Liquidity mining shows an attraction and special incentives for a huge number of investors. Besides, it was launched by IDEX and later polished by Synthetix back in 2017. Thereafter, the decentralized oracle provider Chainlink also came in with its full support mainly in 2019. Specifically, the presence of liquidity mining was felt heavily in the crypto space after Compound and Uniswap made it popular in June 2020.
Today, several existing protocols are using it, considering a smart and efficient way of issuing tokens. Likewise, most certain protocols are decentralized and allow anyone to become part of the liquidity mining process.
Liquidity mining plays a significant role in the DeFi boom. Also, it contributes to the monthly volume increase of DEXs — pushing it from $39.5 million in January 2019 to $45.2 billion in January 2021. As of October this year, its total value locked is $103.05 billion, according to DeFi Pulse.
Continue reading this tutorial to know more about liquidity mining, how it works, its purpose, and which protocols use it often.
What is DeFi?
Before we dive into what liquidity mining is, it’s important to first know what decentralized finance (DeFi) is. To define, DeFi is a market model that leverages smart contracts and blockchain to maintain distributed ledger transactions that supervise pre-programmed conditions.
In addition, the main idea behind it is to offer a DeFi-based system that uses smart contracts to deliver financial services. Which include borrowing and lending. DeFi supports a digital money market that is fair and available to everyone.
At the same point, staking or liquidity mining services are also around. Moreover, they are allowing investors to earn more with their crypto. Instead of keeping their crypto assets, users can place them to use by putting them in the marketplace. But, they require liquidity to perform successfully.
By providing liquidity in the form of their assets, users support the functioning of a marketplace and get rewards in return for their contribution.
What about DEXs?
In broad terms, we can divide cryptocurrency exchanges into two groups: centralized and decentralized.
In a centralized crypto exchange, your account is primarily controlled by the third party that runs the exchange. Whereas, in the case of decentralized exchanges (DEXs), you manage the account on your own.
In addition, DEXs are open platforms that are not reliant on any major firm to govern users’ accounts or orders. Moreover, autonomous decentralized applications (dApps) enable crypto buyers and sellers to trade without relinquishing control to custodians.
Types of DEXs
All DEXs can be subdivided into three categories, and those are listed below:
On-chain Order Books
In a DEX that uses on-chain order books, particular network nodes are subject to managing a record of all orders. In addition, miners are asked to confirm each handled transaction.
Off-chain Order Books
In off-chain order books, all transaction records are hosted in a centralized entity. Therefore, to manage the order books efficiently, it is necessary to use particular relayers. Because of this, it’s right to say that off-chain order book DEXs are only partly decentralized.
Automated Market Makers (AMMs)
AMMs are considered one of the driving powers fuelling the DeFi boom and have been adopted by several popular DEX platforms. Instead of ordering books, AMMs utilize smart contracts to form liquidity pools that automatically conduct trades based on certain negotiated criteria.
Understanding Market Liquidity
Before you get engaged in liquidity mining, it’s important to know what lies behind the liquidity’s purpose and how it works.
Liquidity basically refers to a fund’s liquidity, marked as the ability to buy and sell assets without creating any sharp changes in the asset’s market price. So, here are some key elements on the functioning of a new coin or a crypto exchange. Moreover, those rely on some parameters, including speed, spread, transaction depth, and usability.
Transaction speed implies how quickly you can execute your orders. For instance, if liquidity is low, there is a big chance of delays, and limit orders may take hours or even days to be processed and executed. On the other hand, the processing of orders takes just a few seconds for highly liquid pairs.
The bid-ask spread is recognized to be one of the key strengths of market liquidity. It reveals the variation between the asking price and the offering price of an asset. The narrower the spread between the bid and ask orders, the more liquid the market.
Transaction depth is commonly used to express the degree of market price stability. The greater the depth is, the less significant impact on a particular number of transactions on the price.
Usability is a determining factor too. More often, a cryptocurrency is used as a method of payment, the more liquid it becomes. Consequently, if more merchants start accepting crypto as a payment medium, they will contribute to crypto’s broader adoption and usage in transactions.
What Is Liquidity Mining?
DeFi has been a booming success, and it has seen an upsurge of activity and public interest. Liquidity mining is rightly considered to be one of the key components of this success. Besides, it’s viewed as a useful mechanism for bootstrapping liquidity.
Generally speaking, liquidity mining happens when users of a specific DeFi protocol get benefits from that protocol’s native tokens for joining with the protocol. It’s the method of storing or lending detailed token assets to give liquidity to the product’s fund pool and receive an income afterward.
Therefore, a liquidity miner can receive rewards served by a project’s native token or even the governance rights it represents. But, the tokens are typically created based on the protocol’s programming. However, most of them can’t be used outside of the DeFi platform responsible for generating them.
In addition, the exchange markets’ creation and the hype around those tokens contribute to a rise in their value.
Furthermore, DEXs are always at the attention of new users who can bring capital to the platform and reward them for their contributions. Currently, most DEXs are renewing their order books with AMMs that offer efficient regulation of all trading procedures. In addition, AMMs offer token swapping that forms its potential to trade one token for another within one distinct liquidity pool.
Likewise, when users choose to manage a trade, they are supposed to pay a certain fee. The AMM collects the fees and gives them to each liquidity provider as a reward. So, the token swapper is allowed to trade on a DEX if they pay a fee. Moreover, the liquidity provider manages to earn money by providing the much sought-after liquidity that the user needs.
Capabilities and Benefits of Liquidity Mining
Although liquidity mining has stormed the crypto world very suddenly, it’s already shown itself as a sharp game-changing tool, able to perform multiple functions, which we’re going to review below.
Overall Liquidity Improvement
The liquidity of funds is considered the vital element of the liquidity of the whole economic system. But, sadly, DeFi doesn’t hold a self-built capital pool that would give solid liquidity other than specific industries.
As a result, creating a viable and innovative decentralized fund pool model and overall user incentives via an interest rate mechanism that would add better liquidity has become a primary and well-thought-out goal of DeFi projects.
Price Discovery Promotion
Due to the lightning-fast growth of blockchain technology, various separate entities have performed, in which liquidity mining can unite in one decentralized dimension. Therefore, the method can also speed up the frequency of value exchange and better price discovery.
To clarify, price discovery shows traders’ knowledge of the relevant market supply and demand situation. But also the expectations from future market opportunities. Thus, liquidity mining can allocate resources and allow investors and different financial firms to make more fair price decisions.
More Effective Marketing Strategy
Liquidity mining comes in handy when exciting press coverage and building greater knowledge of the product. First, however, must handle the entire drive correctly to ensure that the liquidity mining budget did not spend on just this one goal.
Broader and Fair Distribution Along With Lower Entry Barriers
One of the vital benefits of liquidity mining is that small retail, and institutional investors have an equal chance to own native tokens of a specific protocol. In addition, this is a valuable benefit to the investors that previously desired but didn’t have a chance to partake in the DeFi ecosystem.
Types of liquidity mining protocols
Liquidity mining protocols appear in all sizes and shapes. Each protocol is freakish and offers its unique traits and reward deal types. Nevertheless, it is marking most protocols into three distinct groups.
In addition, those groups vary by their purpose, method of decentralization, and distribution. However, it depends on what you are searching for in a project. Besides, you can choose a specific group depending on your needs.
● Fair Decentralization Protocols
Fair decentralization, liquidity mining projects often try to reward aggressive community members—however, it spreads governance tokens to all early users who joined the platform most of the time. By doing so, developers ensure decentralization by allotting tokens that do not involve a token sale or market listing.
● Progressive Decentralization Protocols
Progressive decentralization protocols are doubtful to hand over the control of the platform to society directly. As a result, developers usually perform a governance model months after initially launching the platform. Similarly, the token is seldom listed on the market before developers utilize governance online. Thus, the main goal is to assure a fair token allocation to avoid whales growing high governance tokens.
● Marketing-oriented Protocols
Marketing-oriented protocols describe a type of liquidity mining protocol that thrives on hype. The project is often revealed weeks before launch, and they offer incentives to users to market the platform. That way, developers lead a high user base before the platform’s launch. In addition, marketing a platform can help collect funds for liquidity, which developers often lock for long periods.
Protocols That Take Advantage of Liquidity Mining
Liquidity mining can surely revalue a protocol that benefits it, which is why this notion has grabbed the attention of many developers of different platforms and spawned a new trend in the crypto world. So without any further ado, let’s take a closer look and check at some of those protocols.
The Echo blockchain provides efficient network interoperability, is a layer-2 protocol from the Ethereum and the Bitcoin sidechain. In addition, this one-of-a-kind protocol helps other blockchain assets, including ERC-20 tokens. Moreover, on the Echo chain, it represents the tokens via a bi-directional peg. It also allows Echo dApps such as a DEX to support the assets.
The Compound is a decentralized Ethereum-based protocol that supports the lending and borrowing of particular cryptos. Besides, it relieves all crypto owners from dealing with traditional financial agents and saves time and effort.
When using the Compound protocol, liquidity providers can earn COMP tokens as a reward for their joining and exchange them internally on the native platform or on CEXs and DEXs to invest in other tokens.
Built on Ethereum, Aave is one of the well-known decentralized money market protocols. Besides, it allows its users to lend and borrow their cryptos securely. To transact on Aave, lenders need to deposit their funds into liquidity pools. After that, other users have a chance to borrow from these pools.
In each pool, assets are set aside as reserves to hedge against volatility and ensure that lenders withdraw their funds once they exit the protocol.
The Balancer protocol has been reaching momentum and inspiring the growth of the entire DeFi ecosystem. Moreover, its key target is to present a great financial protocol that flexibly offers programmable liquidity. At the same time, instant on-chain swaps with moderate gas costs.
In addition, balancer allows users to trade all backed tokens on one another. As a result, it creates unique liquidity pools where you can add liquidity to the balancer protocols and even invest in other pre-existing pools to earn a yield from your trades.
The curve offers an advanced AMM exchange with low fees for traders and real savings for liquidity providers. In addition, the curve directs mainly on stablecoins. In fact, they are enabling investors to evade more active crypto assets and earn high-interest rates from their lending protocols.
Uniswap is a DEX protocol that works on the Ethereum blockchain. Besides, it doesn’t need any other centralized parties to carry out trades. Instead, Uniswap mainly relies on the model that provides liquidity providers to generate liquidity pools.
In fact, users allow swapping between ERC-20 tokens with no required order book efficiently. Given that Uniswap is decentralized, it doesn’t introduce a listing process either. However, any ERC-20 token can manage because there’s an available liquidity pool for traders.
Yearn Finance, also known as yearn.finance, is served as a set of protocols that works on the Ethereum blockchain. Therefore, it allows users to boost passive earnings by using the trading and lending services provided by the platform.
Liquidity mining is growing in its fame by leaps and bounds and has sparked interest even among the most discerning and knowing DeFi associates.
It’s true to admit that liquidity mining is a relatively simple concept. Yet, we fully suggest carefully considering and assessing your aims and expectations before engaging in it. In fact, it ensures that you have a thorough knowledge of the entire DeFi ecosystem. Most importantly, choose a solid and complex protocol that will allow you to make the most of liquidity mining processes.
Disclaimer: The views and opinions expressed in this article are solely the author’s and do not necessarily reflect the views of CoinQuora. No information in this article should be interpreted as investment advice. CoinQuora encourages all users to do their own research before investing in cryptocurrencies.