Liquidity mining involves depositing (and sometimes locking) cryptoassets in smart contracts in exchange for yield
Liquidity mining can involve considerable risk. This article is for educational purposes only and should not be considered financial advice. Please consider your personal risk profile before making any investment decision.
- Three Simple Liquidity Mining Methods
- Liquidity Provider (AMM Protocol)
- Money Market (Lending Agreement)
- Validator Staking (Proof of Stake Protocol)
- Liquidity mining risk
One of the most exciting opportunities DeFi offers has to be liquidity mining. Liquidity mining is a term used to roughly describe the strategy of earning passive income from one’s crypto assets. The easiest way to conceptualize this is to imagine a high-interest savings account at your traditional bank, or maybe a dividend-paying bond, but that’s just scratching the surface when it comes to liquidity mining.
The mining metaphor in liquidity mining refers to the initial deposit of cryptoassets and the final reward harvest, similar to the model practiced by farmers and agriculturists. This article will discuss several specific methods for generating returns on cryptoassets, and elucidate our understanding of the field of liquidity mining more broadly.
In traditional finance, instruments that bring 5-15% to asset holders are considered high yielding. Commercial bank savings accounts typically offer less than 1% APY (Annual Deposit Yield) on fiat currency deposits. On the other hand, large DeFi platforms like Celsius offer higher yields for fiat stablecoins and other highly liquid crypto assets such as Bitcoin, Ethereum, Paxos Gold, etc.
These numbers are small compared to DeFi products, and smaller protocols offer amazing yields (think 800% APY) to attract funds to their protocols. Often seen as red flags, these yields only apply to smaller, often illiquid crypto assets, and yields fluctuate and gradually decline significantly over time.
This could result in lower-than-expected returns for liquidity miners’ assets and further price declines as investors pull their tokens out for sale. These “carpet” or Ponzi agreements often have similar designs to attract funds through the high APY trap before the creators of the protocols start selling their coins or tokens to unwitting investors and disappear entirely. Expensive two- and especially three-digit APY numbers should certainly draw additional scrutiny.
Three Simple Liquidity Mining Methods
Liquidity Provider (AMM Protocol)
The first way to generate income from crypto assets is to deposit assets into liquidity pools. For decentralized exchanges, collecting funds into liquidity pools allows transactions to take place quickly and easily at any time. That is, these funds are collectively used to process all transactions that take place on these protocols.
Liquidity is an absolute necessity for automated market makers (AMMs). AMM offers permissionless transactions using funds from LPs. Liquidity Providers (LPs) tokens are issued when funds are deposited to track and verify contributions and to calculate a proportional share of the pool to distribute the proceeds.
For example, on Uniswap v2, a pair of crypto assets is deposited in an equivalent amount in exchange for the corresponding LP token. For example, $500 in USD currency and $500 in Ethereum can be deposited into the liquidity pool smart contract in exchange for USDC/ETH LP-UNI-V2 tokens. Since Uniswap is an Ethereum dApp, the LP tokens created will of course also be specific to the Ethereum chain.
By providing liquidity to the protocol with their deposits, users can earn revenue from transaction fees. Uniswap v2 charges a transaction fee of 0.3% per transaction, which is distributed proportionally to each LP token holder based on their share of the liquidity pool.
Using the above example, let’s assume that USDC/ETH LP-UNI-V2 tokens worth $1,000 account for 0.01% of the entire Uniswap liquidity pool, which means that the entire liquidity pool contains even $10,000,000 worth of assets (5 million USDC in USD and $5M in ETH) ). For simplicity, these numbers are hypothetical.
USDC-ETH LP token holders receive UNI token rewards from their share of protocol fees when users exchange USDC for ETH, and vice versa.
If $10 million worth of USDC and ETH are traded on Uniswap per day with a transaction fee of 0.3%, the liquidity provider will share in the reward of $30,000 per day. If we continue with the example above, where the 0.01% bonus will net the LP $0.03 per day, or roughly $11 per year. If one speculates that the price of UNI tokens will appreciate over time in the future, the rewards could be even greater.
Of course, one can expect higher yields by providing more liquidity. Additionally, providing liquidity to smaller pools means a larger share of transaction fees, although smaller pools are more likely to become illiquid or prone to security breaches. Therefore, due diligence on financial security issues is imperative before becoming a liquidity provider.
Also, the cost of using Ethereum can be quite high, as there is a gas fee to deposit both assets into the LP contract. As a result, many people turn to decentralized exchanges like PancakeSwap, QuickSwap and SundaeSwap, which provide liquidity providers with rewards but lower fees compared to Ethereum as they are on the Binance, Polygon and Cardano blockchains run on.
It should be noted that many liquidity pools reward LP token holders with smaller market cap tokens such as CAKE or UNI. While these assets are widely held and traded, inflation rates should be considered before making any long-term investment decisions. Critics have warned that if demand growth fails to materialize, the liquidity of any given protocol could be severely damaged.
Money Market (Lending Agreement)
Cryptocurrency marketplaces or lending platforms also offer crypto users the opportunity to generate income from their holdings. For example, Celsius, Aave, and Compound offer crypto loans to depositors, using overcollateralization to manage counterparty risk. This means, for example, that in order to get a bitcoin loan, a borrower has to put up more collateral than they get on the loan.
To borrow a cryptoasset on Celsius, users first have to deposit another cryptoasset and lock it into a smart contract, posting collateral at higher levels allows users to borrow at lower rates. Loan-to-value ratios range from 50% for the highest interest rate, the highest risk loan, to 25% for the lowest interest rate, with a borrowing rate of just 1%.
By funding borrowers, Celsius users can earn from the assets they deposit, or choose to receive CEL tokens for slightly better interest rates. Celsius offers depositors an annual interest rate of 6.2% on their first 0.25 bitcoin, rewarded from fees charged to borrowers on the same platform.
Lending Bitcoin for liquidity mining, users earn over $600 per year for every $10,000 of BTC they deposit (at the time of publication).
Essentially, this enables users to continue to allow their assets to generate income, while also having the option to obtain liquidity without having to incur a taxable event for selling assets for cash flow. By taking advantage of yield-generating opportunities in the cryptocurrency market, liquidity miners can generate more passive income with lower barriers to entry, as interest rates on DeFi platforms are much higher than those in traditional finance.
Validator Staking (Proof of Stake Protocol)
Staking is a term that describes a user depositing cryptoassets into a specific proof-of-stake protocol, sometimes “locking” them into short-term smart contracts (though not always), and then producing crypto that compounded over time award. Although not traditionally considered liquidity mining, staking technically falls into this category as it involves depositing cryptoassets into a staking pool in exchange for a portion of a node validator’s block reward.
For example, staking ADA on Cardano involves joining a staking pool that always participates in block validation and is not fully saturated with stakers. After putting funds into the staking pool, users will be rewarded with ADA tokens every period (5 days), with an estimated return of 4.5% – 6% APY of their deposits.
An example of staking Cardano’s native cryptocurrency ADA in the Yoroi Light Wallet.
Tezos also offers a staking reward of 6% APY for running your own staking node, although this can be cumbersome for the average user. Centralized exchanges like Coinbase allow their users to stake funds through their own validator nodes, with stakers earning 4-5% APY, while Coinbase keeps the rest for the technically heavy lifting. Funds can be staked or unstakes at will, and the yields are attractive given the liquidity of this arrangement.
Ethereum 2.0, recently renamed ETH’s “consensus layer upgrade,” also allows users to stake funds and even run their own validator nodes when the upgrade is ready to go live. Stakers can be rewarded based on multiple variables by validating transactions. To run a full validator node requires 32 staked ETH, and those with less ETH need to stake a larger pool.
For example, staking Ethereum on Coinbase gives users 4.5% APY. Like many other blockchains, running an Ethereum node requires a capital investment in hardware, as well as additional resources dedicated to maintenance, node operations, on-chain penalties, and regulatory compliance.
Unlike the previously mentioned staking options, staked Ethereum cannot be unstakes temporarily, and users wait indefinitely for the network upgrade to go live before they can access their initial deposits, not to mention the benefits of staking.
Liquidity mining risk
As with any form of cryptocurrency, liquidity mining has inherent risks. Nonetheless, it is important to understand the specific hazards that need to be prepared before engaging in any liquidity mining.
There is always a risk of volatility when using non-stable coin crypto assets for liquidity mining. Those seeking crypto yields could easily be liquidated and lose money if their assets suddenly depreciated and they were unable to add collateral in the case of DeFi lending.
Impermanent losses are another concern, as price fluctuations between paired assets can be in the opposite direction from when the cryptocurrency was initially deposited. However, this only applies to liquidity providers, as impermanent losses do not apply to staking or money markets.
The token economics of inflation is another concern for liquidity miners. After all, if the rewards to liquidity providers are too generous, the spot price of the token could exceed demand, putting downward pressure on the price, creating negative sentiment around the token and dissipating liquidity, and failing to attract interest over time more people.
“Countries such as El Salvador, Switzerland, Taiwan, Portugal, and Singapore have made it clear that crypto assets will be welcome and embrace innovators and encourage economic dynamism through friendly tax regulations.”
Rug pulls, pump and dumps, and outright fraud also pose a threat to those seeking to maximize returns through liquidity mining. Depositing crypto assets into a protocol usually means pairing rug pull tokens with Ethereum as a liquidity provider.
Once the spot price of rug pull tokens reaches a certain threshold, rug pullers sell their tokens and disappear from the protocol. Liquidity providers may find that they have been earning high yields in devalued tokens. Other examples include output being locked up and unavailable until an indeterminate date, leaving liquidity miners with devastating losses.
Finally, there are unknown regulatory risks associated with cryptoassets in almost every jurisdiction in the world, especially when it comes to DeFi and securities products. Countries such as El Salvador, Switzerland, Taiwan, Portugal, and Singapore have made it clear that crypto assets will be welcomed, with friendly tax regulations that embrace innovators and encourage economic dynamism. Interestingly, smaller jurisdictions appear to be leading the way in crypto adoption and regulatory clarity, raising some questions as to why some jurisdictions are moving fast while others lag behind.
Conversely, other jurisdictions either strictly regulate exchanges or ownership of crypto assets, or fail to provide enough clarity for investors to meaningfully participate in the space. Nonetheless, positive regulatory developments have been a general trend globally, with places that initially took a defensive stance against cryptocurrencies, such as Russia and Thailand, recently announced measures to regulate ownership and trading of the asset class.
Regardless of the method used, liquidity mining is a complex and risky endeavor. Nonetheless, the amount of value locked in DeFi contracts continues to trend upward over time. When given the opportunity to put their money to work, crypto users seem eager to use passive income to enrich their lifestyles. The decision to engage in liquidity mining involves considerable risk and is at the discretion of each individual. Therefore, this article should be viewed as educational and by no means an endorsement of liquidity mining as an investment strategy.
Baydakova, A. (2022 21 Feb.). Russian government introduces crypto bill to parliament over central bank objections. CoinDesk.
Reuters Staff. (2022 25 Jan.). Thailand to regulate use of digital assets as payments. Reuters.
Vermaak, W. (2021). What is yield farming? CoinMarketCap.
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