Kaizen Advent №7. Passive Income: Liquidity Mining
Are you feeling lucky? Well, you should, because today we have article number seven in our ongoing #KaizenAdvent series!
The topic of today’s blog post is a nice follow up to our coverage of yield farming. Be sure to check it out, or put it in the bookmarks after you’re done with this piece of writing.
As the title suggests, the subject matter is liquidity mining, something you might be interested in if you look to generate some passive income. Because who wouldn’t want to earn an annual yield on their holdings, but in the range of double or triple digits?
Even if after reading the guide you would deem liquidity mining too risky, it’s still one of the most popular passive income methods in DeFi, and learning about it will make you a more proficient crypto enthusiast.
What Is Liquidity Mining?
Before we give you a straightforward definition of the term, let’s think about why it exists in the first place.
Before the meteoric rise of decentralized finances, we as investors had two primary options to make profits in crypto. You could either engage in day trading, or choose a slow-and-steady approach of holding assets in hopes of seeing them appreciate in value over time.
But surely that wasn’t enough! People wanted more options, something that would require more knowledge and experience, but reward them much more than holding, trading, or staking. Enter liquidity mining, also known as DeFi mining, DEX mining, or DeFi liquidity mining.
“Liquidity mining — a process of lending assets into liquidity pools available on decentralized exchanges, from which they’re rewarded with trading fees and governance tokens.”
The idea is pretty simple. Decentralized exchanges and lending protocols require liquidity to make token swaps possible for traders who don’t want to involve a third-party trading platform in the process, and they reward their contributors with fees and liquidity provider tokens.
It’s a win-win situation for both parties, at least on paper. When it comes to contributors, the rewards they are getting are directly dictated by their proportional share in a liquidity pool.
To understand that concept better, let’s learn about the process of providing liquidity first!
How To Participate in Liquidity Mining?
First things first, you have to choose a decentralized exchange that has liquidity pools.
Some of the more popular and trusted DEX platforms for liquidity mining involve:
🔴 Binance Earn.
All the platforms provide different conditions and may require different token pairs, but one thing that is generally common among them is that they operate autonomously, managed by algorithms, as well as smart contracts.
Now that we know where the magic happens, let’s describe a typical process of providing liquidity in 4 steps!
- The first move after picking a platform is to choose two equal portions of tokens you want to add to the liquidity pool. To form a pair the proportion must always be 50/50, so you’ll need to calculate the right amount of tokens.
- Let’s assume that you have decided to provide NNN and XXX tokens, and you choose to add $100 USD worth of liquidity into the pool. If your NNN token is worth $10 USD and XXX is worth $0.10 USD, you’ll need to add 5 NNN and 500 XXX into the pool.
- Once you’ve double checked your calculations, it’s time to use an automated market maker (AMM) to swap the tokens. An AMM will automatically execute the trade at the best possible price and convert your NNN into XXX.
- Once the trade has been executed, you can add your token pair (NNN/XXX) to the pool. The liquidity you’ve added will give you LP tokens, which represent your share in the pool. In this case, the LP tokens would be named LP-NNNXXX.
That about covers it! Now users can trade in a decentralized fashion, and you are earning trading fees, enjoying some passive income. But that leads us to an all important question…
Is this game worth the candle?
How Profitable Is Liquidity Mining?
The total reward differs based on one’s proportional share in a liquidity pool.
For example, let’s imagine that you have confirmed your $100 USD asset contribution to a pool. If the total worth of the pool is $1000, you own 10% of that pool’s LP tokens. The LP tokens are your claim to the share of the pool’s assets.
Holding LP tokens allows you to withdraw your share without interference from anyone, not even the platform. Since LP tokens are ERC-20 tokens, they can be also be transferred, exchanged, or even staked on other protocols.
Is It Risky?
Liquidity mining does come with an underlying risk though. One of the main drawbacks is impermanent loss, which means a possibility of suffering a loss if the price of their tokens falls while they are still locked up in the liquidity pool. The loss is called impermanent because it can only be realized if the miner decides to withdraw the tokens with decreased prices. Impermanent loss can be offset by the gains, however, crypto assets are known to be highly volatile, so there’s no assurances.
Let’s also not forget about the possibility of the ‘exit scam’, where DeFi platform could close without warning and disappear with all the assets. Another big risk are technical protocol vulnerabilities, which can be exploited by the hackers. It’s not that rare, since the majority of projects are open source, meaning that the underlying code is available for public viewing.
But despite some very real risks, liquidity mining is definitely a feasible option:
✨ It offers a possibility to earn passive income
✨ It decentralizes the blockchain market
✨ It provides users with more investing flexibility
Taking greater risks frequently results in higher returns, and liquidity mining has a relatively low barrier of entry compared to staking. The main difference between staking and liquidity mining is easy to understand — staking is concerned with providing security to a blockchain network, whereas liquidity mining is concerned with providing liquidity to the DeFi protocol.
This cooperation of traders, liquidity providers, and exchanges creates a network that revolutionizes the crypto game and benefits all sides, but as with every revolution, someone can get the short end of the stick. Always do your own research and never provide more than you can afford to lose, even if you are promised a triple digit APY!
Follow Kaizen on social media for more ideas of crypto income during the bear market, we’re only getting started. Find more with #kaizenadvent hashtag.