Prior to the emergence of DeFi, crypto assets could only be stored or traded on exchanges and cold wallets. Apart from HODLing and day trading, there were no other options to make profit. However, the invention of liquidity mining changed the game. Let’s find out.
Liquidity in cryptocurrency markets
“Liquidity” is a concept borrowed from the traditional stock exchanges. This indicator measures the ease of exchanging one asset for another. In cryptocurrency markets, higher liquidity means quicker and easier token swap. Since platforms accept orders from buyers and sellers, the high liquidity of assets allows to accelerate and facilitate the transactions.
Benefits of providing liquidity
DeFi allowed the users to earn passive income by lending assets to newly built trading platforms. Now, you can use your assets as liquidity on decentralized exchanges, lending protocols, and liquidity pools on other kinds of protocols. This means of passive income is referred to as “liquidity mining”. As a rule, it is limited to a specific amount of time required to initiate the protocol.
Liquidity providers (also known as LPs) lend assets to decentralized exchanges in return for certain rewards (for example, trading fees and ERC-20 tokens). The size of rewards depends on the user’s stake in the liquidity pool. The exchanges have three different fees for liquidity providers — 0.05%, 0.3% and 1%.
About cryptocurrency liquidity on AMM
Liquidity providing is an integral part of the AMM system. Without it, decentralized exchanges (such as Uniswap) can’t serve the traders who want to exchange tokens. For this reason, traders are actively encouraged to add liquidity to the cryptocurrency pools. All users are rewarded with trading fees for their contribution
In the case of Uniswap, crypto owners need to provide equal portions of tokens. A trader who wants to contribute 6 ETH (each of which costs $2,500) must provide 15,000 USDT (as a digital equivalent of $15,000). After obtaining liquidity, DEX will grant it to the clients who trade it from the liquidity pool. The swap fees are distributed proportionally among the liquidity providers.
This results in a mutually beneficial cooperation, where each party gets a profit. Decentralized exchanges obtain liquidity, LPs obtain rewards, and end-users have an opportunity to trade in a decentralized exchange quickly and easily.
Main information about impermanent loss
Every type of cryptocurrency transaction (whether mining, investing or trading) carries risks. Therefore, if you don’t want to lose profits, you should constantly monitor the market, especially impermanent loss.
Many users mistakenly think that IL is more complicated than it really is. However, the basic functionality of impermanent loss is relatively simple. Impermanent loss is an opportunity cost of keeping an asset for speculation vs. providing it as liquidity to obtain fees.
If an asset lent to the decentralized exchange gains too much value in a very short time, the user can lose a lot of money. For instance, ETH can double in just four days but the fees provided while farming it will not even cover 50% of what you would have made by HODLing.
However, you should know that IL is only the temporary loss of funds. Losses are only realized if the trader withdraws his/her liquidity. So, it’s possible to prevent impermanent loss if the assets return to their initial price. But unless this happens, liquidity providers have no other choice but to withdraw liquidity and realize their IL.
It is almost impossible to avoid impermanent loss because of the extreme market volatility. Calculating and predicting impermanent loss is a very complicated task.
Liquidity mining is an excellent means to obtain passive income in the cryptocurrency market, which benefits all parties: LPs, exchanges and traders. This concept has existed since DeFi’s rise. Liquidity mining allows the users to get rewards for utilizing their crypto assets rather than storing them in hardware wallets. For lending assets to DEXs, the platforms give their liquidity providers trading fees and governance tokens.
However, there are many other popular ways of making a passive income. One of them is yield farming. As well as liquidity mining, it is based on asset deployment. The only difference is that its main purpose is to maximize returns, and not to maintain the functioning of the DeFi protocols.