One of the flagship products of decentralized finance (DeFi), liquidity mining consists of using cryptocurrencies to provide liquidity to decentralized exchanges (DEX) in order to generate regular passive income. How does liquidity mining work? What are the platforms to take advantage of it?
What is liquidity mining?
ILiquidity mining is a very popular strategy in the field of decentralized finance to generate passive income. It aims to encourage users to deposit their cryptocurrencies on a decentralized platform by offering them a sometimes high annual return.
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To participate in liquidity mining, you have to become a liquidity provider (LP) by adding liquidity to the various trading pairs available on the platform.
For DEXs to perform optimally and be attractive, maintaining adequate liquidity is crucial. Liquidity is essential as it allows users to trade cryptocurrencies smoothly. One of the main advantages of DeFi is precisely to eliminate traditional intermediaries and to make liquidity more accessible to all. However, decentralized finance may encounter liquidity problems in some cases.
For example, a common trading pair might be ETH/USDC, allowing ETH to be traded for USDC and vice versa.
If the platform lacks liquidity providers for this pair, this can lead to high slippage, which means that the user will get a cheaper price when exchanging their cryptocurrencies. In effect, slippage is the difference between the expected price of a trade and the price at which the trade is executed.
👉 Find our complete explanation of what slippage is
Let’s take a concrete example: if ETH is currently trading at €2,000 and there is low liquidity (high slippage), a buy transaction could execute at €2,100, which represents a slippage of around 5%, which is not ideal.
To address this issue, platforms offer incentives for liquidity providers who deposit their ETH and/or USDC on the platform. This adds liquidity and reduces slippage in the previous scenario.
The platforms deploy various strategies to encourage the addition of liquidity as much as possible. They can offer programs of Yield Farming which offer additional rewards to liquidity providers, although this usually involves an additional level of risk. Some DEXs also offer tokens of governance or other native tokens. Moreover, having a wide range of pairs available indirectly helps to increase the liquidity of a token. This allows users to exchange their tokens for a variety of other tokens, which promotes smooth trading and thus strengthens the overall liquidity of the platform.
By offering better liquidity, the platform attracts more users who benefit from reduced slippage when trading and therefore better prices when trading. Each liquidity provider is rewarded with an annual return expressed in the protocol’s cryptocurrency, which incentivizes them to keep depositing their assets on the platform.
As you can see, liquidity mining is relatively simple for users. It is still necessary choose the liquidity pair wisely and carefully assess the potential risks as well as the fees associated with withdrawing the rewards.
Figure 1: “High yields attract short-term cash, but hurt long-term projects”
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Some platforms to take advantage of liquidity mining
Uniswap – Uniswap is the benchmark DEX for depositing cryptocurrencies in liquidity pools given its transaction volume. Uniswap enjoys a competitive edge with its open-source exchange modelwhich allows anyone to create new pools of liquidity for any cryptocurrency at no cost.
curve – Curve is also one of the most recognized DeFi platforms, and this is largely due to its philosophy focused on stability rather than volatility by mainly offering pairs with stablecoins. It offers the opportunity for users to generate passive income by adding liquidity to the platform. In return, the platform rewards them with CRV tokens, Curve’s native cryptocurrency.
QuickSwap – QuickSwap is an Automated Market Maker (AMM)-like DEX based on the Polygon blockchain. It solves user experience issues such as high Ethereum fees and transaction delays by using Polygon’s layer 2 technology, providing fast and inexpensive transactions. It is powered by tokens QUICK And dQUICKoffering features such as staking or liquidity mining.
Pancake Swap – PancakeSwap, initially developed on the Binance Smart Chain (BSC), is now extending its support to Ethereum and more recently to Aptos. Currently ranked 2nd among AMM platforms, after Uniswap, PancakeSwap has similarities with its competitors. This platform offers a variety of featuressuch as liquidity mining, staking and Initial Farm Offerings (IFO) on 3 different blockchains.
Figure 2: Simplified diagram of how an AMM works
👉 What is a DEX (decentralized exchange) in crypto?
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Liquidity Mining Frequently Asked Questions
What are the benefits of liquidity mining?
Liquidity mining allows passive income to be generated by providing cryptocurrencies in liquidity pools. Rewards are automatically added in LP tokens, providing a regular source of income. Another interesting feature is the distribution of governance and native tokens. Liquidity providers can obtain it, which gives them the power to vote on protocol decisions, thereby influencing its development. In addition, liquidity mining has a low barrier to entry, as it is accessible to all cryptocurrency holders and does not require special skills. This enables democratized participation in the DeFi space.
What are the risks of liquidity mining?
Impermanent loss is one of the major risks faced by liquidity providers, as fluctuations in token prices can lead to losses if they withdraw their funds when prices are lower than at the time of the transaction. initial investment. In addition, there are technical risks associated with the protocols, such as the exploitation of vulnerabilities by cybercriminals.
What is the difference between Yield Farming and Liquidity mining?
Yield farming consists of providing liquidity to a DeFi protocol in exchange for returns, often through complex mechanisms in order to optimize the latter. Liquidity mining, on the other hand, is a variant of yield farming where users are specifically rewarded for the liquidity they provide to the pools, receiving the platform’s native token in addition to the revenue generated from the fees. In short, Yield Farming encompasses all means of obtaining yield, including liquidity mining.
What is the difference between Staking and Liquidity Mining?
The main difference between staking and liquidity mining is their purpose and reward mechanism. Staking focuses on securing and validating transactions on a blockchain in order to obtain rewards. In contrast, liquidity mining involves providing liquidity to decentralized exchanges and pools for the purpose of earning rewards as well.
👉 See our clear and precise explanation of what impermanent loss is
Sources: Figure 1: Messari; Figure 2: AZ Corner
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