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The decentralised finance industry grows larger and more sophisticated by the day.
In early 2020, the DeFi industry reached its billion-dollar milestone. Less than one year later, it’s already grown by 4000%, reaching over 40 billion at one point. That’s unprecedented growth in such a short period of time.
But despite the overwhelming influx of new interest and investment, our new digital economy is far from perfect. Thankfully, its flaws are not systematic human greed or corruption, or inequality or exclusivity. Its issues are mostly on the technical and social level, and so in theory will be resolved over time and with wider participation.
What does liquidity mean in crypto?
One of these fixable flaws of the crypto economy is a lack of liquidity.
Liquidity means that an asset can be easily bought, sold, or traded. In a perfect DeFi world, digital assets would move fluidly between exchanges, apps and wallets.
The greater the liquid depths of the cryptocurrency market, the faster our new financial system can be implemented and adopted.
A fluid economy is a powerful one, opening up new financial opportunities and freedom for everyone – not just the upper echelon of Wall Street bros.
However, there is still a lot of friction when it comes to buying and exchanging cryptocurrencies. There are centralised exchanges like Coinbase which people can buy from. Yet the whole point of crypto is to decentralise banking power and distribute funds across a global community, rather than centralised entities controlling the supply.
Centralised exchanges typically own or have custodial access to your funds and the private keys which secure them. Even Coinbase can easily lock out their customers when they like.
It feels like we are just mimicking the failed financial system we have today.
The number of people who hold enough “disposable” cryptocurrency to share and spread it around is still relatively low. So to grow the decentralised economy, many crypto projects offer incentives or rewards for crypto holders to contribute their funds (supply liquidity) and sustain this fast-growing ecosystem.
One of these methods is liquidity mining, also known as yield farming. This can generate very attractive returns and passive income for any person, even with small amounts.
How does liquidity mining work?
Liquidity mining, also known as yield farming, is the act of providing liquidity to a Decentralised Exchange (DEX), which are made up of liquidity pools.
DEXes usually suffer from lower liquidity compared to centralised ones, since the latter attract external vendors, such as Market Makers (MM), to support their liquidity.
Liquidity has three main aspects:
- Speed means how quickly orders are processed. Delays occur when the liquidity is low, sometimes even taking several days to execute. For highly liquid pairs, you can always buy and sell in several seconds.
- Spread is the gap between your Bid and Ask orders in the order book, signaling low liquidity. In a liquid market, the spread is low, which means you can buy and sell the asset with minimal losses almost instantly.
- Slippage means the difference between the expected price and the actual price at which particular trade is executed. In a liquid market, a trader can buy or sell a large order without moving the price significantly.
To ensure sufficient liquidity, centralised exchanges usually work with Market Makers. By adding liquidity, MMs are creating an active trading environment for buyers and sellers.
With DEXes, users don’t need to trade via an order book, as it is replaced with an Automatic Market Maker (AMM), a smart contract that regulates and facilitates direct peer-to-peer trading. DEXes allow users to exchange one token for another in a liquidity pool, without an intermediary. Anyone can contribute their tokens to a pool to increase its supply.
Source: Uniswap AMM
To attract these contributors, known as liquidity providers, Uniswap offers rewards that are paid every time a trader pays transaction fees.
In this way, decentralised exchanges are trying to maintain a symbiotic ecosystem: while the trader pays a small commission to the DEX, the liquidity provider earns rewards by providing the needed liquidity.
One trading pair is represented by the two tokens in each liquidity pool. Most DEXs require providers to contribute an equal amount of tokens to the pool.
What are the risks associated with liquidity mining?
1. Smart Contract Risk
There is a risk that the Smart Contract has a bug that can be exploited. In 2020, a lot of protocols suffered when these vulnerabilities in the code were found by hackers, resulting in significant losses.
2. Project Risk
It is always important to check if the project conducts regular external security audits. In addition, big projects, such as Uniswap or Compound, have open-source code which means everyone can check the code for potential weaknesses
3. Impermanent Loss
The most complicated risk associated with liquidity mining is impermanent loss – a temporary loss of funds due to the volatility in a trading pair. The larger the change is, the bigger the loss.
For instance, a 2x price change results in a 5.7% loss compared to simply holding your assets. The loss is the same regardless of the change in direction. You can find additional information regarding impermanent loss here.
What affects liquidity mining profitability?
Profitability for liquidity providers depends on the market balance, i.e. supply and demand. In the case of yield farming, the system functions very differently from traditional trading, as the more providers contributing to the pool, the lower the profitability.
As a result, in the early days of liquidity mining, the demand for trading significantly exceeded the size of the liquidity pool. Consequently, interest rates in liquidity mining were much higher and ranged from 50% to 1000%+ per annum. As the number of miners grew, the interest rate dropped to 10-20% APY. Even with this lower return, the profitability of liquidity providers is still quite high when compared to other methods, such as staking.
How much can you actually earn with liquidity mining?
It’s hard to estimate the potential profit as the percentage of returns fluctuates every day. It depends on the total size of the liquidity pool, your percentage share in it, trading volume, and the asset price.
As an example, you can find the potential APY for three popular ETH – stablecoins liquidity pools on Uniswap, Balancer, and Sushiswap:
Additionally, not every pool is profitable due to the significant price fluctuations. Even though the APY is usually lower for stablecoin liquidity pools, you are able to reduce the impermanent loss risk. You can find more data regarding different liquidity pools on the Liquidityfolio website.
How can I earn DeFi passive income?
Now is a great time to become a liquidity provider. The industry is scaling fast and liquidity supply needs to meet growing demands. Various projects run liquidity engagement programs, such as ours at Mysterium Network.
Our liquidity campaign is aimed at maximizing providers’ rewards. After the first month of the campaign, the MYST/ETH pool doubled in size. Top liquidity providers were able to generate up to 10% return in MYST in one month!
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