Traditional Finance vs. DeFi
Have you heard about people making money by doing liquidity mining? Are you curious about how it works? Let’s take a look.
Imagine you’re in Paris for your summer vacation and need euros to buy a souvenir near the Eiffel Tower. You only have US dollars, and a merchant doesn’t accept credit cards. Fortunately, you see a little yellow booth with the words “currency exchange” on it. You happily go in to exchange your dollars for euros to buy a souvenir you want. You are happy and so is the exchange booth, because they have made a small commission providing you the service and collected some extra profit on the spread (the difference between a sale and a purchase price of a currency).
As there are many currencies in the fiat world, and many people require to exchange one for another, there are many currencies in the crypto world, and many people want to exchange one for another. For a currency exchange to work, it needs sufficient funds to exchange money for customers. The currency exchange needs to have enough liquidity. This liquidity is provided by the owner of this exchange, who collects exchange fees.
The crypto world works similarly. However, what sets crypto exchanges apart is that anyone can provide liquidity and make money off of it, not just the exchange owner. This is where liquidity mining comes into play.
What is Liquidity Mining?
Liquidity mining is a process where investors provide their crypto assets as liquidity to Automated Market Maker (AMM) platforms and receive passive income. AMM is a decentralized exchange (DEX) that allows users to swap cryptocurrencies without needing an intermediary. AMM is the equivalent of the currency exchange that helps tourists but in the crypto world. In DeFi, these AMM platforms usually use the word “Swap” as part of their names (for example, PancakeSwap, UniSwap, SushiSwap), and they operate entirely on a blockchain, supporting non-custodial wallets.
AMMs use liquidity pools, where investors can deposit their assets to provide liquidity for a particular trading pair. For instance, to exchange ETH for USDT on an AMM platform, an ETH/USDT liquidity pool must exist within it and have enough ETH and USDC deposited for a transaction to take place. Therefore, blockchain users can provide liquidity by depositing their tokens into this pool and earning some profit from the trading fees. And this is what opens up the opportunity to make money from liquidity mining.
Let’s take a closer look at how liquidity mining works.
How Does Liquidity Mining Work?
Automated Market Maker (AMM) platforms like SushiSwap, UniSwap, Curve, PancakeSwap, and QuickSwap are popular options for liquidity mining. Let’s take PancakeSwap as an example and explain how liquidity mining works on this platform.
To grasp the concept of liquidity mining, it’s crucial to understand how a Swap platform functions – especially how currencies are exchanged. Let’s say you wish to swap 100 USDT for BNB. Instead of using a centralized exchange like Binance, you opt for an AMM platform such as PancakeSwap, using your MetaMask non-custodial wallet. When you visit PancakeSwap’s website and navigate the cryptocurrency exchange section, you’ll typically encounter a standard Swap interface.
Taken from PancakeSwap
The exchange process is straightforward: you connect your wallet, select the token you wish to swap (in this case, USDT), specify its amount, and send it to the platform if you are happy with the exchange rate. In return, you receive your desired BNB.
At the bottom right of the interface, you’ll notice the “Trading Fee” highlighted in green, which in this example amounts to just 0.05 USDT (equivalent to $0.05) since we are exchanging only 100 USDT. The platform charges this fee, and a portion of it is distributed to liquidity providers. However, for this swap to occur, there must be a USDT/BNB liquidity pool on PancakeSwap with sufficient deposits of both USDT and BNB. Fortunately, PancakeSwap has such a pool, which can be found in the “Farms” section of the website.
In order for you to swap USDT for BNB on PancakeSwap, someone must contribute liquidity to the USDT-BNB liquidity pool by depositing USDT and BNB in equal proportions. Let’s assume that you are the one who decided to invest in liquidity mining, providing the USDT-BNB pool with liquidity. As a result, the platform gives you unique USDT-BNB LP tokens, representing your ownership in the pool. Essentially, these tokens serve as your certificate of ownership.
Taken from PancakeSwap
LP tokens, such as USDT-BNB LP, can be stored in your crypto wallet, allowing you to earn passive income through fees. Additionally, PancakeSwap also presents an enticing opportunity to stake your LP tokens, yielding a significantly higher return of 14.87% at the time of writing.
Taken from PancakeSwap
But it’s crucial to acknowledge that revenue earned through staking LP tokens at PancakeSwap is paid out in its native token – CAKE, not in USDT or BNB. While this presents a good prospect for increasing your earnings, it also introduces potential problems that we will explore later in this article.
So, by providing liquidity and then staking your LP tokens, you have the opportunity to earn a passive income. Additionally, the platform can facilitate cryptocurrency swaps among its customers. It’s worth noting that liquidity mining has a low entry amount, allowing you to start with just a few dollars.
By the way, earning passive income is possible not just through liquidity mining. Have you heard of yield farming?
Liquidity Mining vs. Yield Farming vs. Staking: What's the Difference?
If you’re new to DeFi, you might have encountered the terms “yield farming” and “liquidity mining” and wondered if they are interchangeable. While yield farming refers to earning yield in DeFi, it encompasses various strategies, including liquidity mining, staking, and lending.
So what sets liquidity mining apart from yield farming, staking, and lending?
What is Yield Farming?
In simple terms, liquidity mining is a strategy for earning passive income in DeFi. It involves depositing tokens into a liquidity pool and receiving an annual interest, often in the form of platform tokens. At the same time, yield farming is a broader term covering all types of passive income earned from crypto assets, including liquidity mining.
What is Staking?
Staking is a process where blockchain users lock their assets to help secure the blockchain and validate transactions. It is available on blockchains that utilize the Proof-Stake (PoS) consensus mechanism. Investors participating in staking can either delegate their tokens to validators or become validators themselves, earning rewards from the blockchain. These rewards are generated from a gas fee that every blockchain user pays when conducting transactions or from newly minted tokens.
However, it’s important to note that the staking income is generally lower than that of liquidity mining. On the other hand, staking is a less risky strategy for making money in DeFi than liquidity mining. The key distinction between staking and liquidity mining lies in the requirement of token investment. Staking involves investing a single token, whereas liquidity mining requires depositing at least two tokens in equal proportions, which might cause the problem called impermanent loss. Additionally, staking primarily benefits the blockchain network, while liquidity mining supports a specific DeFi platform.
What is Lending?
DeFi lending is a practice of borrowing and lending funds without intermediaries like banks. By utilizing smart contracts on blockchain platforms, you can engage in lending activities and earn a steady income. However, it’s essential to differentiate between lending and borrowing, as only lending generates income.
DeFi lending involves providing tokens to a DeFi platform, which then lends them to borrowers. As a lender, you earn a small income, typically around 3-4% annually. The interest is generated from borrowers. It’s important to note that a lending strategy carries low risks.
On the other hand, borrowing funds through DeFi platforms requires collateral, often in BTC, ETH, or stablecoins. Borrowers also need to pay the interest to the lenders.
Knowing the difference between these concepts can help you choose the most suitable strategy for your investment goals in DeFi.
So, before investing in liquidity mining, you should be aware of the hidden traps, as risk comes from not knowing what you’re doing, as Warren Buffett says.
Understanding the Risks of Liquidity Mining
Like any other investment strategy, liquidity mining involves certain risks that investors must be aware of before investing. These risks include:
1. Instability of yield. When you open a deposit account in a bank, the bank guarantees a fixed percentage that you will receive according to the contract. However, with AMM platforms, rewards are unstable and can change frequently. The activity of the trading pair on the exchange affects the rewards paid for liquidity mining. The more regularly the pair is involved in a Swap, the more fees the platform receives, and therefore the more it can share with those providing liquidity, thereby affecting the liquidity pool’s APR. If the platform’s popularity drops or the specific trading pair becomes less popular, the yield can be significantly lower than the one the platform was showing at the time when you were investing.
2. Rewards value depreciation. When customers exchange tokens on an AMM platform, the platform shares a small fraction of the transaction fee with those who provide liquidity. However, rather than paying liquidity providers in the deposited tokens, AMM platforms often reward them with their native tokens. These native tokens are subject to potentially significant price fluctuations, which can affect the value of rewards earned by liquidity providers.
For example, let’s consider CAKE, a token issued by the PancakeSwap platform. PancakeSwap rewards liquidity providers with CAKE tokens for providing liquidity in the platform’s pools. If the value of CAKE depreciates significantly, the value of earned rewards will decrease, affecting the income of liquidity providers and the actual APR. The chart below shows the price changes of CAKE over time, highlighting the potential for price fluctuations in these tokens.
Taken from TradingView
3. Impermanent loss. Impermanent loss is the temporary loss of value that can occur when providing liquidity to a decentralized exchange. This loss shows the difference between the profit from placing tokens in a liquidity pool and the profit which could be earned by simply holding the asset in your wallet. It occurs when two or more assets in the liquidity pool have significant price changes relative to each other.
For instance, let’s say you invested in an ETH/USDC liquidity pool, and over time, ETH grew by 20% while USDC remained stable. Then the value of your investment in the pool will be slightly less than if you had kept ETH and USDC separately in your crypto wallet. And while, in some cases, the impermanent loss can be compensated with the rewards that you are earning, in other cases, the impermanent loss will be more significant. The reason for this is the arbitrage that is performed to maintain ETH and USDC in equal shares, as liquidity pools require by their nature.
4. Hacker attacks. In traditional banking, the chances of a hacker attack are relatively low as banks have high-security servers that keep all user information hidden from outsiders. However, it’s a lot more common with AMM platforms. AMM platforms use open-source smart contracts, meaning everyone can access the platform’s code. While the transparency of open-source code is a significant advantage, it also exposes the platform to security risks. Attackers can exploit any vulnerability in the smart contract to steal the platform’s funds. There have been instances where millions of dollars worth of digital assets were lost due to such attacks. If the platform you provide liquidity to is hacked, your investment is at risk, and there is no refund guarantee.
While the first three risks affect potential profitability, the final one can lead to a total loss of investment and therefore represents the highest risk. So, developing your own DeFi risk management is essential to avoid such risks.
Final Thoughts
Liquidity mining is an accessible way to invest in DeFi and earn passive income from your crypto assets. You can make profits by providing funds for swap platforms to conduct exchange transactions with their customers. Liquidity mining has a low entry barrier; even small investments can generate returns.
However, like any investment opportunity, liquidity mining comes with risks. These include impermanent loss, hacker attacks, decreased reward prices, and unstable interest rates. But with a sensible risk management strategy, these risks are manageable.
Overall, liquidity mining is a powerful investment tool, but it requires careful consideration and due diligence. So, if you’re considering investing in liquidity mining, make sure you do your research, weigh up the risks and benefits, and diversify your portfolio.
We hope this article provided informative and accurate information. Keep an eye out for our future articles, and we wish you success in your liquidity mining endeavors.
Invest wisely!