In the DeFi Beginning there was Liquidity Mining — So What is It and How Does It Work?
Introduction
Liquidity Mining undeniably was the first big thing in DeFi. Its underlying concepts have not died with the ever evolving DeFi space which indeed has grown more complex [see, e.g. Cointelegraph. PolyCub: The next generation of DeFi-yield optimizers has arrived. (Accessed April 3, 2022)] but likewise more lucrative for investors [see, e.g. BeInCry.pto Staff. DeFi 2.0 Meets Yield Optimization with PolyCub. (Accessed April 3, 2022)].
[Note: Yes folks, the preceding paragraph was my transparent attempt to get the word out concerning the recent launch of the new and novel DeFi 2.0 platform, PolyCub Finance. Should you have any questions about PolyCub or it’s novel approach to DeFi 2.0, check out this wonderful comprehensive guide: POLYCUB ULTIMATE GUIDE — What Is Polycub And How Do I Use It?].
As this mechanism of liquidity mining is so prevalent within the history of DeFi, and, as the concepts surrounding liquidity mining are present within the newer mechanisms of DeFi 2.0 that are presently emerging, it is important that all understand what liquidity mining is. As such, in this article, we will attempt to learn the essentials concerning this mechanism.
Origins of the Phrase ‘Liquidity Mining’
Liquidity mining arises from two very important concepts in the world of cryptocurrencies, liquidity and mining. By liquidity, we mean the availability of coins/tokens in a given platform, essential for the creation, growth and expansion of DeFi markets. By mining, on the other hand, we mean the PoW-based technique in which by making the computational power available you receive new coins just minted by the algorithm.
[Guazzo, G. Liquidity Mining vs Yield Farming. (Accessed April 4, 2022)].
So when you take these two different concepts and marry them, the solemnization results in ‘liquidity mining’.
So, What is Liquidity Mining?
In a search for an acceptable answer to this question, the following comprehensive answer was found:
Liquidity mining or liquidity mining is a characteristic and strategy of some decentralized finance protocols (DeFi) with which they seek to attract users. This focuses on encouraging the injection of liquidity into the protocol in exchange for distributing a series of tokens among users that give access to the governance of the project and that can also be exchanged for better rewards or for other cryptocurrencies.
[Bit2Me Academy. What is Liquidity Mining?. (Accessed April 4, 2022)].
To understand this concept better, let’s look at the following diagram by way of example:
In this example [see, Guazzo. Supra], there is a new DeFi platform the has minted Governance Tokens which it wants (needs) to distribute. Within the Platform’s home page, the issuer provides the method that investors may utilize to obtain these Governance Tokens. This method is: the tokens may be acquired through Liquidity Mining.
So, the investor who wants to acquire the Governance Tokens must provide liquidity to the specified ‘pool’. To accomplish this task, the investor must deposit equal amounts of both Token ‘A’ and Token ‘B’ into the Pool. In exchange for the deposit, the investor receives Liquidity Provider Tokens (LPs) which the investor will need for the final redemption (where the end reward is received). For so long as the investors tokens remain in the Pool the investor will continue to earn the designated swap fees, plus, a proportional amount of the Governance Tokens mined at each block. The investor, to receive his share of fees and Tokens must redeem the LPs previously issued to them. Once the LP Tokens are redeemed, the investor receives the appropriate share of the fees and Governance Tokens earned.
Boiling this process down to its simplest form, the investor who wants to partake of liquidity mining lends liquidity to a specified pool. Then, dependent on the sum of liquidity provided and the amount of time the liquidity is deposited, the investor receives new tokens freshly minted plus swap fees.
No Discussion of Liquidity Mining would be Complete without Paying Homage to Impermanent Loss
What is impermanent loss?
Impermanent loss is a temporary loss of funds a liquidity provider exhibits due to price volatility in a trading pair. Simply put, this loss occurs when liquidity is applied to a pool and the price of the assets deposited in the pool change over time from the time deposited. The bigger the change in the underlying asset price, the more exposure to impermanent loss is present. Of course, this loss is not realized until the position in the liquidity pool is terminated.
[Nagoda, K. Definition and Mitigation of Impermanent Loss in Liquidity Pools. (Accessed April 4, 2022)].
Impermanent Loss may be viewed as the “… opportunity cost of holding onto an asset for speculative purposes versus providing it as liquidity to earn fees” [Mihajlović, M. What Is Liquidity Mining?. (Accessed April 4, 2022)].
There clearly is a well established trade off between risk aversion and yield anytime Liquidity Pools are utilized by investors. Liquidity pairs with riskier assets tend to provide better yield than those containing Stablecoins. Therefore, one method of mitigating impermanent loss to your investment is to utilize Stablecoin pairs in your Liquidity Mining decisions whenever possible. However, you may have to sacrifice some yield in the process.
Some Final Thoughts
Liquidity mining is simply a passive income method that helps crypto holders profit by utilizing their existing assets, rather than leaving them inactive in cold storage. Assets are lent to a decentralized exchange and in return, the platform distributes fees earned from trading to each liquidity provider proportionally.
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As noted at the onset, liquidity mining was basically the first yield use case in the DeFi universe. As the markets continue upon their evolutionary paths and new mechanisms to provide yield to investors appear, underlying most of the new strategies is some reliance upon the old fellow ‘liquidity mining’. It is therefore appropriate to revisit liquidity mining from time to time, remembering the basic concepts set forth herein.