Until the appearance of DeFi, crypto asset owners had only a few options — selling them, storing them in cold wallets, or keeping them on exchanges. The only ways to gain money were HODLing and intraday trading. But later, liquidity mining made a revolution. To find out more about liquidity mining, keep reading.
Meaning of liquidity in cryptocurrency
The term “liquidity” was taken from common markets (for example, stock exchange). Liquidity refers to the ability to convert assets to cash. The higher it is, the quicker you can get your hands on your cash. Since exchanges accept orders from buyers and sellers, the asset readiness increases the speed of transactions.
Definition of providing liquidity
DeFi made it possible to obtain passive income from lending to newly built trading platforms. To date, users can deploy their assets as liquidity on decentralized exchanges, lending protocols, and liquidity pools on other kind of protocols. This way to earn passive income is referred to as “liquidity mining”. As a rule, it is restricted to a certain amount of time required to make the protocol operational.
LPs lend assets to decentralized exchanges in order to get rewards. They obtain their share of trading commissions paid by exchange users, which depends on their share in the liquidity pool. This commission is usually set at 0.3% but can be as low as 0.05% for stable assets, and as high as 1% for more exotic pairs.
Particular aspects of cryptocurrency liquidity on AMM
Sourcing liquidity from users is an inherent part of AMM. Decentralized exchanges (such as Uniswap) take a different approach to buying and selling digital assets. Unlike common exchanges, they provide the liquidity of cryptocurrency by incentivized lending. Investors obtain a share of the trading fees instead.
On Uniswap, sources of coin liquidity deliver a pair of tokens of identical value. A customer who intends to contribute 5 Ethereums (which cost $12,500) has to add a digital equivalent (i.e. 12,500 Tether). After obtaining liquidity crypto, Uniswap will provide it to the traders investing into the ETH/USDT (or any other) liquidity pool. The entire amount of swap fees will be distributed to liquidity providers.
This ensures a mutually effective relationship between both parties. Decentralized exchanges receive liquidity, liquidity providers get their rewards, while other clients get the chance to trade on a decentralized exchange quickly and efficiently.
What is impermanent loss?
Every single transaction (trading, mining, etc.) involves a high risk. After all, due to the high volatility of assets, the profits become unstable. Each liquidity provider must be informed of potential problems and track the market. This especially applies to impermanent loss (IL).
Impermanent loss is an often misunderstood concept of DeFi. Actually, IL is a measure of how much you could have earned by choosing to hold your crypto instead of adding it to a liquidity pool. The thing is, users who put their assets in a liquidity pool lose a lot of benefits (including speculative gain).
Assets lent to the decentralized exchanges can increase or decrease in value very quickly. Thus, tokens (for example, Ethereum) may increase twofold in just 72 hours! In such a case, the opportunity costs for liquidity providers will be considerable. Their rewards could be significantly lower than potential income from HODLing.
But you should be aware that such negative financial outcomes are just temporary (therefore, this type of loss is called “impermanent”). Impermanent loss isn’t realized until the tokens are withdrawn from the liquidity pool. If your assets go back to their initial price while still in the pool, you can profit from it. But if they don’t, you need to withdraw your assets from the cryptocurrency pool and realize an impermanent loss.
Unfortunately, IL is all but inevitable. This is explained by the incredible market volatility.
In summing up
Liquidity mining has proven to be one of the best ways to earn a passive income in the cryptocurrency market. This symbiotic relationship of LPA, exchanges and traders has existed since the inception of DeFi. As opposed to trading their assets or saving them in hardware wallets, users add them to decentralized liquidity pools and get rewards. The exchanges reward their liquidity providers with liquidity tokens and charges paid by other customers.
Recently, the digital market has mainly shifted to yield farming. This is a new and popular way to generate rewards with cryptocurrency holdings. Yield farming is often called the successor of liquidity mining. It involves lending crypto assets with the purpose of earning great returns. However, it is focused on maximizing a rate of return on capital instead of supporting the implementation of the DeFi protocols.