Liquidity mining – Incentivizing liquidity provision in decentralized exchanges

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Decentralised Finance (DeFi) has given rise to a novel way to earn passive returns on crypto assets. Crypto investors primarily use a long-term buy-and-hold strategy, leaving their assets to sit idle as they rise in value over time. To enhance their return potential, investors can use liquidity mining, enabled through DeFi, as a strategy to earn interest on their holdings passively.

What is liquidity mining? Investors offer liquidity in exchange for an income or yield stream. This liquidity is provided to a Decentralised Exchange (DEX), where an investor’s crypto assets are deposited into the DEX’s liquidity pools for which they receive tokens and/or a portion of the trading fees linked to the respective pools. This is a win-win for both parties – the DEX can provide more stable markets to trade as the underlying liquidity is incentivized to remain in place long-term, while investors earn a return in their role as liquidity providers (LP).

Before getting started, it’s best to be aware of the benefits and risks associated with liquidity mining. The benefits include:

  • Passive Income: The primary reason to become an LP is that an investor can earn an income passively, 24/7. This yield requires little maintenance or position monitoring, provided it has been set-up correctly, and an LP has the additional potential benefit of increased rewards should the liquidity pool they participate in experience greater trading activity.
  • Potential for high yields: The level of interest or yield an LP can earn is a function of their risk appetite. The larger the amount an investor is willing to allocate to a liquidity pool, the greater the potential rewards earned. Thus, rewards are proportional to the size of an investor’s contribution. Furthermore, in a crypto bull market environment, as trading activity increases so does the level of interest earned.
  • Low barriers to entry: DeFi is permissionless by design, meaning that anyone can become an LP, provided they have a non-custodial wallet with the minimum amount of relevant crypto asset(s) required. Most DEXs also allow the option for interest earned to be reinvested automatically, thereby incrementally compounding an investor’s initial capital over time.
  • Supporting the growth of DeFi: The reciprocal relationship between the DEX and its LPs aids in making these exchanges more stable trading venues and the DeFi ecosystem more robust. This facilitates new entrants which further increases potential liquidity and allows for other applications to be built within the ecosystem which seek to tap into this liquidity.

Risks to be mindful of:

  • Impermanent loss: A liquidity pool comprises two cryptocurrencies, a trading pair, which are equally weighted in value. The risk of the prices of these two assets moving in opposite directions to each other is called impermanent loss. The larger the price change difference, the greater your risk. Therefore, it is important to be mindful of the inherent price volatility of the two cryptocurrencies you wish to add to a liquidity pool before doing so.
  • Hacking: A recurrent potential risk across the entire crypto ecosystem. Liquidity pools are naturally attractive to hackers as they contain a large amount of crypto assets.
  • Volatility: Crypto prices are volatile, meaning the value of your liquidity contribution as an LP and the rewards you receive are open to substantial, and rapid price fluctuations. Be attentive to this risk before committing any capital here.

Now that you’re familiar with the basics, follow these steps to get started:

  1. Fund your wallet: Add the appropriate crypto assets you wish to add to a liquidity pool to your self-custodial wallet
  1. Select exchange: There are a ton of exchanges to choose from, it’s best to select from those which have high trading volume, substantial liquidity, and low transaction fees.
  2. Add Liquidity: The final step is to add liquidity to the pool you have selected.

You are all set! Becoming a liquidity provider is a great way to earn a passive return on your crypto assets as it requires minimal effort to set-up and is relatively low risk. It is also a great way to explore and participate in the DeFi ecosystem. Good luck!

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