Liquidity mining presents a path into the opportunities of earning passive income in cryptocurrency investing — but not without its risks.
There are few things unifying people globally as much as the drive to earn more money. That’s where blockchain technology and cryptocurrencies step in with options such as liquidity mining, staking, and crypto trading. This article focuses on liquidity mining, showing how it can help one earn passive income.
Briefly on Liquidity Mining
To begin with, just what is liquidity mining? Simply put, it refers to providing liquidity to a decentralized exchange in the form of cryptos. The process may also be identified as yield farming.
The entire process requires one to grasp other key terms, such as:
- Decentralized exchange (DEX) – A crypto exchange platform that allows for a secure online peer-to-peer transaction, eliminating intermediaries
- Smart contracts – An agreement between two parties in the form of a computer program designed to execute orders after certain preconditions are met
- Automated Market Maker (AMM) – A digital order book that enables the automatic trading of digital assets without permission on liquidity pools
How the Process Works
The main aim of operating a DEX is to provide liquidity for users to enable more accessible crypto exchanges. DEXs are always willing to issue rewards to users who help provide capital to the DEX.
An AMM, a form of a smart contract, automatically allocates liquidity from a user providing it within the DEX to a trader requiring it without permission. The AMM then provides a commission to the liquidity provider, based on the fee the trader remits for using the DEX’s services. That’s how anyone can earn passive income from liquidity mining/yield farming.
Start by Joining a Liquidity Pool
To begin with, one has to scout for a conducive liquidity pool. A liquidity pool is a large AMM that provides liquidity to traders to avoid drastic price fluctuations. The liquidity pools, AMM, smart contracts, and DEXs all fall under decentralized finance (DeFi), which first came to light via the Ethereum blockchain.
The liquidity pools enable all users acting as liquidity providers to operate seamlessly with the needs of traders seeking liquidity within the DEX. The trustless operations as a requirement of AMMs also make the process risk-free where any theft of cryptos provided as liquidity is concerned.
Different liquidity pools offer different yields depending on the various associated trade attachments. They include the impermanent loss risk, the presence of and frequency of audits, and the liquidity pool’s popularity and size. The size of the pool is an essential factor that influences the choice of pools, which requires further explanation.
Liquidity Pool Size
A liquidity pool’s size estimation depends on its total value locked (TVL). A large TVL is a good gauge of how much traders and liquidity providers trust and prefer the liquidity pool over other competition.
The TVL simply refers to the total value of cryptos that liquidity providers have locked in a liquidity pool. The size of a DEX platform and its popularity is directly proportional to the sum of TVL on its liquidity pools.
The largest pools by TVL won’t necessarily mean that these pools have the lowest impermanent loss or the best APY. A smaller pool will usually offer the best in both to boost its popularity and size. But traders requiring massive liquidity will still have to opt for the largest pools by TVL.
Ways to Estimate Liquidity Mining Yield
As of May 2021, the highest commercial bank deposit interests offered are 36% in Venezuela and 34% in Argentina. However, the annual inflation rate in both far exceeds the deposit interest rates, meaning a depositor will undoubtedly have a higher figure but worth less than what they deposited. Neither is depositing in both easily accessible.
Liquidity mining, in turn, offers even higher yields but without a similar inflation rate. There are two ways yields are estimated, as annual percentage rate (APR) and as annual percentage yield (APY).
An APR looks at the percentage of farmed value one earns after locking liquidity in a pool. An APY, in turn, looks at the yield one gets to earn from locking liquidity, inclusive of returns reinvested. APY is the more preferred method of yield estimation.
While earning is rosy and attractive, it is only fair to outline the pitfalls. There are several risks associated with liquidity mining.
The first is impermanent loss. It’s the temporary loss arising from volatility in the trading pair prices. It is temporary since prices can swing back to favor the liquidity provider. Pairs involving stablecoins in many pools have no impermanent loss.
Liquidity providers who lock enormous amounts for the longest time are also the largest beneficiaries of liquidity mining. To do so, one needs to understand De-Fi in more depth to know how and when to lock what amounts in which pools. That could be a trade risk to a beginner trader.
Project risks also arise, where there is the possibility of a backdoor exit for some. Such occurrences are, however, limited to small unaudited platforms whose coding is not open-sourced. There are also bugging and coding risks, also limited to the above platforms.
Better View Through the Risk Lens
Liquidity mining is an excellent avenue of generating passive income. Before one dives into it, it is wise to be familiar with the concept regarding it and any potential risks. This article has provided related insights to aid users to make calculated decisions.
Lastly, a piece of advice for those just starting out in liquidity mining: best to stick to the larger DEXs with the most extensive liquidity pools. That is, until one understands how to ascertain all the risks such as impermanent loss, trade risks, project risks and bugging/coding risks. Gaining a grasp of those risks will help place the liquidity mining opportunities in better view.