cryptocoingossip

In the initial days of cryptos, one depended upon exchanges and wallets to do a crypto activity.

The exchanges and wallets are run by the companies, leading to the crypto market’s centralization. That is contradictory to the crypto ethics of decentralization.

But soon, DeFi changed the crypto market scenario by introducing the Automated Market Maker leading to built many decentralized exchanges using Liquidity pools.

The DeFi revolution brought many opportunities to trade and earn cryptos. Of those opportunities, Liquidity Mining is one.

What Is Liquidity Mining?

Liquidity Mining is simply getting a reward for depositing crypto assets in a liquidity pool.

I’ve already written about Liquidity Pool and different DeFi protocols using it. Here I’ll explain briefly about Liquidity Pools.

A liquidity pool is nothing but a pool with crypto assets where anyone can deposit their crypto asset, and anyone can borrow it, and the pool balance is maintained by the smart contract.

So if you deposit any crypto asset to the pool, you’ll receive a reward in the form of a token as proof for your deposit and the fee along with it; this process is called Liquidity Mining.

How Does Actually Liquidity Mining Work?

Liquidity mining is done in a Decentralized exchanges liquidity pool.

Since there is a smart contract controlling the liquidity pool, one can provide the liquidity and become the liquidity provider.

Once many liquidity providers provide the funds to the pool. Smart contracts lock the funds for a specific time period so that the borrowers can use the pool effectively.

In return for providing the liquidity, the pool smart contract assigns the token to be paid to the Liquidity provider as representative of their share in the pools. Usually, these tokens are called LP tokens (Liquidity Provider tokens) and are in the form of native tokens of the exchange. Along with the LP token, the liquidity provider also receives the fee, and both LP tokens and fees are paid based on the number of funds locked in the pool.

The process is similar to mining on Proof-Of-Work (POW) blockchain like Bitcoin, where miners receive new coins and a fee for validating transactions on the blockchain using computing power. The process is similar, so it is called Liquidity Mining.

Now, many decentral exchange platforms offer different types of Liquidity Mining to attract the Liquidity provider.

Types of Liquidity Mining.

Before jumping into the types, the point to be noted is. In Liquidity Mining, fee distribution among liquidity providers is always proportional to how much they contribute to the pool, but it is not always the same for distributing LP tokens. So Liquidity Mining can be bifurcated on the nature of distributing LP tokens.

Fair Distribution.

In a fair distribution, the exchange distributes the LP tokens to all active participants equally so that all the participants get to govern the platform.

Progressive Distribution.

Contrary to fair distribution, progressive distribution exchange protocols do not equally distribute the LP tokens. Instead, after the launch, the protocol distributes tokens slowly, with this approach, it necessitates establishing a governance model once the project is launched.

This method prevents the imbalance in the allocation of governance tokens. By doing so, it keeps whales and institutional traders from amassing large amounts of native tokens.

Growth Model Distribution.

Here decentralized exchanges adopt the model of distributing tokens to the members who promote the project.

The method ensures initial publicity of the project so that the project creates initial buzz on the market, and protocols employing the growth marketing model are only revealed a few weeks before the launch date, unlike others that have a roadmap month in advance.

Benefits of Liquidity Mining.

Passive Income.

Liquidity Mining is one of the great ways to earn a kind of guaranteed passive income.

I mean “kind of” because there is some risk involved in it. We’ll discuss that later but despite the risk, there is a high chance of earning a good passive income by just providing liquidity, not involving actively.

Low Entry Barrier.

As I mentioned earlier, anyone can provide liquidity to the pool. There are no eligibility criteria.

Even with a small amount, you can start providing liquidity and earn the reward proportionate to that.

This encourages small investors to participate in the DeFi revolution and make protocols more decentralized than some rich institutional investors control.

Distribution of Governance and Native Token.

Liquidity Mining is a great way to distribute the native token of the project to gain the initial reputation and eyeballs within the community.

For the investors having a Native token within the decentralized exchange gives governing authority on the platform and influences the platform characteristics in various ways:

• Revise the development fund.
• Vote to change the fees.
• Implement changes to the UI.
• Change the distribution of fee rewards.

But before the DeFi revolution, the distribution of tokens was done through unfair practice, where only a few whales finally took hold of most funds.

Nurtures the Trust and Builds a Loyal Community.

Liquidity distribution occurs most of the time in a new Decentralized platform, and early liquidity providers become active in the community while the exchange itself continues to grow.

When platforms grow, early liquidity providers are most likely to use the system and keep tokens. And benefits didn’t end just by receiving the income from the current holding. By continuing to engage with the protocol, Liquidity providers continue to receive additional benefits.

Drawbacks of Liquidity Mining.

Impairment Loss.

An impairment loss is a kind of loss that occurs when the price of a crypto deposit on the liquidity pool drops drastically more than when you contributed to the pool.

This loss can directly affect you when you decide to withdraw money, but you can offset this particular risk with the gains you obtain from trading fees. However, the volatility of the cryptocurrency market means that you should be at least somewhat cautious when depositing your money into DEXs.

Project Risk.

Decentralized exchange protocols are more complex. This complexity means that protocols are open to technical liquidity mining risks. Cybercriminals can exploit the protocol and the assets within.

Even though any platform can be exploited, it is highly recommended that you perform extensive research on a project and its platform before deciding to place your assets into its liquidity pool.

Exit Scams.

This kind of scam occurs when liquidity pool developers and protocol developers decide to shut the protocol down and take away all of the money.

Also, scammers set up a new cryptocurrency and push capital into the coin through DEX services. This quick investment drives coin prices sky-high, inspiring other investors to jump on the bandwagon. The liquidity pools powering these trades can grow to millions of dollars in less than a day, and then the scammer withdraws the entire liquidity pool.

Since all the projects encourage anonymity and can be started without any identity verification or registration, it is easy to fall prey to these kinds of scams.

If you don’t want to be prey for these kinds of scams, then it is essential that you perform your due diligence to learn everything you can about a project before investing in it.

Conclusion.

Doing research about the platforms before doing Liquidity Mining can generate good passive income.

Not only passive income, you can leverage LPtokens and rewards to do further investment, particularly called Yield Farming, that could also generate more income.

From an earnings perspective, Liquidity Mining is a good way to earn money. And from a market perspective, Liquidity Mining is a great way to attract liquidity to exchange, so the market becomes more decentralized.