Liquidity mining is a way of generating rewards by providing liquidity via cryptocurrencies to decentralized exchanges (DEXs). DEXs attempt to reward users that contribute capital to their platform, as providing liquidity is the core goal of a DEX.
It is also closely related to a model called automated market maker (AMM), which typically involves liquidity providers (LPs) and liquidity pools. Let’s see how it works.
Why do DEXs need to reward liquidity providers?
Simply said, by providing liquidity to DEXs, liquidity providers need to suffer a loss called impermanent loss.
What is impermanent loss and how does it work?
Impermanent loss usually impacts liquidity pools that are supposed to have a 50/50 token ratio. For instance, liquidity providers in the USDT/BTC liquidity pool must provide equal amounts of USDT and BTC to the pool. When users trade using a liquidity pool, which is common on decentralized exchanges, the ratio will fluctuate depending on the number of tokens in each pool, affecting the price of those tokens.
Assume ten liquidity providers each provide 1 BTC and 50,000 USDT to the liquidity pool, with equal values for both tokens. Each deposit is worth $100,000 as BTC and USDT are both worth $50,000 each. Now, the liquidity pool currently has 10 BTC and 500,000 USDT, a 50/50 split that grants each liquidity provider a 10% stake in the pool. Each provider liquidity will be given LP tokens, which they can spend at any time to redeem their 10% share in the pool.
Because token values are based on the ratios of their liquidity pools, they might differ from those on other exchanges. If the price of BTC increased by 100%, making the value of 1 BTC worth $100,000, then the total value of the liquidity pool would change to 7.071 BTC and 707,110 USDT. This is due to a change in the pool's ratio, which is no longer 50/50, affecting the price of BTC.
How does AMM compensate the impermanent loss and increase motivation?
There are two kinds of rewards:
With the automated market maker (AMM) model, DEXs collect fees and distributes them as a compensation to each liquidity provider (LP). To achieve this, DEXs provide a mechanism in which each user group can assist one another. As token swappers pay a tiny fee to trade on a decentralized exchange, the LPs get rewarded for supplying the liquidity required by the token swappers.
On the other hand, governance tokens are important in liquidity mining since they are frequently used as a secondary type of reward. A lot of protocols choose to reward LPs with typical yield rates while also including governance tokens in the mix. This extra source of income acts as an added incentive for LPs to provide liquidity, further promoting liquidity mining as a whole.
Leveraged Yield Farming and its risk
There are various facilities that allow yield farmers to borrow assets in order to increase their return on yield farming. As the leverage increases, so does the return. Leveraged yield farming involves two key participants:
Farmers who borrow tokens from lending pools to yield farm with leverage.
Lenders who deposit their single tokens in lending pools to earn yields.
However, there is one risk to be mindful of when you open a leveraged position: probable liquidation. There are a few key figures to keep an eye on when it comes to the danger of liquidation:
Debt Value is the total value of the borrowed tokens
Position Value is the value of your farming position, collateral + borrowed assets + yields (also known as the total value of your LP tokens)
Debt Ratio is your Debt Value divided by the Position Value