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 cryptocurrency investing strategy is to purchase and hold a crypto until it increases in value, also known as HODLing (holding on for dear life), there are several additional methods you can use instead to earn passive income. One such strategy involves liquidity mining, which leverages on the decentralized finance (DeFi) sector.

Simply put, liquidity mining is a way for users to earn a steady stream of passive income by using their cryptocurrencies to provide liquidity for decentralized exchanges (DEXs). By providing liquidity, you’ll be rewarded with trading fees and governance tokens. In this article, we’ll be exploring what liquidity mining is, how you can start earning passive income with it, and its benefits and risks.

Key Takeaways: 

• Liquidity mining is a DeFi mechanism in which participants provide some of their cryptocurrency assets into various liquidity pools, for which they receive tokens and fees. 

• Some of the benefits of liquidity mining include earning a passive income, high yields and a low barrier to entry.

• Some of the risks associated with liquidity mining include impermanent loss, project risks and potential rug pulls.

What Are DEXs?

Before we learn more about liquidity mining, let’s take a quick look at DEXs, which make liquidity mining possible. 

Traditional finance exchanges typically use an order book model. An orderbook is a centralized database that stores all the buy and sell orders at different prices that have been inputted by users. Should there be a match between the buy and sell order of two different users, the transaction will then be carried out. 

DeFi introduced a new order book mechanism, known as the automated market maker (AMM), pioneered by the DeFi protocol Uniswap. AMMs facilitate permissionless cryptocurrency trading between users by utilizing liquidity pools, removing the need for a centralized entity to match transactions. These pools are created with smart contracts and are operated by algorithms, making them fully autonomous.

These pools achieve deeper liquidity as participants deposit their cryptocurrencies, allowing for more capital-efficient swaps for users, minimizing slippage and maximizing the number of cryptocurrencies they can receive.

What Is Liquidity Mining?

Liquidity mining is a DeFi mechanism in which participants provide some of their cryptocurrency assets into various liquidity pools, for which they receive tokens and fees. Participants who provide their cryptocurrencies are known as liquidity providers (LPs) and often receive an LP token, which they can eventually use to exchange for a percentage of the trading fees earned by the platform. Distribution of fees is based on the amount of liquidity each provider has contributed.

History of Liquidity Mining

Liquidity mining gained significant traction in the summer of 2020, which is also known as DeFi Summer. DeFi became more widely known in the market, and the architecture of efficient and permissionless trading brought a lot of market participants on board. At the same time, protocols were offering extremely high rewards, with the annualized percentage yield (APY) offered by some protocols reaching triple digits or even more, fueling DeFi’s growth even more.

Liquidity mining thus became extremely profitable, especially for LPs who could begin providing liquidity with large sums of capital, allowing them to grab a bigger portion of a protocol's transaction fees distributions. This in turn also improved liquidity within pools, making it more attractive to trade and increasing the activity taking place on the protocols.

Currently, the APYs offered by most protocols have come down significantly. This is, however, a relatively good sign, as it demonstrates the market is maturing and makes it more sustainable for market participants.

Nonetheless, activity on DeFi protocols is still high, with market participants constantly seeking the next best opportunity.

How to Start Liquidity Mining

To begin liquidity mining, you can start with one of the oldest protocols: Uniswap.

1. Head over to https://app.uniswap.org/#/pools.

2. Click on Connect Wallet to connect to a noncustodial wallet that has existing funds.

3. Click on New Position.

4. Select the pair for which you’d like to provide liquidity. 

5. Select a fee tier to determine the rewards you’ll be receiving. Despite being in a lower fee tier, it may turn out that a pool has a much larger amount of activity, which will translate to more fees — and more rewards for LPs.

6. By entering the amount of liquidity you’d like to provide for one asset of the pair, the required amount for the other asset will automatically be generated for you. Note: Less frequently traded LP tokens will typically have higher returns, but will come at a higher risk.

7. Click on Add to provide liquidity.

Other protocols users can consider providing liquidity to are Curve, a stablecoin swap protocol, and Balancer, one of the older DeFi protocols. Curve is recommended for users with a smaller risk appetite, given its lower risk of impermanent loss with stablecoin swaps (see below under Risks of Liquidity Mining).

Benefits of Liquidity Mining

Now that we 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:

• Passive income

• Potential for high yields

• Distribution of governance and native tokens

• Low barrier to entry

• Nurturing a trusting and loyal community

Passive Income

Liquidity mining is one of the best ways for cryptocurrency market participants to generate passive income. Providing liquidity into liquidity pools is often a passive strategy, as users just have to hold onto their LP tokens, and rewards will automatically be added to their LP token holdings.

More importantly, when users provide liquidity into a pool that manages to attract market participants, the growth in activity will translate to greater rewards for LPs. These rewards will automatically go toward the LP tokens held by the LPs. Thus, LPs can benefit from changing market conditions without having to actively manage their positions. 

High Yield

Before beginning to participate in liquidity mining, 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 holds true if you first want to dip your toes in before fully committing to the liquidity mining strategy.

DEXs 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 from trading fees that accrue whenever trades occur on an exchange. 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.

When markets are active and there’s a lot of trading activity going on, the rewards provided by protocols can be relatively high — and significantly higher than simple bank deposits.

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 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 have 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 privileges of holding native tokens include:

• Revise the development fund

• Vote to change fees

• Implement changes to the UI

• Change the distribution of fee rewards

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

Permissionless: Low Barrier to Entry

Engaging in liquidity mining is permissionless. As long as a user owns a noncustodial wallet, such as MetaMask, and holds onto a certain amount of cryptocurrency, they can provide liquidity. Rewards earned from providing liquidity can also be redirected into the pool, which grows the user’s base capital and stake in the pool, allowing them to receive a larger share of the rewards over time.

Liquidity Mining Benefits the DeFi Market

It can be argued that liquidity mining is an essential component of DeFi.

LPs play a part in making the DeFi ecosystem more robust, helping more people to participate in DeFi when they have access to more capital efficient swaps. This increased liquidity also permits more applications to be built to tap on the ecosystem.

Nurtures a Trusting and Loyal Community

One benefit of liquidity mining that’s often overlooked is the fact that it nurtures a trusting and loyal community, since many investments occur within 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 begin liquidity mining, it’s important to know about impermanent loss 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 them than they had when you first placed them into the 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.

In addition, in the event that you receive more of a cryptocurrency that has decreased in price, then you would have made fewer losses by holding onto the cryptocurrency itself, instead of providing liquidity.

Project Risk

There are also some technical liquidity mining risks to be aware of that are inherent to any protocol. The more highly advanced the protocol, the more complex the source code that it runs on. 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 its project. Even though all projects can be exploited, it’s still highly recommended 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 an acceptable 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 system does have a few built-in risks that could arise. One of these involves the potential for rug pulls, a type of fraud that occurs when liquidity pool developers and protocol developers decide to shut the protocol down and take 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. One example is the now-defunct Compounder Finance (not the similarly named Compound Finance), whose developers closed the project in 2020 and ran away with $10.8 million of investor assets, allegedly via a backdoor coding mechanism.

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

Liquidity Mining vs. Other Passive Investment Strategies

Before you settle on an investment strategy that’s right for you and your portfolio, be sure to compare DeFi liquidity mining to other passive investment strategies. 

Liquidity Mining vs. Staking

The first type of passive earning strategy to consider alongside liquidity mining is staking, which allows users to pledge their cryptocurrency as a form of collateral within proof-of-stake (PoS) algorithms. When users lock up their cryptocurrency, they’re helping to validate transactions and secure the blockchain. This is a rather passive strategy, as users can simply delegate their cryptocurrency holdings to validators.

Users who stake higher amounts typically receive higher rewards, similar to what occurs when liquidity mining crypto. 

Another clear advantage of staking is that the risks are comparatively low. While project failure is possible, liquidity mining risks are considerably more severe, given the volatility of the market and the increased chances for exploits. 

Liquidity Mining vs. Yield Farming

While some investors use the terms liquidity mining and yield farming interchangeably, 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 may 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 cryptocurrency 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 easy to get started with, making 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 crypto liquidity mining, 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 cryptocurrency, it looks as though it’s here to stay. If you’re searching for a sound investment strategy to serve you well in 2023 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’ll be better equipped to invest your assets in liquidity pools. With the right approach, you can garner high yields to bolster your portfolio and earn consistent passive income. While other passive investment strategies may have their benefits, liquidity mining is the most accessible investment strategy you can implement.

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