What is liquidity mining? Yield farming explained

If you've been around crypto for a while you are probably familiar with the term mining. When you hear this word, its typically referring to the traditional way of mining that requires physical equipment to verify transactions on a network. The process of mining brings new coins into circulation as an incentive to help run the network. These shiny new coins are paid directly to miners for their service.


For example: Bitcoin miners are paid in BTC, Monero miners are paid in XMR, and so on.


There's another form of mining called liquidity mining that pays crypto rewards but without the hardware requirements of traditional mining. This provides a much lower barrier to entry than traditional mining which makes liquidity mining a more lucrative choice for earning passive income.


Before learning how liquidity mining works, it's necessary to first understand liquidity pools.


What are liquidity pools?

Ever wondered where the tokens on decentralized exchanges come from? The answer is liquidity pools. All tokens in liquidity pools are supplied by regular people just like you and me. Instead of an exchange owning the tokens, the supplied (pooled) tokens reside on a smart contract that is 100% managed by code. If there is no liquidity, there are no tokens to swap for.


Liquidity provider (LP): A person who supplies their tokens to a liquidity pool


Why do people supply liquidity? What are the benefits?

  • Passive income (yield farming)

  • Liquidity mining incentives


What is yield farming?

Like I mentioned earlier, decentralized exchanges could not operate without liquidity providers. Because of this, decentralized exchanges have built-in incentives to entice people to supply their tokens to the exchange. These incentives reward LPs with a portion of the trading fees from people swapping their pooled tokens.


For example: If you own 10% of the pooled tokens, you will receive 10% of the rewards.


This is how yield farming works. Simply put, yield farming is depositing your coins to earn interest on them. This works just like earning interest from holding money in a bank account, except with higher APY.


How do I become a liquidity provider?

The first step for becoming a LP is navigating to the exchange you want to supply liquidity to. Once on the DEX's main page, there is usually a tab near the top labeled "pool" or "liquidity".


After finding the LP section, you will be asked to supply a pair. When you supply liquidity, it requires an equal amount of 2 tokens (pair) to be deposited. Without going into too much detail, pairs are required for determining price movement when swaps occur.


When choosing a pair, the most common practice is to deposit the following:

  1. The token you want to pool

  2. The base currency (ETH, SOL, BNB, etc.) of the exchange you're using

For example: Let's say you want to become a LP of the DAI-ETH pool on Uniswap. When supplying liquidity you will be asked to deposit an equal value of DAI and ETH tokens. You deposit $500 of DAI and $500 of ETH.


The graphic below expands on this example and shows from beginning to end what the LP process looks like. I've numbered each action chronologically in the order that they occur.

  1. LP deposits a token pair (ETH + DAI)

  2. LP receives a proportional amount of LP tokens from the DEX to prove their ownership of the pool

  3. Traders that swap DAI for ETH (or vice versa) pay a small trading fee which is paid to ETH-DAI LPs. These fees add up over time based on how long the LP provides liquidity.

  4. The LP deposits their LP tokens back into the DEX in order to withdraw their tokens from the pool

  5. LP receives the initial ETH + DAI they deposited + all the accrued rewards from trading fees


What is liquidity mining?

Liquidity mining is a mechanism that further incentivizes users to supply tokens to a liquidity pool. This mining method can only be used by crypto projects that are still distributing new coins into circulation. Projects do this as a way to reward their early supporters and incentivize them to stick around longer.


Instead of using hardware to mine coins, liquidity mining is achieved by becoming a liquidity provider of a specific token and then depositing the LP tokens into a liquidity mining contract. It's basically yield farming on steroids because you earn interest from yield farming while simultaneously earning extra rewards for being a LP.

Physical mining

Liquidity mining

Requires hardware to mine

No hardware requirements

Used in Proof of Work protocols

Used in Proof of Stake protocols

Main risk: Not breaking even

Main risk: Impermanent loss

For the next example, let's pretend there's a project called YYY that is offering YYY tokens through liquidity mining.


Example: In order to receive brand new YYY coins, you must first become an LP of the YYY-ETH pair. You will follow Step 1 from above by depositing an equal amount of YYY and ETH to the exchange. Once you deposit YYY and ETH, you will receive LP tokens representing your share of that pool. Here's where things get different. Instead of holding onto the LP tokens, you must deposit them into a liquidity mining contract (provided by YYY) that enables you to earn the extra rewards. You can stop mining and claim your rewards at any time by withdrawing the LP tokens from the mining contract. You can then withdraw your original YYY & ETH tokens (+ trading fees earned) by depositing your LP tokens back into the exchange.


Risks

There are 2 main risks to consider before liquidity providing.

  1. Smart contract hacks

  2. Impermanent loss

Smart contracts always come with the underlying risk of a possible hack. The best way to mitigate this risk is to only use protocols which have been thoroughly audited or are backed by some form of insurance (like AAVE).


Impermanent loss is something that keeps most people out of liquidity mining simply from the fear that they will lose a portion of their gains. Binance has a really good explanation of impermanent loss that can be found here. I highly recommend watching their 3 minute video to gain an understanding of what impermanent loss is.


Stablecoin pools are the best way to avoid exposure to impermanent loss because they have a predictable (stable) price - meaning DAI, USDC, Tether should always be worth $1. If you were to pool 2 coins that have volatile prices, it increases the chance that you will experience impermanent loss.


Another way to minimize impermanent loss is through liquidity mining. The liquidity mining rewards help offset losses that could occur in the event of high price changes from the pooled tokens.


As far as these risks go, I only provide liquidity whenever there are liquidity mining incentives in place. From my experience, liquidity mining rewards almost always outweigh potential impermanent loss. Also you probably don't want to become a LP unless you have a decent chunk of money to work with, $50 will almost certainly end up as as loss.


In order to mitigate impermanent loss, it's important to create a strategy before pooling your tokens so you know which price scenarios give the best opportunity to pull your LP tokens to minimize potential loss. I'll probably make a more in depth post in the future on strategies for liquidity providing but this should provide you with plenty of knowledge to confidently get started.

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