If you’re a crypto enthusiast who is always on the lookout for emerging trends within the DeFi and cryptocurrency space, then you should definitely home in on liquidity mining. This relatively new technique allowed the DeFi ecosystem to increase about 10 times in size during 2020, and this exponential growth is bound to continue in the future.
Liquidity mining is viewed as a major incentive and attraction for a large number of investors. It was introduced by IDEX back in 2017, fine-tuned by Synthetix and decentralized oracle provider Chainlink in 2019, and started being used at full throttle after Compound and Uniswap popularized it in June 2020. As of today, it’s been adopted by several protocols and is considered to be a smart and efficient way of distributing tokens. The majority of these protocols are decentralized and allow almost anyone to become part of the liquidity mining process.
As well as this, liquidity mining is said to have had a role to play in the 2020 DeFi boom, and it also contributed to the monthly volume growth of decentralized exchanges — from $39.5 million in January 2019 to $45.2 billion in January 2021. As of May 7, 2021, its total value locked is estimated at $76.9 billion. As of November 10, 2021, its total value locked is estimated at $112.08 billion.
Read on to find out more about how liquidity mining works, what functions it performs, and which protocols have been making the most of it.
DeFi explained [one more time]
The term “Decentralized Finance”, better known simply as DeFi, encompasses financial services that are provided on a blockchain and don’t require the involvement of any central authority like banks, credit unions, or insurance funds. DeFi involves taking conventional elements of the traditional financial system and replacing third-party services with smart contract functionality. Simply put, DeFi is like a bridge between multiple traditional banking services built on solid blockchain technology. The majority of DeFi protocols run on the Ethereum blockchain, although other options are available.
Being a permissionless, borderless, and, crucially, up-and-coming financial system, DeFi is set to continue riding high. It offers users much sought-after flexibility to carry out transactions anytime from anywhere and needs only a stable internet connection. DeFi grants its participants a unique opportunity to conduct their transactions considerably faster and drastically reduce fees related to transfers. Just as importantly, given that intermediaries are removed from the process, users manage to gain some additional benefits not present in traditional finance. For instance, DeFi lending protocols provide higher interest rates for deposits and even lower fees, along with more favorable terms on loans.
Still not sure what actually stands behind the DeFi concept? Check out the video in which our blockchain consultant discusses it in detail by examining the technology perspective, analyzing its key benefits, comparing DeFi and CeFi, and providing real-life examples of DeFi applications.
What about DEXs?
In broad terms, all cryptocurrency exchanges can be divided into two groups: centralized and decentralized.
In a centralized cryptocurrency exchange, your account is primarily controlled by the third party that runs the exchange whereas in the case of decentralized exchanges (DEXs) you manage the account on your own. DEXs are open platforms that are not reliant on any central firm to govern users’ accounts or orders. They are autonomous decentralized applications (dApps) that enable crypto buyers and sellers to trade without relinquishing control to custodians.
What types of DEX are out there?
All DEXs can be subdivided into three main categories: on-chain order books, off-chain order books, and automated market makers (AMMs).
On-chain order books
In a decentralized exchange that utilizes on-chain order books, special network nodes are responsible for maintaining a record of all orders. In addition, miners are required to confirm each transaction that is being conducted.
Off-chain order books
In off-chain order books, all records of transactions are hosted in a centralized entity. To efficiently manage the order books, it is necessary to use particular “relayers”. Because of this, it’s true to say that off-chain order book DEXs are only partially decentralized.
Automated market makers
Automated market makers are considered to be one of the driving forces fuelling the DeFi boom, and they have been embraced by several popular DEX platforms. Instead of order books, AMMs use smart contracts to create liquidity pools that will automatically conduct trades based on certain negotiated criteria.
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Understanding market liquidity
Before you get involved in liquidity mining, it’s of primary importance to understand what stands behind the concept of liquidity itself and how it works.
Liquidity essentially refers to a fund’s liquidity, which is defined as the ability to buy and sell assets without causing any sharp changes in the asset’s market price. This is a key element in the functioning of either a new coin or a crypto exchange and is dependent on some parameters, including transaction speed, spread, transaction depth, and usability.
Transaction speed implies how quickly your orders can be executed. If liquidity is low, there’s a high probability of delays, and limit orders may take hours or even days to be processed and executed. On the other hand, for highly liquid pairs, the processing of orders takes just a few seconds.
The bid-ask spread is considered to be one of the key measures of market liquidity. It reflects the difference between the asking price and the offering price of an asset. The narrower the spread (or gap) between bid and ask orders, the more liquid the market.
Transaction depth is generally used to describe the degree of market price stability. The greater the depth, the less significant the impact of a particular number of transactions will be on the price.
Usability is a determining factor too. The more often a cryptocurrency is used as a means of payment, the more liquid it becomes. Consequently, if more merchants start accepting crypto as a payment medium, they will contribute to the wider adoption and usage of crypto in transactions.
What is liquidity mining?
Decentralized Finance has been a resounding success and it has witnessed an upsurge of activity as well as public interest. Liquidity mining, for its part, is by rights considered to be one of the key components of this achievement, and it’s viewed as an effective mechanism for bootstrapping liquidity.
Generally speaking, liquidity mining takes place when users of a certain DeFi protocol get compensation in the form of that protocol’s native tokens for cooperating with the protocol. It’s the process of depositing or lending specified token assets with the purpose of providing liquidity to the product’s fund pool and obtaining an income afterwards.
A liquidity miner can gain rewards represented by a project’s native token or sometimes even the governance rights that it represents. The tokens are normally created based on the protocol’s programming. Though most of them cannot be applied outside of the DeFi platform responsible for generating them, the creation of exchange markets as well as the hype around those tokens contribute to a rise in their value.
DEXs are always on the lookout for new users who can bring capital to the platform and will reward them for their contributions. Currently, the vast majority of decentralized exchanges are thought to be replacing their order books with automated market makers that offer efficient regulation of all trading procedures. AMMs offer token swapping that makes it possible to trade one token for another within one particular liquidity pool. When a user decides to conduct a trade, they are supposed to pay a certain fee. The AMM, then, collects the fees and provides them to each liquidity provider as a reward. Consequently, while the token swapper pays a fee to be given an opportunity to trade on a DEX, the liquidity provider manages to earn money for providing the much sought after liquidity that the user needs.
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The capabilities and benefits of liquidity mining
Despite the fact that liquidity mining has stormed the crypto world very suddenly, it’s already established itself as a serious game-changing tool, able to perform many different functions, which we’re going to examine below.
Overall liquidity improvement
The liquidity of funds is considered to be the vital element of the liquidity of the entire economic system. Compared to conventional industries, DeFi doesn’t possess a self-built capital pool that would grant stable liquidity. As a result, designing a viable and innovative decentralized fund pool model along with comprehensive user incentives via an interest rate mechanism that would inject better liquidity has become a primary and well-thought-out objective of DeFi projects.
Price discovery promotion
Due to the lightning-fast development of blockchain technology, numerous separate entities have appeared, which liquidity mining can unite in one decentralized dimension. The technique is also able to speed up the frequency of value exchange and therefore promote price discovery.
Price discovery reflects traders’ understanding of the relevant market supply and demand situation and expectations from future market opportunities. Liquidity mining has the capacity to upend the allocation of resources and even enable investors and various financial institutions to reach more reasonable decisions based on price.
More effective marketing strategy
Liquidity mining comes in really handy when attracting press coverage and raising greater awareness of the product. However, the entire campaign needs to be carefully managed to ensure that the liquidity mining budget isn’t spent on just this one goal.
Broader and equal distribution along with lower entry barriers
One of the most substantial benefits that liquidity mining offers is that both small retail and institutional investors have an equal chance of owning native tokens of a specific protocol. This benefit is undoubtedly valuable to those investors who previously wanted but didn’t have a chance to participate in the DeFi ecosystem.
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Types of liquidity mining protocols
There are different types of liquidity mining protocols, and each of them possesses its own unique features. Most protocols can be divided into three groups: fair decentralization protocols, progressive decentralization protocols, and marketing-oriented protocols.
Fair decentralization protocols
Liquidity mining projects that focus on fair decentralization normally look for ways to reward their active community members. Oftentimes, all users who decide to join the platform are given governance tokens. As a result, developers ensure decentralization by providing tokens in a way that doesn’t require a token sale or market listing.
Progressive decentralization protocols
Progressive decentralization protocols don’t grant control over the platform to the community straight away. Developers may need up to a few months, for example, to implement a governance model after the platform itself has been launched. Likewise, the token itself can sometimes be listed on the market before developers provide online governance.
With marketing-oriented protocols, the project is typically announced weeks before its launch, and all those wishing to participate in it are encouraged to market the platform before it’s up and running. In this way, developers manage to accumulate a solid user base before the platform is fully functioning. Consequently, marketing a platform helps collect funds for liquidity, which can be locked by developers for extended periods.
Overview of protocols that take advantage of liquidity mining
Liquidity mining is able to completely revalue a protocol that takes advantage of it, which is why this notion has grabbed the attention of a large number of developers of different platforms and spawned a new trend in the crypto world. Without any further ado, let’s take a closer look at some of those protocols and check out what they’re capable of.
The Echo blockchain is a layer-2 protocol that is made up of an Ethereum sidechain and a Bitcoin sidechain to provide smooth and efficient network interoperability. This one-of-a-kind protocol facilitates other blockchain assets, including ERC-20 tokens, to be represented on the Echo chain via a bi-directional peg, allowing Echo dApps such as a decentralized exchange to natively support the assets.
Being a blockchain application development platform and network fueled by Bitcoin in tandem with smart contracts, Echo has its own native token called Echo. It is used to maintain the entire consensus mechanism and pay for the transaction fees inside the Echo protocol.
Echo’s goal is to build a whole new ecosystem that grants users and developers the opportunity and freedom to transact and interact without any hurdles or restrictions.
Compound is a decentralized Ethereum-based protocol that supports the lending and borrowing of particular cryptocurrencies such as Dai (DAI), Ether (ETH), USD Coin (USDC), Tether (USDT), Wrapped BTC (WBTC), Basic Attention Token (BAT), Augur (REP), and Sai (SAI). It relieves all crypto owners from dealing with traditional financial intermediaries and saves a lot of time and effort. When using the Compound protocol, liquidity providers can earn COMP tokens as a reward for their participation and exchange them internally on the native platform, or on both centralized and decentralized exchanges to invest in other tokens.
Built on Ethereum, Aave is referred to as one of the most popular decentralized money market protocols. It allows its users to lend and borrow their cryptocurrencies in a secure and efficient manner. In order to transact on Aave, lenders are required to deposit their funds into liquidity pools so that other users can then borrow from these pools. In each pool, assets are normally set aside as reserves with a view to hedging against volatility and ensuring that lenders will be able to withdraw their funds once they wish to exit the protocol.
Currently, Aave has about 20 cryptocurrencies available, including DAI, ETH, BAT, MKR, SNX, USDT, USDC, TUSD, USDT, sUSD, BUSD, wBTC, ZRX, etc. Aave also has its own governance token, AAVE, which was preceded by another native token called LEND that was abandoned after a migration.
Another prominent feature of Aave is its flash loans. Compared to traditional loans, flash loans empower users to borrow an unlimited amount of funds without requiring any collateral, on the condition that users pay it back within the same transaction.
At the time of writing, Aave is the third-largest DeFi protocol with a TVL of $16.45 billion.
The Balancer protocol has been gaining momentum and stimulating the growth of the entire DeFi ecosystem. Its key mission is to introduce an elaborate financial protocol that offers programmable liquidity in a flexible and decentralized way as well as instant on-chain swaps with moderate gas costs. Balancer enables its users to trade supported tokens against one another, create special liquidity pools where you can add liquidity to the Balancer protocols, and even invest in other pre-existing pools to gain a yield from your trades.
Just like other DeFi applications, Balancer has its own native utility token — the Balancer token (BAL) — which is used for participating in the management of the Balancer protocol and is earned by providing liquidity or trading on the platform.
So far, Balancer has three types of pool to choose from: private, shared, and smart. In private pools, only owners have the ability to control the pool parameters and add liquidity; shared pools normally welcome everyone who wishes to contribute liquidity to the pool; smart pools, apparently, are controlled and managed by smart contracts.
The popularity of the Balancer protocol is continually growing. In 2021, Balancer V2 was released, offering greater efficiency and flexibility. The new version of the protocol offers capital and gas efficiency advantages over Balancer V1 due to the facilitation of liquidity. Its new feature, Internal Balances, allows users to save big time on gas, while the Asset Manager feature allows ideal vault assets to be deposited into partner lending protocols. As a result, it helps liquidity providers earn more yield.
Curve was introduced in 2020 as an attempt to offer an advanced automated market maker exchange with low fees for traders and substantial savings for liquidity providers. Curve focuses mainly on stablecoins, therefore granting investors an opportunity to evade more volatile crypto assets and earn high interest rates from their lending protocols. According to DeFi Llama, Curve is the largest protocol with TVL of more than $20 billion.
Curve has a lot in common with other protocols like Uniswap and Balancer. The difference, however, is that Curve accommodates only liquidity pools that consist of similarly behaving assets like stablecoins or the so-called wrapped versions of assets (e.g. wBTC and tBTC). This kind of approach enables Curve to use more sophisticated algorithms, present the lowest possible fee levels, and avoid the impermanent losses seen on some other DEXs on Ethereum.
Uniswap is a decentralized exchange protocol that runs on the Ethereum blockchain. It doesn’t require any intermediaries or other centralized parties to carry out trades. Uniswap mainly relies on the model that allows liquidity providers to create liquidity pools. It allows users to efficiently swap between ERC-20 tokens with no required order book. Given that the Uniswap protocol is totally decentralized, it doesn’t include any listing process either. Any ERC-20 token can be launched on the condition that there’s an available liquidity pool for traders.
As well as this, Uniswap has its own native token called UNI, which entitles its owners to governance rights. This implies that all UNI holders have the right to vote on changes to the protocol.
In 2021, Uniswap released the third version of its software, which became another large step forward for the protocol. One of the biggest changes offered by the new version is the so-called ‘concentrated liquidity’, which makes the functionality of AMM more efficient for users. A basic AMM enables users to deposit 2 tokens into any given liquidity pool. Then, each pool offers a price for both tokens, which is determined by the ratio of the two tokens. When buying or selling tokens from AMM pools, traders pay a very small fee for each trade. This fee is further shared out among all the pool’s depositors based on a pro-rata basis.
Launched in 2020, Yearn Finance (also known as yearn.finance) is represented as a set of protocols that rely on the Ethereum blockchain. This protocol allows users to boost passive earnings on their crypto assets by using the trading and lending services provided by the platform.
Yearn Finance provides its services autonomously and removes the necessity to engage financial intermediaries such as financial institutions or custodians. Those who participate in the protocol are paid the native cryptocurrency called YFI, which is the ERC-20 token that controls and incentivizes the whole Yearn Finance platform and enables its holders to vote on different proposals. The protocol is maintained by several independent developers and is managed primarily by YFI holders, making it possible for all of Yearn’s features to be implemented in a decentralized way.
Liquidity mining has been growing in its popularity by leaps and bounds and has sparked interest even among the most discerning and knowledgeable DeFi participants.
It’s true to admit that liquidity mining is a fairly simple concept. Yet, before engaging in it, you’re strongly advised to carefully consider and assess your aims and expectations, ensure that you have a thorough understanding of the entire DeFi ecosystem, and, most importantly, choose a solid and sophisticated protocol that will enable you to make the most of liquidity mining processes.
Here at PixelPlex we have been successfully delivering top-notch, powerful, end-to-end DeFi solutions for those who are primed for setting out on new adventures. Plus, whenever you need an expert consultation — know that our top consultants are here to help.
Contact us any time and we’ll be more than happy to embark on an exciting journey with you around the DeFi world and ensure that your project will be a roaring success.