Decentralized finance is an exciting industry that has given rise to many new concepts. One such concept is liquidity mining, an opportunity for existing crypto users to put their assets to work. While liquidity mining carries some risks, many people seem to favor this approach.
Understanding Liquidity Mining
According to the latest cryptocurrency news, liquidity mining remains a crucial vertical in DeFi. The concept of liquidity mining is to have users provide crypto assets to decentralized liquidity pools. Those providers will receive trading fees and potentially tokens for doing so. It is a passive revenue stream for existing crypto holders, even though it carries a few risks people tend to overlook at first.
Liquidity mining revolves around pooled liquidity that is managed by a smart contract on the blockchain. All decentralized exchanges embracing the Automated Market Maker (AMM) model let users contribute liquidity to trading pairs – by supplying an equal share of both assets of the trading market – in any quantity.
Adding liquidity means users send their funds to the smart contract, although they can reclaim it at any given moment. However, the process involves transaction fees for approving the token contribution, sending the tokens to the pool, claiming rewards, and removing liquidity afterward.
What Are The Liquidity Mining Benefits?
There are many reasons why users want to engage in liquidity mining these days. Financial gain is the primary driving factor, although there are other potential benefits for users to look into.
- Earning trading fees, proportionally to one’s provided liquidity in the pool.
- Potentially high yields on liquidity.
- The potential to acquire governance tokens, depending on the project.
- Very accessible to anyone with crypto assets.
Taking bigger risks will often yield higher yields on your initial liquidity contribution. For example, providing two volatile crypto assets as liquidity may yield better rewards than supplying two stablecoins. However, stablecoins cannot fluctuate much in value, whereas assets like ETH, BNB, or others can see their price change by 10% or more at any moment. Moreover, earnings are affected by the popularity of the trading pair you provide liquidity for, as trading fees play a crucial role in how much you can earn.
On the governance token front, they are not guaranteed when engaging in liquidity mining. A platform like Pancakeswap will let users stake their Liquidity Provider (LP) tokens to earn CAKE, the platform’s native token. Uniswap has no such incentives at this time, and some other platforms do not offer native rewards either. Additionally, these tokens fluctuate in value, too, affecting potential earnings.
Don’t Overlook Liquidity Mining Risks
While all of the above sounds appealing, there are certain drawbacks to liquidity mining too. There is no such thing as a free lunch, especially in the crypto industry.
The first issue is impermanent loss, which poses the biggest problem. Locking your crypto assets in liquidity pools is appealing, but if the token price(s) change(s), it will affect the assets you initially invested. Either you receive roughly the same amount of each asset, but it is worth less now, or one of the two assets becomes “dominant” and affects the balance of the other token you want to withdraw. Moreover, the trading fees earned may not offset these losses, resulting in an overall loss.
A second issue is a potential for rug pulls. Anyone can create a DeFi rug pull with ease, which mainly affects new recently launched tokens. However, a liquidity pool creator could shut down the pool at any moment and take off with any money invested in the token. Therefore, performing a thorough analysis of tokens before providing liquidity for them remains essential.
Issue number three is the project representing the token you provide liquidity for. If that project has a code exploit, it becomes possible for culprits to trigger all kinds of nasty effects. Of course, that also applies to the platform where you contribute to the liquidity pool itself. Established DEXes like Uniswap and Pancakeswap are usually safe, but that doesn’t apply to smaller AMM platforms.
Is It Even Worth It?
Like all investment options to generate passive revenue, liquidity mining isn’t for everyone. Nor is it a guaranteed way of making money in decentralized finance. The risks may not outweigh the potential benefits, although that will require some thorough research to figure out. Always list the pros and cons, conduct some simulations regarding earnings, and what would happen if the value of supplied tokens drops by 10-20%.
It may be wise for those who want to venture down this path to start with a small amount and see what happens. However, blindly throwing thousands of dollars into a liquidity pool and hoping for the best may yield unsatisfactory results.
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