Introduction
According to proponents, DeFi (decentralized finance) is a new financial system that will eventually come to challenge TradFi (traditional finance). DeFi at its core is best understood as an umbrella term for financial services and products built on blockchain technology. A natural extension of cryptocurrency's core ethos, DeFi removes many of the centralized intermediaries and instead market participants interact with one another directly via smart contracts. To gain a broader understanding of DeFi, read Nansen’s guide: Everything You Need To Know About DeFi.
DeFi mimics many of the services available within TradFi, and in doing so opens up opportunities for investors with digital assets to generate yield. This article examines Liquidity Mining, one of the most popular strategies used to earn. Before we dive into Liquidity Mining, however, it is important to appreciate how DEXs (Decentralized Exchanges) operate to facilitate a better understanding of Liquidity Mining. Traditional exchanges use the order book model. A centralized database holds various buy and sell orders at different prices, and the exchange matches two traders with one another whose criteria meet. Decentralized exchanges, meanwhile, operate with the AMM (Automated Market Maker) model, allowing permissionless digital asset trading through liquidity pools. The AMM model has become the core layer of DEXs and powers all of these permissionless exchanges. This guide gives a brief overview of the best DEXs in the digital asset space: DeFi's Best Decentralized Exchanges. Uniswap, the largest DEX on the Ethereum network, pioneered the AMM model which became universally adopted, and the platform necessitated huge demand for liquidity. In providing an efficient swap service, DEXs produced a method for investors to generate yield via both liquidity mining as well as swap fees. This article outlines the fundamentals of this DeFi yield strategy.
What is Liquidity Mining?
Yield farming encompasses many activities within DeFi where investors utilize their existing assets to generate additional yield. Liquidity mining is a substratum of this broader definition, and in its simplest form, liquidity mining defines itself as investors lending their assets to a DEX or another DeFi platform that requires liquidity in exchange for rewards. Specifically, in most Liquidity Mining programs users provide liquidity in the form of LP (Liquidity Provider) tokens in exchange for a percentage of the trading fees generated by a chosen liquidity pool, in addition to governance token rewards.
How Does it Work?
Liquidity pools constitute the backbone of the entire DeFi ecosystem and allow permissionless trading. Replacing the traditional interplay between buyers and sellers, traders instead transact directly with the pool. The pool must maintain an equal ratio of deposited assets, which determines the prices of the assets within the pool, commonly denoted in the formula: x*y=k. LP Tokens are created by investors who supply liquidity and constitute equal parts of the selected pool, e.g. USDC-ETH. Investors are rewarded with trading fees for supplying liquidity; the larger their contribution to the liquidity pool, the larger their percentage of the rewards. In addition to fees, rewards also typically come in the form of the platform's native token, which often acts as the governance token entitling holders to vote on the protocol’s future direction, and sometimes even how the platform distributes rewards. Liquidity mining is centrally a financial incentive to ensure the best trading experience for traders swapping on decentralized exchanges. Investors form LP tokens with equal parts of the pairing, deposit them in the liquidity pool contract, and then receive a portion of the trading fees associated with that pair in addition to governance token rewards.
How Popular Is It?
Liquidity Mining has played an enormous role in the development of DeFi and will likely remain an integral part of how DeFi functions. It has allowed protocols to bootstrap liquidity, fairly distribute tokens amongst investors, and allow for efficient and permissionless trading of digital assets. DeFi trading would likely not exist at its current scale without liquidity mining. Liquidity mining has matured in the same way DeFi has matured. The year 2020, more specifically the summer of 2020, saw liquidity mining explode in popularity across the industry. Investors were creating pairs offering three-figure APYs, sometimes even four-figures, and yield farming became a buzzword heard everywhere. Despite using the term yield farming, people were often referring to liquidity mining. During the DeFi summer of 2020, it was incredibly lucrative and at the zenith of its popularity in popular culture, taking place with the backdrop of the start of an enormous bull run for digital assets. Liquidity mining remains highly popular amongst DeFi enthusiasts but with more diverse methods of earning with digital assets, capital has been allocated to different strategies. The current state of liquidity mining is contextualized in a risk-off macroeconomic environment and crypto bear market, with high market volatility, making impermanent loss a greater danger for investors. Liquidity mining remains the foundation of decentralized exchanges, still attracts vast swaths of liquidity, and has become far more sustainable. The APYs have dropped, which is a good thing for the long-term future of liquidity mining, which will continue to play a central role within DeFi.
What are the Key Benefits?
Passive Income. Liquidity mining is one of the best ways for investors to generate additional crypto with their existing digital assets.
Profitability. Liquidity mining offers far higher returns than those found in typical investment vehicles and if investors plan to hold both parts of the LP token long-term, it is a fantastic revenue generation opportunity. Benefits DeFi. Liquidity mining is an essential part of DeFi. Investors who offer liquidity are helping DeFi grow and positively impacting the entire ecosystem, facilitating better trades and creating more liquid marketplaces. Permissionless. Anyone can provide liquidity, providing they own a non-custodial wallet and have funds. There is no minimum capital requirement, and liquidity providers can compound their rewards to increase their stake in the pool, making this strategy accessible to all levels of investors. Distributed governance. Decentralized exchanges utilize liquidity pools to distribute their governance tokens. Rewarding platform users with an ownership stake and the ability to direct the development of the protocol.
Liquidity Mining vs. Staking
Staking generally refers to when users lock their assets to help secure a blockchain and validate transactions, typically available on networks that employ the PoS (Proof of Stake) consensus mechanism. Investors delegate tokens to validators or become a validator and receive the block rewards if their validator is chosen to create a block. Staking is a relatively straightforward process; read this guide to discover how to stake Ethereum: Nansen's Guide to Staking Ethereum. Staking exposes investors to less risk than liquidity mining and only involves a single token making the risk and volatility easier to track.
Liquidity Mining vs. Yield Farming
Yield farming is the broader term for earning yield with digital assets and encompasses liquidity mining, staking, and lending. Liquidity mining is typically what people consider when talking about yield farming. The key difference is that yield farming is wider in scope and can apply to various types of platforms.
Risks of Liquidity Mining
Liquidity mining delivers high returns and naturally involves a fair amount of risk. The two largest risks to investors are volatility and bad actors. Volatility. Digital assets fluctuate in price, and impermanent loss is the difference in value at deposit versus withdrawal. It is the term used to describe losses faced by liquidity providers due to price divergence. More volatile assets experience greater impermanent loss, and investors should be aware that impermanent loss happens in both directions. In certain situations, investors would generate more profit just by holding the assets instead of creating an LP token. The general assumption is that the trading fees make up for the impermanent loss.Bad Actors. The majority of investors cannot code and therefore do not understand smart contracts. Typically referred to as a rug pull, when bad actors strike it’s usually when developers dump all their tokens draining the liquidity from the pool or alternatively use a back door in the smart contract to remove investors' funds. Rug pulls were rife in the summer of 2020 but are becoming less common as the space matures, and the acceptance of smart contract audits and teams undergoing KYC has helped reduce the frequency of these incidents.
Future of Liquidity Mining
Liquidity mining has become a cornerstone of how DeFi operates and will play a continued role in the sphere. As the bear market enveloped crypto, investors switched to providing liquidity for stablecoins to generate yield with stable assets, and this guide shows investors how to earn with stable assets: The Best Stablecoin Yield Farming Strategies. When the general market trend reverses, and the environment becomes increasingly risk-on, investors will likely contribute liquidity to more volatile pairings. DeFi evolves rapidly, and with a constant demand for capital to operate more efficiently, the future looks bullish for liquidity mining. As the process benefits the whole ecosystem, it will continue to grow alongside this nascent economic sphere.
Using Nansen to Identify Opportunities
DeFi is an enormous landscape; discovering liquidity mining opportunities involves visiting lots of decentralized exchanges and viewing lots of pairs. That is before the investor begins to calculate the potential of impermanent loss, the size of the liquidity pool, and its overall stability. Nansen is a blockchain analytics platform that incorporates on-chain data with millions of wallets to provide market insight, refining vast quantities of information into visualized dashboards for investors.
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Nansen’s DeFi Paradise dashboard shows the top liquidity pools across all chains. Featured above is liquidity pools ranked by volume, which allows market participants looking for stable liquidity mining options to rapidly identify the best pools where they can contribute liquidity. This dashboard also displays the number of Smart Money wallets- the most profitable wallets on-chain- contributing to the pool, when the pool went live, and the total number of transactions with the pool. Understanding these metrics allows the investor to better grasp the pool's nature and the associated risks with participation.
For investors with a higher risk appetite, the dashboard can be filtered by Net APY. Nansen calculates impermanent loss and subtracts it from the pool’s offered APY, to show the actual return. These insights allow mercenary farmers to move from liquidity pool to liquidity pool, soaking up early APY rewards and for the more cautious liquidity provider to find large well established pools. These insights allow investors to navigate thousands of liquidity pools at a single point of contact and understand the characteristics of these pools. Nansen is an indispensable tool providing investors with the information they need to outperform the market at large.
Conclusion
The Automated Market Maker model allowed decentralized exchanges to thrive with some of the largest offering liquidity depth that rivals even centralized exchanges. Liquidity Mining underpins this trading model by incentivizing users to deposit liquidity. Liquidity providers form vital components of DEXs’ ability to operate.Liquidity mining brings success to both DeFi and investors, and it will continue to assist DEXs in offering a better user experience with bolstered liquidity. DeFi’s novel approach to financial services has introduced this new passive income stream for crypto investors, with crypto investors directly supporting the development of this new decentralized approach to financial services.
