DeFi 101: The History of Liquidity Mining
Liquidity mining skyrocketed in 2020 with the release of popular decentralized exchanges, but what came before?
What is Liquidity Mining?
Liquidity mining involves users providing liquidity to a decentralized exchange or liquidity pool, and in return, earning rewards in the form of cryptocurrency and fees. These fees vary depending on the exchange used. However, the typical rate is 0.3% per swap, where the total reward is proportional to a user’s share in the liquidity pool.
However, the underlying mechanism behind liquidity mining is more complex than that. Essentially, liquidity mining incentivizes users to contribute to the liquidity of a particular market by offering them rewards for doing so. The idea is that by providing liquidity, users are helping to create a more stable and liquid market, which in turn benefits all participants.
While liquidity mining has been around for a few years, it gained significant traction in 2020 and beyond due to the explosion of DeFi applications and the increased popularity of cryptocurrencies. In fact, many DeFi protocols now offer liquidity mining as a core feature, and it has become a major way for users to earn passive income in the cryptocurrency space. Let’s explore some of the most popular protocols today.
The concept of liquidity mining can be traced back to 2017 when the decentralized exchange IDEX first introduced the system. Instead of requiring users to lock up their capital in a separate pool, IDEX tokens were given as a reward for simply filling a basic limit order. This made it easy for users to earn rewards for providing liquidity, and it helped build a more liquid market.
Although IDEX may have pioneered the idea, liquidity mining has come a long way since its inception. Popular protocols such as Synthetix, Compound, and Uniswap have all done their part to redefine its future.
Following IDEX, in 2019, Synthetix launched its own type of liquidity mining strategy. The program rewarded sETH/ETH liquidity providers on Uniswap by enabling them to earn a proportional amount of SNX tokens based on their provided liquidity. This not only gave users extra rewards on top of their Uniswap trading fees but also made it easier for new traders to get into the Synthetix ecosystem by providing a way to convert ETH into sETH with minimal slippage. Later on, the program also started to reward users who deposited sUSD on Curve Finance alongside other popular stablecoins.
The liquidity mining model pioneered by Synthetix marked a noteworthy milestone in the industry, paving the way for other projects to adopt similar approaches. One such project was Compound, a decentralized money market that incentivizes users with COMP tokens for both lending and borrowing capital on their application. This distribution model was a hugely beneficial strategy for Compound as it increased the value of the protocol by attracting more assets to their pools.
With the introduction of Compound’s COMP token in 2020, a surge of new DeFi projects and yield farming opportunities, referred to as “DeFi Summer”, started to pop up and implement similar yield farming approaches. As more projects have launched, different methods of yield farming have since been experimented with in real-time to determine their efficiency and refine less effective strategies.
Uniswap came to fruition in 2018 after its founder, Hayden Adams, identified a problem with existing centralized exchanges. He observed that they suffered from a lack of liquidity, making it challenging for traders to locate the assets they desired. To address this, he came up with the idea of incentivizing users to provide liquidity to markets through rewards. By doing so, he aimed to create a more liquid market that would benefit all participants.
In 2020, Uniswap helped popularize liquidity mining by introducing unique features, such as enabling users to provide liquidity to markets in exchange for rewards in the form of UNI, the native token of Uniswap. This was one of the first widely adopted examples of liquidity mining in crypto, and it helped to quickly build a large and liquid market for trading on Uniswap. The method soon became mainstream, with many protocols implementing the same structure for incentivization.
Today, the process for providing liquidity to a pool remains largely unchanged. Users deposit their tokens into the pool and, upon completion, receive liquidity tokens. The number of tokens allocated corresponds to the amount of liquidity added to the pool and represents their value share. Whenever a transaction is executed, a small fee of 0.3% is deducted from the sender and distributed among all liquidity providers. Furthermore, if a protocol has established a pool, they may also offer rewards in their native token to lower the possibility of impermanent loss. To withdraw liquidity and any associated fees, providers must “burn” their tokens, which exchanges them for their share of the pool.
Marketing protocols often adopt a pre-launch strategy, whereby they announce the project to the public well in advance of its official release. This enables interested parties to generate buzz and promote the platform before it becomes fully operational. By doing so, developers can establish a robust user base even before the launch, and also gather sufficient funds for liquidity, which may need to be locked for an extended period.
Protocols that emphasize fair decentralization strive to establish an impartial ecosystem for all participants by equitably distributing native tokens to both early adopters and active users. Unlike Initial Coin Offerings (ICOs) that necessitate the acquisition of a governance token, fair decentralization protocols do not sell the native currency. Instead, they implement distinct criteria to ensure a just distribution of tokens. Once launched, power over the protocol is transferred to the community.
Finally, progressive decentralization is a key feature in DeFi liquidity mining protocols as it enables a gradual shift of power to the community. This approach facilitates a controlled distribution of tokens, preventing disproportion in the allocation of governance tokens. This also means the implementation of a governance model post-launch. It is important to note that, progressive decentralization protocols do not immediately grant control to the community, and developers may require a certain period to implement a governance model after the platform is launched. Additionally, the token may be listed on the market before governance is provided online.
In summary, liquidity mining enables users to provide liquidity to a decentralized exchange or liquidity pool to earn rewards in the form of cryptocurrency and fees. This type of reward system incentivizes users to contribute to the liquidity of a particular market, creating a more stable ecosystem that benefits all participants.
Although pioneered years before by IDEX, liquidity mining gained significant traction in 2020, with many DeFi protocols now offering liquidity mining as a core feature, making it an increasingly popular way for users to earn a passive income. Popular protocols such as Synthetix, Compound, and Uniswap, have all done their part to redefine the future of liquidity mining.