A Complete Guide to Liquidity Mining in 2023
Liquidity mining is an innovative way of earning rewards by providing liquidity to a cryptocurrency trading platform. By innovation, we mean there is nothing like it outside of Defi.
It's become increasingly popular with crypto traders over the last couple of years, inspiring some of the greatest memes in the crypto space. But most importantly, it allows them to earn rewards without investing large amounts of capital or actively managing trades.
This guide will explain what liquidity mining is, how it works, and the benefits and risks that come with it. We'll also provide some tips on how you can get started in liquidity mining so you can start earning rewards quickly and safely.
Introduction to Liquidity Mining
Liquidity mining is a type of algorithmic trading that allows users to earn rewards by providing liquidity on cryptocurrency exchanges. By supplying buy and sell orders, traders can earn rewards from the exchange for helping with price discovery and enhancing market efficiency.
These rewards come in the form of tokens or coins, with different exchanges offering different types of rewards. Liquidity mining is a relatively new concept, exclusive to Defi, but it has become increasingly popular due to the potential rewards that can be earned.
“Passive income” is a major buzzword in the personal finance space, and yield farming does just that, with even the smallest of bag-holders able to get in on the action.
How It Started: Uniswap V2
Uniswap v2 is one of the most important developments in crypto that you need to know about. While it may feel like ancient history at this point, it all blew up after Uniswaps V2 went live.
It’s a decentralized trading protocol that allows users to trade tokens on various blockchains while avoiding intermediaries or middlemen. Instead of banks and traditional financial institutions getting rich from the fees generated by retail investors, it’s the retail investors making money off the fees.
They provide the liquidity. They reap the rewards. It gave protocols deep liquidity, and Uniswap took a cut of the action. It was a beautiful system for its time, and for years, every DEX in Defi modeled their products after it.
Uniswap provides liquidity, price transparency, and cost efficiency, thanks to its automated market-making mechanism. The platform uses an adaptive fee system that raises or lowers trading fees to better adjust supply and demand levels.
With support for new ERC-20 standards staking pools, Uniswap v2 created secure and reliable trading opportunities for everyone in the crypto space.
As impressive as it was, it had its fair share of problems. The first is impermanent loss for liquidity providers. The second major issue is that it wasn’t capital efficient.
And the third problem: “What happens when the tokens run out?”.
No successful protocol can have limitless tokens. An infinite amount will eventually drive the value to zero.
So How Does Liquidity Mining Work?
Liquidity mining works by allowing traders to provide liquidity on an exchange's order book. By providing buy and sell orders, traders can help create market depth and improve efficiency.
This, in turn, helps to reduce slippage and provide a more even spread of prices for all traders on the exchange. In return for providing liquidity, traders are rewarded with tokens or coins from the exchange.
Benefits of Liquidity Mining
There are several benefits to liquidity mining.
Firstly, it helps to reduce slippage, which can have a significant impact on traders' profits.
Secondly, by providing liquidity, traders can help create a more efficient market and make it easier for other traders to access the best prices.
Thirdly, liquidity miners can earn rewards in the form of tokens or coins from the exchange, which they can then use for trading or to earn further rewards.
Risks of Liquidity Mining
As with any type of trading, there are risks associated with liquidity mining.
The exchanges themselves may be unreliable and could suffer from security issues which could lead to the loss of funds. When a protocol pulls the plug and steals all of the users’ funds, the term in crypto is called a “rug”. If someone else steals the funds, it’s usually referred to as a “hack” or “exploit”.
Secondly, the tokens or coins provided as rewards may be illiquid and difficult to trade. Finally, the rewards for liquidity mining may be lower than other forms of trading, so it may not necessarily be the most profitable way to earn rewards.
Everything You Need to Know About Impermanent Loss
One of the biggest risks associated with liquidity mining is something called impermanent loss. It occurs when the value of a token or coin used as collateral in a trade is affected by market movements, resulting in a decrease in profits even if the position was profitable before the move occurred.
As an example, let’s say you have funds in the ETH/USDC pool. Even those IL is usually much greater in a pool involving a stablecoin with a volatile asset, you pull the trigger anyway because you think the high APR will make it worth it.
Then, something happens. It could be bad or good, as a major price fluctuation in either direction can cause impermanent loss to happen. You try to exit the pool in the middle of the craziness, and what you withdraw isn’t what you put in.
Either you have way more USDC or way more ETH. Usually, you’re going to get way more of whatever you don’t want more of, which is why you likely decided to exit the pool in the first place.
To reduce the impact of impermanent loss, traders should diversify their positions and use reasonable amounts of leverage. They should also ensure that they understand the risks associated with liquidity mining before starting.
What Happens When the Tokens Run Out?
The second problem is the farm tokens. Uniswap V2 styles farms pay in the individual Dex’s token. To try and incentivize users from dumping their tokens all the way to 0, exchanges put a cap on how many tokens their farms will produce.
Emissions start off really hot and heavy, but over time decrease in an effort to keep the price in an attractive range for investors and still be profitable for yield farmers.
But this strategy has backfired and given rise to what’s called “mercenary capital”. Users go to brand new exchanges, farm pools until the emissions slow down, and then pull out of the liquidity pools and take their capital to the next Dex.
This creates a farm and dump system that can, and often does, permanently damage the value of the farming token. As the farmers leave, private/seed investors also start to pull out. Without the farmers and investors, the emissions no longer matter, and the exchange has to close up shop.
So while this does fix the problem of tokens running out, it doesn’t fix it in a positive way.
DEXs have tried two different methods to fix the problem. The first is to take unused liquidity and farm it on other protocols to keep APR high even with lower emissions.
The second solution was to ask partner projects to provide their own incentives to help deepen liquidity for their pools. So instead of the DEX paying out 100% APR to incentivize liquidity for a new project that wants to be whitelisted, the new project coughs up half of the rewards, and the DEX forks over the other half, helping to keep the emissions low but returns high.
Both of these ideas have had limited success. Why? Because the best solution to date is Uniswap V3.
Uniswap V3: Solving the Capital Efficiency Problem
Uniswap V3 is the latest iteration of the popular crypto-asset exchange, and it packs a powerful punch for traders looking for capital efficiency.
By introducing several advanced features, such as improved liquidity and low-cost transactions, the platform allows traders to maximize gains from their investments while minimizing their exposure to risk.
Furthermore, it provides access to a broader range of assets, enabling sophisticated strategies that can provide exceptional returns from limited investments.
With these features in place, Uniswap V3 has established itself as a leader in capital efficiency for the cryptocurrency industry.
The smartest thing the team did was license this product. Previous iterations were open source, which is why so many exchanges copied the model. But with V3, they couldn’t do that, creating a model on what’s known in the crypto space as “concentrated liquidity” that no one was allowed to copy.
Breaking Down Capital Efficiency
Capital efficiency is a measure of how efficiently an investor can use their capital to generate returns. It takes into account the cost of transactions, the liquidity available in markets, and the potential gains from sophisticated trading strategies such as arbitrage.
Uniswap V3 provides traders with a suite of features that simplify maximizing these potential gains with limited investments.
In the V2 model, users would add their capital and it would be used to cover any price range. What ended up happening in this situation is that only 15%-20% was being used for trades. The vast majority of funds in the pools were being unused but given the same returns as funds sitting idle.
To remedy this, V3 allows users to set a price range, which makes the efficiency of the pools skyrocket. Hence the term “capital efficiency”. Any time prices fall out of range, users would have to manually adjust their ranges to once again earn the maximum possible returns.
This also gave rise to a host of Defi projects that no one had seen before. They manage other people’s concentrated liquidity in exchange for a cut of the profits. Protocols like these enable users to earn the most revenue passively while creating a brand new type of financial product.
Tips for Getting Started with Liquidity Mining
If you're interested in getting started with liquidity mining, a few tips can help you get the ball rolling.
Firstly, it's important to do your research and ensure you understand how the process works and its associated risks. The V3 model is incredibly advanced, even for people with years of Defi experience. If you want in on the action, look into a protocol that manages concentrated liquidity.
Secondly, pick an exchange that rewards traders for providing liquidity and look at what types of rewards they offer. There are several beginner-friendly strategies for yield farming and we’ll get into them in detail in another post.
Finally, find a strategy that works for you and stick to it – don't be tempted to jump from one plan to another, as this could lead to losses. Trying to play the mercenary capital game rarely works out well for casual users.
Most of the people making money this way have been at it for several years, are in paid discord groups, and have insider information most people don’t.
V3 for Everyone
Uniswap’s V3 model license has run out, as of April 2023. Now the race is on for every DEX in Defi to implement and find ways to improve it. It’s already live on many exchanges, with several others working on their own versions.
Using Alphaday to keep up to date with Liquidity Mining news
Conclusion
Liquidity mining can be a great way to earn rewards without investing large amounts of capital or actively managing trades.
However, it's important to understand the process, its associated risks, and how to stay safe when trading.
Hopefully, this guide has provided helpful information on liquidity mining so you can start earning rewards quickly and safely. Good luck!