Like borrowing costs on standard savings accounts or certificates of deposit, many cryptocurrency investors desire an annual yield on their assets. One of the most widely used strategies for achieving this objective is liquidity mining. By engaging in viability mining, you consent to use your crypto tokens as a source of funding by decentralized trading exchanges. As a result, an annual rate of return (APY) in double-digit or even triple-digit proportions is possible.
In this article, we will discuss the following:
- What is Liquidity Mining?
- How Liquidity Mining Works?
- What is IL?
- Advantages Of Liquidity Mining
- Disadvantages of Liquidity Mining
What is Liquidity Mining?
You can earn incentives through crypto liquidity mining by giving some more of your cryptocurrency tickets to a decentralized trading service. These tokens will make low-friction transactions between anonymous cryptocurrency owners possible.
Without the assistance of a third-party trading platform, buyers and sellers can connect and swap various cryptocurrency tokens using a decentralized exchange (DEX) like Uniswap (CRYPTO: UNI) or SushiSwap (CRYPTO: SUSHI). Without ever contacting an external server or database, this performs using payment systems on a platform like Ethereum (CRYPTO: ETH) and Binance Coin (CRYPTO: BNB). These exchanges allow for entirely anonymous transactions and never use profit-seeking mediators like banks or financial analysis services providers in their exchanges. In systems that support decentralized finance (DeFi), DEXes are crucial.
DEX exchanges require funding to provide their trading services. So this is made possible in social media liquidity pools, where participants may store their cryptocurrency assets and earn rewards like crypto tokens or interest. The locked-in money thus acts as the decentralized crypto exchange’s primary funding source. The DEX trading platforms would swiftly come to a halt without this accessible liquid core of digital capital.
The liquidity pools, in turn, depend on the participation of investors eager to hold their cryptocurrency tokens in exchange for advantages. Trades on the DEX platform are ultimately made possible by investments. Liquidity mining is storing tokens in a DEX liquidity pool to earn incentives.
How Liquidity Mining Works?
Participants can lock their goods into common liquidity pools for liquidity mining. This pool is only available through DEXs and often has liquidity in tokens or currencies. By enabling peer-to-peer transactions, DEXs are cryptocurrency markets that do away with the requirement for a middleman like a bank. This type of transaction is entirely autonomous and controls intelligent contracts and algorithms.
Consider a scenario where you want to access a liquidity group on Uniswap, the oldest and biggest DEX. There will be multiple steps to this procedure, involving several smartphone apps or websites. However, you must first have access to some digital currency. We’ll use Ethereum and the stablecoin Tether (CRYPTO: USDT) for this example. Most of the time, we cannot store the coins you invest in the default wallet provided by your crypto trading service. Alternatively, move them to a wallet in your self-control, known as self-custody.
What is IL?
Risks associated with trading, investing, and mining make it challenging to continue making money in the market. Similarly, the disadvantages of liquidity mining restrict users from supplying liquidity without continuing to keep an eye on the cryptocurrency market: temporary loss (IL). Many people are curious about the enigmatic IL. Many people also erroneously think that IL is more complicated than it is. Although calculating and forecasting IL may be completely separate, the fundamental operation of irreversible loss is relatively straightforward.
The economic benefit of keeping an asset for expansion motive instead of making it available as liquidity to receive fees is an impermanent loss. The next step is to sign into your account and add your tokens to the liquidity pool on the Uniswap mobile app or user interface. Select the desired Uniswap trading pair by clicking the “pool” button, followed by the “new transaction” link, and then observe how they distribute benefits. We’re going with Ethereum and Tether because they’re one of the most well-liked coin combinations on Uniswap. You can choose from several reward packages linked to various interest rates applied to traders who genuinely use the virtual currency you’re offering. The pool fees for popular cryptocurrencies and crypto tend to be lower than those for uncommon and exotic coins.
More on IL
Let’s choose the middle fee tier of 0.3%, which most Ethereum-Tether liquidity miners on Uniswap do. So this often results in an APR of 80% to 90%, though the precise figure changes over time. In reality, the liquidity miners receive a portion of the money charged from DEX traders, and as trading volume rises, the proportion of the pot gets bigger. Therefore, if a specific tier on the Uniswap trades happens to be very active, a lower fee may result in a higher reward. You get a more significant share of the overall pie if you have a larger percentage of locked-in liquidity.
It’s finally time to choose how much Ethereum you like to lock up. A certain amount of Tether tokens allocates automatically. The Tether to Ethereum fluctuates according to your fee tier, and both coins must be present in your wallet.
After gathering your liquidity tokens, you may relax and wait for your rewards to start. While a combination of stablecoins may produce almost nil payouts, risky and rare token pairs often yield higher rewards. It is virtually impossible to avoid IL because digital assets are so volatile. The user runs the risk of not earning or perhaps losing money if an asset within the selected LP depreciates or appreciates too much after being placed. For instance, Ethereum’s value might double in just five days, but the fees one receives from mining won’t even come close to covering what it would have earned through HODLing.
The term “impermanent loss” is definable. Only if the user chooses to withdraw his funds are losses recognized. Therefore, if the market returns to its initial price, it is feasible to avoid IL. Without that, they compel LPs to realize their IL and remove liquidity.
Advantages Of Liquidity Mining
Knowing what liquidity mining allows you to understand its benefits as a financial planner better. The principal advantages of liquidity mining are as follows:
Increase the Yield
Before you begin liquidity mining, it’s essential to understand that your yield is inversely correlated to the actual risk you tolerate with your investment, making it an excellent method for any investor. Your rewards will match your dedication if you make a sizable investment. The same is true if you want to try out liquidity mining in small doses before committing fully.
Without specific liquidity for investors who want to transfer tokens from other cryptocurrencies, decentralized exchanges cannot run. Therefore, when you provide liquidity in this manner, exchanges are motivated to reward you for your services.
The benefit of DeFi liquidity mining is that it enables equal management distribution via native tokens. Before the invention of cryptocurrency liquidity mining, token distribution was mostly unjust and uneven. Additionally, DeFi protocol architects frequently preferred Asset managers over minimal investors because they have recourse to more cash than the latter. Therefore, investors with low and high capital levels have an equal opportunity to acquire native tokens thanks to DeFi liquidity mining. Furthermore, thanks to these tokens, you have some electoral votes in the DEXs you have invested. Additionally, you can modify the protocol’s properties if you have tokens for a specific exchange.
They use Tokens to bet, earn money through produce farming, or even get a loan, although their primary usage is for governance.
DeFi liquidity mining has a low entry threshold and equally distributes rewards to investors. Everyone may profit from this investment strategy, as was already stated. Cryptocurrency liquidity mining enables you to provide any amount of liquidity in consideration for real incentives if you’ve always loved the idea of the decentralized ecosystem but lacked the resources to do so.
Disadvantages of Liquidity Mining
Liquidity mining has offered the DeFi community more advantages than we can imagine. However, we cannot disregard the dangers of mining for liquidity. We’ll discuss the risks of liquidity mining in this section:
DeFi is skilled at managing the impact of central authorities and mediators over your funds. Insider information, however, may create an unfair playing field even in liquidity mining. The incentive programs designed to ensure a fair distribution can be utilized by those who notify of creating the new liquidity pool before others. One of the best ways to deal with this is to open up the mining program and associated liquidity pools in the protocol. This method may protect the population rather than specific investors whenever more protocols turn into DAOs.
Excessive gas prices
The Ethereum blockchain is the most widely used blockchain for consensus mechanisms. However, despite promises to switch to the proof-of-stake (POS) consensus, it still uses the proof-of-work (POW) consensus, which requires processing fees, or gas expenses.
Increased gas prices may drive away small investors, providing benefits from liquidity mining to those who can manage to pay considerable fees. This Ethereum resolves issues by Eth2.0, which will even the playing field and enable more retail users to deal on the network and take advantage of incentive programs like liquidity mining.
The complexity of a protocol’s source code increases with its level of sophistication. Protocols are, therefore, susceptible to technical errors. If the code perfectly anticipates, dishonest people may exploit a network and its resources.
As a form of passive income, liquidity mining enables cryptocurrency owners to make money off of their current holdings rather than keeping them in refrigerated conditions. They lend Assets to a decentralized exchange for a balanced redistribution of transaction fees to each liquidity provider.
If you have a firm understanding of liquidity mining and its potential benefits and drawbacks, you should be more prepared to place your money in liquidity pools. If you employ the right strategy, you can get high yields that boost your portfolio and enable you to generate ongoing passive income. Although other passive investing strategies may have benefits, liquidity mining is the most practical investment strategy.