Before the invention of Decentralized Finance, owners of cryptocurrencies could only trade them, store them in hardware wallets, or keep them on the stock exchanges. Apart from holding and intraday trading, there was no other way to make profits. However, liquidity mining changed the game. Let’s find out what liquidity mining is and what advantages it has.
What does liquidity mean in cryptocurrency?
This term was drawn from traditional markets (such as stock exchange). Liquidity refers to the ease with which an asset or security can be converted into ready cash. Good liquidity means that a token can be quickly and easily purchased or sold without having much effect on its price. Since platforms take orders from buyers and sellers, the easy availability of assets accelerates the transactions.
What is a liquidity provider?
Decentralized Finance gave us an opportunity to earn passive income with P2P lending. Now, users can use their assets as liquidity on DEXs, lending protocols, or liquidity pools in other decentralized finance projects. This method to earn passive income is known as “liquidity mining”. Usually, it is limited to a specific number of months or years — just enough time to make the protocol work.
LPs lend assets to decentralized exchanges in return for a share of transaction fees and free tokens. These rewards are proportional to the client’s share of the total liquidity provided. Liquidity providers obtain approximately 1% (depending on the stability of assets).
How does AMM liquidity work?
Liquidity sourcing is an integral part of the AMM system. In contrast to traditional exchanges, decentralized exchanges (such as Uniswap) don’t match buy and sell orders. Rather than that, they provide the liquidity by means of incentivized lending. Contributors get a share of the trading fees in return.
On Uniswap, coin liquidity pools provide a pair of tokens of the same value. A user who wants to deposit 5 ETH worth 12,500 US Dollar should add a bitcoin equivalent — 12,500 Tether. After obtaining liquidity crypto, users of Uniswap can put it into the ETH or USDT liquidity pool. The entire amount of the swap fees will be distributed to liquidity providers.
This ensures a win-win relationship between the sides. Decentralized exchanges get liquidity, providers obtain rewards, while the rest of users get an opportunity to trade in DEXs promptly.
Understanding impermanent loss
Each cryptocurrency transaction carries a certain risk, whether it is trading, investing or mining. Because of asset volatility, the profits become unstable. Each liquidity provider needs to understand possible risks and monitor the market. Impermanent loss is of special importance.
IL is frequently misinterpreted, even though its purpose is very easy to understand. Impermanent loss is like an opportunity cost of leaving your tokens in the liquidity pool VS keeping them in your wallet. When users put their assets to the liquidity pools, they lose other advantages (such as profits from speculating).
Assets lent to DEXs may significantly rise or lose in value in a very short time. For instance, tokens (such as ETH) can double within a matter of days! In that case, the opportunity costs for liquidity providers are significant. Their awards could be much lower than anticipated revenue from holding (usually, lower than 50%).
Nevertheless, negative financial consequences are only transient (that’s why it is called “impermanent loss”). The impermanent loss only becomes realized once the liquidity providers withdraw their liquidity cryptocurrency from the liquidity pool. If their assets accelerate to their initial price while being in the pool, they can earn profit. In other case, they need to withdraw their assets from cryptocurrency liquidity services and realize their impermanent loss.
This circumstance is almost inevitable because of the huge market volatility. The most difficult thing about the aspect of impermanent loss is not determining but predicting it.
Liquidity mining is an excellent means of earning a passive income in the cryptocurrency market. This symbiotic relationship between LPs, stock exchanges and traders has been in existence since the inception of Decentralized Finance. Rather than trading their assets or storing them in hardware wallets, customers add them to the liquidity pools to receive rewards. The platforms reward their liquidity providers using their own tokens and charges paid by the rest of users.
Today, the cryptocurrency market has transferred to yield farming (this is another investment strategy in DeFi). As well as liquidity mining, yield farming involves lending crypto assets. At the same time, it is concentrated on maximizing annual percentage yield instead of maintaining the functioning of the DeFi protocols.