What is Liquidy Mining?
When talking about high DeFi yields to someone who has never experienced them, quite often the first thing they ask is “but where does the money come from?”. This is a complicated question, because there are many different ways that yield is generated in DeFi. However, one of the most common ways to earn in DeFi is liquidity mining, and it’s one of the best ones to explain to a newcomer because it’s a model that’s unique to DeFi. In a sentence, liquidity mining involves providing assets to a decentralised exchange, and in return receiving fees and rewards as compensation. Let’s explore it in a little more detail though.
The Basics
To understand liquidity mining, first of all you have to understand how a decentralised exchange (DEX) works.
Most centralised exchanges (stock exchanges etc.) use an order book method. This is where buyers and sellers place bids and a central order book matches them together. Usually there’s a transaction fee or a spread, and the central body will take the profit.
In a DEX, transactions instead usually use what’s called an automated market maker (AMM). Basically, this is a big pool of assets that people can come to at any time and trade from. There is an algorithm which dictates how much you can trade for, and the exchange rate is decided by the relative weight of each half of the pool.
The assets are provided by ordinary users, and you are entitled to a cut of the transaction fees relative to how much of the pool you provided.
This makes liquidity mining is a great example of democratised finance, because instead of fees and profits going into the pockets of vast financial firms, they are shared out fairly among those who contribute.
LP Tokens
In most liquidity pools, you need to provide to both halves of the pool in equal measure, although recently some dapps are innovating and allowing users to only provide a single asset.
Once you’ve added your funds to the pool, you’ll receive Liquidity Provider (LP) tokens in return.
LP tokens are basically like receipts that you can use to reclaim your funds when the time comes. LP tokens are an asset in their own right, and you shouldn’t just let them gather dust in your wallet. Most people will stake their LP token to earn additional interest, although it should be noted that this interest is usually paid out in a volatile token which may or may not retain its value. Due to this, it’s often a good idea to periodically sell the reward token for “hard” cryptocurrency like Bitcoin or Ethereum.
It’s also possible on some platforms to use LP tokens as collateral for loans, but most people choose to stake them and earn rewards.
The Dreaded Impermanent Loss
A lot of users are put off liquidity mining due to a complicated phenomenon known as impermanent loss, although in truth it’s not quite as scary as some people imagine. Explaining impermanent loss in detail is beyond the scope of this quick introduction, but put very simply, if the two assets in the pool diverge in value, the liquidity provider will lose out to some extent. For example, if you were staking both Bitcoin and Ethereum, and Bitcoin went way up in value while Ethereum remained flat, when you came to withdraw your funds, you’d get slightly more of the now relatively less valuable Ethereum, and less of the relatively more valuable Bitcoin. The reason it’s called impermanent loss is because if the relative values were to return to their original balance, the loss would disappear.
This loss can be a few percent, but it’s unlikely to much more than that, and usually the fees and rewards will more than compensate.
Finding the Best Pool For You
One way you can avoid impermanent loss is by choosing pools where the assets are unlikely to diverge too much. Stablecoins are the ultimate example of this, and you can be certain you won’t experience any impermanent loss at all (because the underlying assets won’t fluctuate in value).
Some pools will offer incredible interest rates of well over 100%, but these will almost always contain a highly volatile token that could collapse in value at any time. If you want to gamble then that’s fine, but for beginners starting out, it’s best to either stick to stablecoin pairs or to pairs that only include well-established coins that have a promising feature (i.e. not the platform’s own reward token, which will tend to suffer from extreme inflation). Also keep in mind that the interest rates are not fixed, so an eye-catching 200% APY could easily decline to something more mundane after a week or so.
At DeFi Decrypted we publish a daily DeFi yield update, which highlights a particularly eye-catching yield available at that particular moment. You can find this “Yield of the Day” on Telegram, Twitter, and Instagram. It’s a great way to keep track of the fast-changing world of DeFi without scouring dozens of different platforms every day.
In the next article we’ll take a look at a specific platform that offers liquidity mining, the popular PancakeSwap.
