Liquidity Mining: Possible Benefits and Risks

One of the best methods to become successful when investing in cryptocurrencies is to make additional passive income. There are various approaches to accomplish this, such as liquidity mining, yield farming on DeFi (decentralized finance) platforms, or staking your assets.

With the help of decentralized networks like blockchains, a new fintech concept named decentralized finance aims to upset the established financial system. Thanks to the DeFi concept, the system operates by eliminating centralized institutions, enabling peer-to-peer (P2P) communication between all users.

The main focus of this article will be liquidity mining. We will go through what it is and the risks and rewards for investors using it. Moreover, we will explain how to take part in mining liquidity and will share some modest predictions for the future.

Long story short, the process of crypto liquidity mining is known for giving some of your tokens to a decentralized trading service where you can receive incentives. Other market participants will be able to use these assets for the purpose of making transactions on the market.

But let’s dive into more details.

Using a decentralized exchange, also known as a DEX, buyers and sellers can interact and swap a wide variety of cryptocurrency tokens without the help of a third party. There are several exchanges on the market, such as Uniswap or SushiSwap. The entire process is accomplished using smart contracts, thanks to blockchain networks like Ethereum, without ever contacting an external server or database.

These features allow conducting entirely anonymous transactions and never involve third-party middlemen like banks or financial services providers in these transactions. DEXs are an essential component of DeFi systems.

DEXs require funding to provide their trading services. This is made possible via liquidity pools, in which investors might store their cryptocurrency assets and start earning rewards in crypto tokens or interest. The locked money thus acts as the decentralized crypto exchange’s leading funding source. That said, DEX trading platforms couldn’t operate without this accessible liquid core of people’s capital.

The liquidity pools depend on the participation of users eager to lock in their cryptocurrency tokens in exchange for benefits. Trades on the DEX platform are ultimately made possible by these investments. Thus, liquidity mining is the practice of storing tokens in a DEX liquidity pool to earn incentives.

Imagine a scenario where you want to access a liquidity pool on Uniswap, which is, by the way, the oldest and biggest DEX. This procedure will take multiple steps, using various phone applications and websites.

First things first, you must have access to some digital currency. We will use Ethereum (ETH) and the stablecoin Tether (USDT) as an example. Note that Ethereum and Tether are one of the most used coin pairings on Uniswap. Most of the time, the coins you invest cannot be stored in the default wallet provided by your crypto trading service. Instead, they must be relocated to a wallet in your control, known as self-custody.

The next step is to link your crypto wallet and add your assets to the liquidity pool on the Uniswap mobile app or browser-based interface. Select the desired Uniswap trading pair by clicking the “pool” button, followed by the “new position” link, and then observe how the benefits are distributed.

Furthermore, you can choose from a number of incentive tiers linked to various interest rates applied to traders who use the virtual currency you’re offering. The pool charges for popular cryptocurrencies and stablecoins tend to be lower than those for uncommon and exotic coins.

Let’s choose the average fee rate of 0.3%, which is what most Ethereum-Tether liquidity miners on Uniswap undertake. This often results in an APR (Annual percentage rate) of 80% to 90%, although the figure varies with time. In practice, the liquidity miners receive a portion of the revenue earned from DEX traders, and as trading volume rises, the proportion of the pot gets bigger. Consequently, if a particular tier on the Uniswap trading platform demonstrates remarkable participation, a reduced cost may result in a higher reward. You get a bigger piece of the overall share if you have a larger percentage of locked liquidity.

Now, choose how much ETH you would like to lock up. Then, you will see that a certain amount of Tether tokens are instantly paired. The ratio of Tether to Ethereum fluctuates according to which fee level you choose, and both coins must be present in your wallet.

After collecting your liquidity tokens, you may relax or focus on your primary business while you wait for your bonuses to start coming in. While a combination of stablecoins may produce payouts that may not be extraordinarily high, risky and rare token pairs often deliver bigger bonuses.

Now that you know how liquidity mining works and what it is in theory let’s take a look at its benefits and risks.

In addition to the liquidity providers, DeFi platforms and the larger blockchain community can all benefit greatly from liquidity mining. These are the benefits:

Balanced allocation of tokens – This only applies to DeFi protocols that give governance tokens as compensation to liquidity providers. LPs are usually compensated by the proportion of their commitments to the liquidity pool on most platforms. Greater token rewards are given to LPs in proportion to their increased risk. Uses for governance tokens include:

Remember, though, that this model is still vulnerable to a particular level of injustice since many powerful investors could take over the dominant role despite an equitable allocation of governance tokens.

Passive earnings – Liquidity mining is an excellent way for LPs to generate additional income, just like passive stakeholders do in staking networks. This is one of the most important factors of this whole concept, as it attracts people with extra money and faith in the crypto idea as a whole.

Everybody is rewarded – This interaction approach benefits all participants in a DeFi marketplace. The platform is beneficial for most users, including traders, developers, and others involved. It also rewards LPs for borrowing their tokens and providing traders with a highly liquid marketplace. 

Minimal entrance criteria – Since most platforms accept low initial deposits, it is simple for beginner participants to get involved in liquidity mining. Users can also use their gains to buy more stakes in the liquidity pools.

Open governance – Considering the fact that everyone can be a part of liquidity mining regardless of the stake they hold, everyone can also collect the governance tokens and use them to vote on project-related development proposals and other important choices made by the stakeholders. Due to all of this, even the smallest investors can play a part.

Liquidity mining is a type of investment technique with advantages but also drawbacks that should be taken into account before investing in it. Risks associated with this method include:

Sudden Loss – The potential of losing money if the value of your tokens declines while they are still locked up in the liquidity pool is one of the key concerns to liquidity miners. Because this loss may only be fulfilled if the miners choose to redeem the tokens at a loss, it is called impermanent loss. The profits from the LP payouts can occasionally make up for this unrealized loss, but as you already know, cryptocurrency assets are vulnerable to massive price swings.

Scams are all over the place – The chance that the leading developers of a DeFi platform may shut down the business and vanish with investors’ money is, unfortunately, quite real and frequent throughout different blockchain platforms. There have already been several cases of such scams. Take the Compounder Finance rug pull, which cost investors more than 10 million US dollars. Such incidents often occur in the DeFi market due to a lack of regulation. Therefore, be very careful where you put your capital.

Increased security risks – Technical flaws could allow cyber attackers to exploit platform technology to steal money and cause chaos. Since the majority of initiatives in the cryptocurrency industry are open-source software and the underlying code is available for public viewing, such safety problems are frequent in this industry. In the event of a security breach, investments in liquidity pools could be robbed, or the value of tokens could fall as a result of bad news reports. 

Inequality of information – The fact that information is not appropriately shared with the public is the most significant hurdle for traders in decentralized networks, such as DeFi exchanges. Information disparity contributes to social issues like “cyber corruption,” dishonesty, and insecurity.

Now that you know what the benefits and drawbacks of this method are, you may wonder what the steps are to get started with liquidity mining.

Liquidity mining may seem straightforward, but finding a liquidity pool to join can be more complex than expected.

The procedure’s first and most crucial part is selecting which liquidity pool to join. Due to the fact that all cryptocurrency transactions are irreversible, make sure to pick a trustworthy pool. The pool’s average earnings, reputation, as well as other data and criteria should be taken into consideration. When you are looking for a good liquidity pool, please consider the following:

The daily trading volume is a crucial factor in liquidity pools. The trading commissions will determine the size of your profits, which will account for all of your earnings. For example, Uniswap, the most prominent cryptocurrency DEX, collects fees ranging from 0.05% to 1%, with higher costs typically applied to smaller cap tokens.

One of the most important factors is the pool’s capacity. Smaller pools are much more prone to dramatic price fluctuations, which makes you more susceptible to temporary loss. In light of this, it is advisable to focus on older tokens. However, as already stated, choosing assets with lower caps delivers more benefits.

The level of risk and profit that each client is willing to accept will range, and this will specify the reserve size each should take into account.

If you have done your research and found the right platform, you will be required to register for a pool account. You just need to deposit your crypto and wait for your earnings.

Among the most well-known liquidity mining programs are, for example, 1inch Liquidity Mining Protocol or Binance Earn. 

Now that you are more familiar with the concept of liquidity mining, you may wonder what the future might hold.

While liquidity as a service is now one of the most vital fields in crypto, nobody can tell whether it will be the future of project funding.

According to several skeptical experts, projects such as Curve or other “elite” projects that intend to become the central liquidity hub through reward systems will win most of the market share, or the hype will fade away.

Every liquidity mining program’s long-term sustainability is primarily connected to the amount of interest for the core token. However, most initiatives can’t sustain long-term demand for the token, resulting in a constant outflow as users shift to more profitable projects.

However, there are projects such as PancakeSwap, which is perhaps one of the few platforms that have been able to find the perfect mix between appropriate incentives for liquidity miners and long-term demand.

One of the primary reasons PancakeSwap has been able to retain its momentum for so long is the platform’s rapid pace of new advancements. Many projects failed to deliver new products to expand their token utility. A project that offers more features and improves security will find it easier to attract investors.

To become successful, these platforms should desirably include a slew of extra features such as NFT collectibles, prediction markets, initial farm offerings (IFOs), and others. Therefore, the network will be more likely to manage to retain its users’ interest over time.

On the other hand, seeing many prosperous and progressive concepts, several optimistic experts believe that the result of liquidity mining will be a world with numerous competing partnered initiatives controlling enormous areas of liquidity rather than an oligopoly by elite projects.

Indeed, nobody knows what the outcome will be for crypto in general, considering the current historical bear market and the regulations that are likely to show up sooner or later. The present generation of projects emerging in the aftermath of the turbulent years of liquidity mining reflects an evolution in how initiatives persuade and create incentive funds from users and DAOs. Thus, liquidity mining will likely stick around, with many investors remaining optimistic about the concept.