Before the emergence of decentralized finance, crypto assets were either actively traded or stored on exchanges and hardware wallets. There was no option in between and as such, the community was limited to either learning how to day trade or learning how to stay satisfied with HODL profits.
The arrival of DeFi changed the game by allowing users to earn passive income by deploying their assets as liquidity on decentralized exchanges, lending protocols, and liquidity pools on other kinds of protocols. In the context of DEXs and AMMS, DeFi specifically made it possible to increase one’s capital by lending it to newly built trading platforms.
As mentioned earlier in our DEX lesson, exchanges built on the AMM model require liquidity from contributors to thrive. Without any liquidity, the exchange cannot serve traders who wish to swap tokens. Therefore, teams are massively incentivized to reward those providing liquidity by later distributing trading fees in reward for their prior contribution.
We note that the mechanism of profiting by deploying liquidity is ever-changing and that historically two main methods exist: liquidity mining and yield farming. Liquidity mining is the predecessor of yield farming, which is why we are covering it first.
Liquidity mining is a process in which crypto holders lend assets to a decentralized exchange in return for rewards. These rewards commonly stem from trading fees that are accrued from traders swapping tokens. Fees average at 0.3% per swap and the total reward differs based on one’s proportional share in a liquidity pool.
In the case of Uniswap, and all DEXs who use the same AMM model, crypto holders must provide equal portions of tokens (in terms of value). If we have 4 ETH tokens (where each is priced $2,500) we have a total of $10,000. Therefore, lending 4 ETH means that we also have to provide 10,000 USDT (valued at $1 per token).
Again, the liquidity provided to Uniswap will be granted to clients who trade assets from the ETH/USDT (or any other) liquidity pool. These fees are then collected and distributed to liquidity providers (LPs).
The end result is a symbiotic relationship where each party receives something in return. Exchanges receive liquidity, LPs fees, and end-users have the ability to trade in a decentralized fashion.
Mining, investing, and trading all pose risks that make it difficult to stay profitable in the market. Likewise, liquidity mining also has its own drawbacks that prevent users from providing liquidity without having to monitor the cryptocurrency market: impermanent loss (IL).
Many wonder what the mysterious IL is. However, many also mistakenly believe that IL is more complex than it really is. Calculating and predicting IL may be an entirely different story, but the basic functioning of impermanent loss is relatively simple.
Impermanent loss is defined as the opportunity cost of holding onto an asset for speculative purposes versus providing it as liquidity to earn fees.
Since digital assets are extremely volatile, it is almost impossible to avoid IL. If an asset within the LP of choice loses or gains too much value after being deposited, the user is at risk of not profiting or even losing money. For example, Ethereum can double in value within 5 days but the fees granted while farming it will not even cover half of what one would have made by HODLing.
Impermanent loss has rightfully earned its name. Losses are only realized if the user decides to withdraw his liquidity. Therefore, it is possible to avoid IL if the market returns to the original price. If that does not happen, LPs are forced to withdraw liquidity and realize their IL.
After exploring liquidity mining and yield farming you will have the chance to explore impermanent loss in more detail in a separate lesson.
Liquidity mining is simply a passive income method that helps crypto holders profit by utilizing their existing assets, rather than leaving them inactive in cold storage. Assets are lent to a decentralized exchange and in return, the platform distributes fees earned from trading to each liquidity provider proportionally.
Liquidity mining is the first yield use case in DeFi. It existed during the very beginning of DeFi’s rise. However, as the market gradually evolved the market shifted to a different yet similar passive investment method: yield farming.
Although yield farming is based on liquidity mining, we will use the next lesson to figure out the differences between them and discover which method is more profitable.
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