can about a project before investing in it.

Liquidity Mining vs. Other Passive Investment Strategies

Before you settle on the investment strategy that’s right for you and your portfolio, be sure to compare DeFi liquidity mining to other passive investment strategies. Even though you likely have the answer to the question “What is liquidity mining?” by this point, other passive investment strategies like staking and yield farming also have notable advantages.

Liquidity Mining vs. Staking

The first type of passive earning strategy to consider alongside liquidity mining is staking, which is a consensus algorithm that allows users to pledge their crypto assets as a form of collateral within proof-of-stake (PoS) algorithms. 

While miners use a certain amount of computational power to obtain consensus in a proof-of-work (PoW) blockchain, the investors who make the highest stakes will be selected to validate blockchain transactions. Along with improved energy efficiency in comparison to PoW blockchains, PoS algorithms deliver unique opportunities for obtaining rewards.

The people who stake higher amounts will typically receive higher rewards, which is similar to what occurs when performing liquidity mining of crypto. 

Another clear advantage of staking is that the risks are comparatively low. While project failure and liquidity risks are possible, liquidity mining risks are considerably more severe. For instance, rug-pull fraud is only possible with DeFi liquidity mining.

Liquidity Mining vs. Yield Farming

While some investors use the terms liquidity mining and yield farming interchangeably at times, it’s important to understand that liquidity mining is a subset of yield farming, which involves locking crypto assets in various blockchain protocols to earn passive income.

While liquidity mining results in an investor earning native tokens, the investments that occur with yield farming will result in the investor earning interest. The two strategies share similar benefits and risks.

Is Liquidity Mining Worth It?

Even though you now have a firm grasp of the concept of liquidity mining, this strategy isn’t right for everyone — and may not be worth it for you personally, depending on your current investment strategy. To determine if liquidity mining of crypto is right for you, make sure that you weigh the pros and cons. 

The main benefit of investing in liquidity mining is that your yield is proportional to the risk you take, which allows you to be as risky or as safe with your investment as you’d like. This particular investment strategy is also very easy to get started with, which makes it ideal for beginners.

On the other hand, there are a few risks to keep in mind. Although rare, it’s always possible that a hacker could gain access to the project you’re involved in, which may result in you losing access to your assets. The same is true if a case of rug-pull fraud occurs. If you engage in liquidity mining of crypto, always focus on strategies to minimize these risks in order to avoid making costly investment mistakes.

While liquidity mining is a very recent investment strategy for crypto assets, it looks as though it’s here to stay. If you’re searching for a sound investment strategy to serve you well in 2021 and beyond, liquidity mining may be right for you. Again always perform comprehensive research before making an investment. 

It’s also important that you begin with smaller transactions, which will give you a better idea of the potential losses and rewards before you make a more substantial investment.

The Bottom Line

Once you have a thorough understanding of liquidity mining and its potential risks and gains, you should be better equipped to invest your assets in liquidity pools. With the right approach, you could garner high yields that bolster your portfolio and allow you to earn consistent passive income. While other passive investment strategies may have their benefits, liquidity mining is the most accessible investment strategy you can implement.