Until the appearance of DeFi, there were not many ways to make passive income on crypto. Users could only sell their assets, store them in cold wallets, or keep them on exchanges. The only ways to make money were HODLing and intraday trading. But later, liquidity mining made a revolution in this industry. If you want to find out what liquidity mining is, keep reading.
The meaning of the term “liquidity”
Market liquidity means the market’s ability to allow assets to be purchased and sold easily and rapidly. Put simply, liquidity is the opportunity to get your cash whenever you want. The higher it is, the quicker you can change tokens on an exchange platform. Since exchanges take orders from buyers and sellers, the high liquidity of assets increases the speed of transactions.
Who are liquidity providers?
The invention of DeFi allowed token holders to earn passive income from lending their assets to new platforms. Through DeFi lending, participants can add their crypto assets into different liquidity pools and get rewards in the form of tokens and fees. This way to earn passive income is called liquidity mining. Generally, it is limited to a specific time period required to activate the protocol.
The protocol rewards liquidity providers who lend assets to the decentralized exchanges with specific rewards, such as transaction fees and ERC-20 tokens. The size of the reward depends on the participant’s total share in the pool. Generally, liquidity providers obtain between 0.05% and 1% (0.05% fee tier is designed for stable pairs, and 1%- for exotic assets).
Sourcing liquidity on AMM
Liquidity sourcing is an essential part of the automated market maker system. As opposed to traditional exchanges, decentralized exchanges such as Uniswap don’t match buy and sell orders. These DEXs provide crypto liquidity by means of incentivized lending. Investors are rewarded with a share of the trading fees for lending their assets.
On DEXs like Uniswap, users deposit an equivalent value of each underlying token in return for pool tokens. For example, a user who decides to contribute 4 ETH worth $11,200 needs to invest a crypto equivalent — 11,200 USDT. After earning liquidity crypto, users will be offered to add assets to the liquidity pool. The trading fees will be distributed proportionally to each investor in the liquidity pool.
This creates a symbiotic relationship between all sides, where decentralized exchanges get liquidity, LPs get rewards, and other participants can trade on DEXs quickly and easily.
What you should know about impermanent loss
Any type of cryptocurrency transaction (be it investing, trading or mining) involves a risk. The high asset volatility makes revenues inconsistent. Therefore, all liquidity providers should be prepared for possible challenges and monitor the market closely. Such indicator as impermanent loss is of particular importance.
The goal of IL is quite simple. This indicator shows the losses liquidity providers may experience due to price divergence. By investing their assets in the liquidity pools, users lose lots of benefits (for example, they can’t profit from speculation).
Assets that the users lend to the decentralized exchanges can increase or decrease in price significantly in a very short time (some tokens may double within a few days)! In that event, the opportunity costs for liquidity providers will be very high. Their earnings will be way lower than potential revenues from HODLing (usually, < 50%).
Nevertheless, negative financial performance is only transient — that’s why it is called “impermanent”. Impermanent loss isn’t realized until the tokens are withdrawn from the liquidity pool. If your assets go back to their initial price while being in the pool, they can still get profit. Failing this, they need to withdraw their assets from cryptocurrency liquidity services and realize their impermanent loss.
Because of the volatility of crypto prices, IL is just inevitable. It is one of the biggest challenges faced by liquidity miners.
Liquidity mining is a new method of gaining a passive income in the digital market. This form of collaboration between liquidity providers, traders and stock exchanges has existed since the beginning of Decentralized Finance. Instead of selling your assets or storing them in hardware wallets, you can invest them in the liquidity pools and get rewarded with trading fees and governance tokens.
Today, users of the crypto market are increasingly shifting to yield farming. This is a new method to earn cryptocurrency, which involves using complex strategies to lend, stake, and hold digital assets across multiple cryptocurrency or DeFi protocols. A yield farming protocol usually focuses on maximizing returns instead of maintaining the functioning of the decentralized finance protocols.