Liquidity Mining: Beginner’s Guide

Dany Chetverikov
October 7, 2020
Liquidity mining explained

DeFi is the most hyped topic in the crypto right now, with all the buzz centered around Liquidity Mining (also called Yield Farming) — the new way to make more crypto with your crypto. Instead of just HODLing, you can put your assets to work by depositing it to the marketplaces to lend it to others for rewards in fees.

Pretty simple, right? Not so fast. Yes, this concept is rather straightforward, but there are underwater stones that you should be aware of before diving in. In this article, we will cover the most important of them and explain everything you need to know about liquidity mining.

Total Value Locked: The index that measures how much overall crypto is currently locked in DeFi. 

What Started The Liquidity Mining Buzz

The Compound Finance credit market was not the first liquidity mining project, but it was the one that gave this sector an initial boost with the introduction of their governance token – COMP.

Governance Token: The type of token that gives its holders decision-making rights over the project’s protocol, its product, and features.

Users “farmed” the COMP tokens as rewards for providing their assets to the liquidity pool of the marketplace. At certain points, COMP was worth enough that borrowers were actually making money from taking out loans, that’s how crazy it was. 

This attracted many liquidity providers to the platform. Soon other DeFi projects started imitating Compound and competing for the most innovative ways to draw liquidity to their protocols.

How Liquidity Mining Works

Liquidity Mining is built around the concept of Automated Market Makers, or AMM (another DeFi buzzword)

Automated Market Maker (AMM): Robotic protocol that is always willing to buy and sell cryptocurrency for which it has a market. 

Two key concepts in AMM are liquidity providers and liquidity pools. It works pretty simply. 

Liquidity providers deposit their cryptocurrencies into the liquidity pools of the marketplaces, which serves as a basis for others to lend, borrow, and exchange tokens. 

Users pay fees for each operation. The protocol then distributes the fees among the liquidity providers depending on their share in the overall pool. 

Another stimulus for providing liquidity to the AMMs may be the distribution of a new token. There can be no way to buy a new cryptocurrency, you can only find it in small amounts. In this case, the liquidity provider earns dividends by providing liquidity to a specific pool. 

The implementations and rules of distribution vary from one protocol to another, but the main point here is simple – liquidity providers get rewards based on the amount of liquidity they are providing to the marketplace.

The most popular coins in yield farming are stablecoins, but that is not the generic requirement. Many DeFi protocols reward the liquidity providers with their own tokens.  That’s where the tricky part starts. 

For example, when you deposit ETH on the Compound marketplace you earn cETH. You can then deposit the cETH to another AMM which will farm you another token. This token can also be deposited to the liquidity pool of the third marketplace. The process can go infinite. Now you see where all that space for speculation in liquidity mining comes from?

How Big Are The Profits

The rates in DeFi depend on the protocol but reach 2-6%. Most U.S. and EU bank accounts earn less than 0.1% these days, which is close enough to nothing.

It is complicated to calculate even the short term revenues, as the DeFi is a dynamic market with volatile returns. It is also very competitive. If a certain strategy gives huge profits for a while, then other liquidity providers hop in and the profits spread among more investors. That gives fewer dividends to them individually. 

Keeping that in mind, the two most popular metrics include the Annual Percentage Rate (APR) and Annual Percentage Yield (APY). The difference is simple – APY considers the reinvesting of assets back to the liquidity pool, while APR does not. 

The yield farming industry grows very fast, so it is clear that in the future the market will adapt more short-term ratios to calculate dividends, but it is not there just yet.

The Risks Behind Liquidity Mining

If you’ve read the article to this point, you probably understand that DeFi is much more complex than regular banking. There are risks to keep in mind, and if you do not feel confident, you should apply the main rule of crypto — dip your toes first and try it with a small amount of cash.

A significant risk of DeFi lies in the nature of decentralization — in smart contracts. Even teams with much experience behind their shoulders and regularly audited projects can still have bugs in their protocols. Keep that in mind when you lock your hard-earned funds in the DeFi. 

It is also important to note that all of the liquidity mining protocols work on the ERC-20 Ethereum token standard. The marketplaces are connected and actively interact with each other. It means that if there is a bug in one of the protocols the issue may affect other marketplaces. 

Closing Thoughts

As an innovation, DeFi makes sense. Bitcoin lets you store money and transact it electronically, without a bank or a government. DeFi is building banking functions, like lending and interest on top of that, also without banks. Whether the enthusiasm for it is justified comes down to the question of whether DeFi can change the landscape of finance in the near term.

As for now, the fast growth of the yield farming market opens a whole new range of possibilities for investors to put their holdings in use and make profits from this booming industry.

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