April 27, 2023
The way people engage with financial services has been transformed by decentralized finance (DeFi). Liquidity mining is one of the DeFi products that is most widely used.
We will examine what liquidity mining is, how it functions, and why the DeFi ecosystem needs it.
By providing liquidity to DeFi protocols, users can earn profits through a process known as liquidity mining. In order to enable decentralized trading on a specific decentralized exchange (such as Uniswap) platform, there need to be liquidity in the trading pairs, for example when you want to swap ETH to USDC there needs to have a pool which contains ETH and USDC and the pool funds are provided by liquidity miners.
Users get a portion of the platform's transaction fees (usually in the form of the platform native token) in return for supplying liquidity.
On a blockchain network, liquidity mining is possible thanks to smart contracts.
The platform's liquidity pool, into which users deposit their virtual assets, is utilized to facilitate trades. Users get a portion of the transaction fees in return for supplying liquidity in the form of a native token. In other words, the platform needs people to add liquidity to the trading pools (eg. ETH/USDC) so that other users can freely trade these tokens in this pool and can do simple transactions from ETH to USDC or from USDC to ETH.
For users and investors, liquidity mining offers a number of advantages.
First of all, it enables liquidity providers to receive compensation for supplying liquidity to DeFi protocols or trading pools.
Additionally, it aids the DeFi platform's liquidity, which may result in higher trading activity and decreased slippage.
Although liquidity mining might be profitable, there are risks involved.
Impermanent loss, which happens when the price of the tokens you added to the liquidity pool, fluctuates in relation to one another. Even if liquidity providers are receiving benefits/rewards for providing liquidity, in absolute values they are losing value due to the price fluctuation between the two virtual assets.
However, this risk can be mitigated if you add liquidity to stablecoins pools (eg. USDC/USDT). In this case the price of USDC in principle is 1$ and the price of USDT is 1$ so, impermanent loss risk would be mitigated in this liquidity pool.
Users can apply a variety of tactics when providing liquidity.
Finally users can also provide liquidity to stablecoins pools where impermanent loss risk is very low. Since the price of stablecoins have very low price fluctuations the risk is mitigated. However these pools are usually crowded with liquidity providers and returns can be lower.
Liquidity mining is crucial for the DeFi ecosystem since it enables the use of decentralized exchange platforms. Due to liquidity provision it is now possible to buy and sell several tokens in a decentralized way, previously tokens would need to be listed by a centralized entity.
Liquidity mining principle can also be applied to loan markets where a user deposits X amount of tokens and those tokens are taken from the pool by a borrower who leaves collateral for that loan. The interests are then paid to the liquidity provider by the borrower.
Users are now encouraged to actively participate in the DeFi ecosystem by offering liquidity in exchange for benefits.
Liquidity mining is crucial for fostering DeFi's expansion.
Users are encouraged to contribute liquidity to DeFi protocols, which increases platform liquidity and draws in additional visitors creating network effects. DeFi adoption may rise as a result, and the decentralized financial system may continue to expand.
A fundamental idea in the structure of the DeFi ecosystem is liquidity mining, which gives users the chance to get rewards for supplying liquidity.
Although it can be beneficial, there are risks involved, therefore users should be informed of the possibility of suffering from impermanent loss.
Overall, liquidity mining is a crucial technique for fostering DeFi's expansionand enhancing the platform's liquidity and usability.