Liquidity Mining – Everything you Need to Know About It

Beginner’s Guide / 30.09.2020

In the world of DeFi, market making is a critical component of growth. Without it, there is no new development. However, the current forms of generating liquidity are inefficient. Liquidity mining is the market’s solution to this problem. Specifically, liquidity mining creates a community-based, data-driven system to generate liquidity in the market. Miners receive rewards for providing liquidity to the sector.

The process requires depositing or lending designated blockchain assets. These systems employ a mining mechanism to provide liquidity for a product’s fund pool. Additionally, one trait all of these platforms share is that they allow users to earn interests for their participation. Specifically, You earn rewards for operating a market making bot. This bot maintains orders on an exchange order book. 

Similar to Proof-of-Work Mechanism

The actual term “Liquidity Mining” derives from the addition of the mining mechanism. This is similar to a proof-of-work mining system in that miners run open-source software on their own computers and use their own scarce resources. In this case it’s their inventory of crypto assets.

Unlike PoW blockchains like Bitcoin, users utilize more than just computational power. They also utilize their  token inventory. This approach is more democratic because it doesn’t require expensive mining equipment. Importantly, liquidity miners receive their rewards in a specific project’s native token. 

Governance Rights

There are also instances when they can simply receive the governance rights the token represents. Liquidity mining platforms can utilize various cross chain capabilities. Some of these systems don’t require you to trade into the direct asset of the blockchain you desire to utilize. Features like atomic swaps make this possible today. As such, atomic swaps are popular in the DeFi sector.

The main point is that these tokens provide voting rights to the user. Each platform may have different minimum token volume requirements before these rights are accessible. Be sure to review your terms of service. Most platforms base your rewards on three main criteria.

Order Amount

The larger your order is, the more rewards you will earn. The goal here is to maintain a high level of participation from the average user. 

The Spread

The spread is the distance to the mid price of your orders on the platform.

The Timeframe You Maintain Orders on the Order Book

The longer you maintain your order open, the more rewards you earn.

Currently most governance tokens also serve a speculative purpose. Since the DeFi sector is just starting to gain momentum. Investors buy these tokens with the hopes to resell for a higher value as the platform’s popularity grows. Some platforms will succeed. Sadly, most won’t. The difference between success and failure is often transparency.

What Problems Does Liquidity Mining Attempt to Fix?

Liquidity mining helps rectify a few areas of concern in the DeFi world currently. Specifically, it improves liquidity for new projects. Access to funding is vital to the cold start of a project. Unlike traditional industries, the DeFi industry lacks the self-built capital pool that starts ups require to achieve stable liquidity. Currently, exchanges and token issuers pay quantitative hedge funds millions to provide liquidity in the sector.

Liquidity mining resolves this problem in a unique way. It allows regular users to provide the missing liquidity. Users lend out their crypto and earn interest. What makes it more advanced than previous yield farming strategies is that  it creates user incentives through an interest rate mechanism.

All of these systems function similarly in that the more a user lends, the more interest they earn. Consequently, the liquidity pool grows due to these actions. As the liquidity pool expands, user’s profits grow as well. In this way, liquidity mining effectively links value islands in a decentralized dimension. This strategy accelerates the frequency of value exchange. The end goal is to promote price discovery.

How Does Liquidity Mining Work

Each Liquidity Mining platform differs slightly but the basic functions remain the same. You lock up your crypto in a smart contract on the DeFi platform. These funds go to a lending pool. This pool is where people borrow from. You receive interest for participating. It’s that simple. 

Benefits of Liquidity Mining

There are many benefits to liquidity mining that make it so popular. For one, it permits regular users to earn a passive income without previous requirements. Most liquidity pools provide a frictionless onramp to the market. The platforms are easy to sign up for and they don’t require any special equipment like traditional mining. Keenly, the best platforms allow you to start earning interest instantly. 

Risks of Liquidity Mining

There are also some risk that liquidity mining investors should be aware of. These risks span the gamut from technical risks to a market collapse. Mainly, computer errors or bugs are the biggest threat to the success of these platforms. In June of this year, miners from the platform Compound, lost tens of thousands of dollars when they were accidentally liquidated. The culprit turned out to be an improper pledge rate setting.

Another major risk faced by liquidity mining participants is inventory risk. Sudden, negative price movements can eat away at the platform’s inventory value. You can also have a scenario where a market maker acquires too large of a stake in a project. Users most remain vigilant in their market analysis to avoid these concerns. Invest at your own risk. 

History of Liquidity Mining

Liquidity Mining is still fairly new to the market. Compound launched “Liquidity Mining” on June 16 of this year. The feature was an instant success. Compound reported an increase in locked funds from approximately 180 million to 650 million in just 20 days. Additionally, user registration increased to over 6000 active lenders and borrowers. It was clear the market desired this solution.

A New Day is Here

Since then, the market has exploded. Every week new DeFi platforms enter the sector with more aggressive incentive programs. Today, anyone can earn a healthy ROI lending out their crypto via these platforms. At this time, the key is to be cautious and DYOR to avoid major losses. 

David Hamilton aka DavidtheWriter is a long time Bitcoinist and cryptocurrency journalist. Currently, he has over a thousand articles published on blockchain technology. His expertise and experience makes him one of the most reputable writers in the sector.