The adoption of blockchain technology has exposed the world to diverse industry-breaking products and services, one of many revolutionary aspects of it is decentralized finance(DeFi), an advanced layer for setting up financial applications and carrying out trades and exchanges on the distributed ledger.
That said, a notable drawback of these services is limited flexibility, for the cryptocurrency realm, liquidity happens to be the pressing factor. Low or lack of liquidity effectively renders projects and businesses useless as individuals cannot tap into their full potential.
To understand Liquidity Mining and Yield Farming, you need to be frank with other aspects of blockchain technology that shape these products.
A great place to start is Bitcoin, learning how Bitcoin works and what necessities Ethereum brings to the table as the second largest cryptocurrency by market capitalization. With this fundamental knowledge, it's much easier to grasp how DeFi has built incentives into the industry by leveraging smart contracts to deploy products where participants earn for their involvement in the project's growth.
What Is Liquidity?
Liquidity refers to the available convertible value for a given asset. For example, if a user wishes to trade $1 billion Bitcoin for Ethereum or USDC on Hive Blockchain, but given that the Hive ecosystem currently doesn't have that much Ether or USDC to facilitate that trade, we can say there is no liquidity, Ether, and USDC in this context effectively is the liquidity needed for that Bitcoin to be exchangeable.
What Is Liquidity Mining?
Liquidity Mining is a solution crafted to solve the issues with low liquidities for trades on blockchain networks. Typically, liquidity mining is the process of offering a given asset out to a specific protocol in exchange for rewards most often derived from fees incurred from trades that take place on the protocol.
Decentralized Exchanges(DEXs) most often leverage this business concept to attract users with idle assets. The more liquidity one provides, the higher the incentives he'd earn from swap fees. Typically, these figures vary from pairs or pools to pools( pairs or pools means a smart contract that holds two assets together in other for individuals to be able to trade one for the other, see how AMMs aid this in our introductory coverage of DeFi), the riskiest pools often have higher rewards.
How Does Liquidity Mining Work?
Even if you're not on the same wavelength as most crypto experts, understanding liquidity mining is quite easy as it is a pretty straightforward concept.
It is like loaning money to a person or company to fund a business and you earn commissions or interest over time. However, in practice with crypto assets, it is a tiny bit different, how?
Liquidity pools work with token pairs, thus, each pool requires an equal amount of tokens to balance trade settlements and ensure the protocol doesn't get exploited. So, a user typically needs to provide two assets to a pool and earn rewards via the swap fees.
Using Bitcoin and USDC for example, if a user wants to provide 2 BTC to a protocol as liquidity, he typically needs to provide USDC that is equivalent in "price value" not 2 USDC, because BTC is much more expensive, and these smart contracts monitor market values via the use of blockchain oracles to facilitate trade.
So, let's assume the price of 2 Bitcoin is $20,000, that's $10k a unit, and USDC is $1 each, a user typically needs to provide 2BTC and 20,000 USDC which is the equivalent of 2 BTC. The Smart contract takes these tokens, pairs them up, and distributes an asset to the person's address signifying his position in the pool(in percentage). To get back the 2 BTC and 20,000 USDC, a user would need to sign a liquidity removal contract and the previously deposited asset in his address will be removed and his own assets returned. But then, are there any risks to this? I'm glad you asked.
Impermanent Loss Explained
Personally, the first time I joined a liquidity pool, I didn't know about this and lost some money in the process, so don't be like me, always do your own thorough research!
So what is Impermanent Loss?
Impermanent loss is an incurred loss on one's liquidity position, often caused by the price changes in the assets one provided as liquidity. How?
Let's assume the total liquidity in the pool where we previously provided 2 BTC and 20,000 USDC to is 20 BTC and 200,000 USDC, this would mean that we own 10% of the entire liquidity in the pool, the liquidity ratio of the pool is 4,000,000(20×200,000).
Take note, this is what the protocol understands, it does not care about the units of the assets, just the percentage we own and its dollar valuation. The assets pool always has to both maintain an equal value and ratio as to when they were deposited.
So, if let's say BTC suddenly grows to $40,000 each, with arbitrage traders helping stabilize the pool's ratio, the liquidity in the pool would fall to 10 BTC and grow by 400,000 USDC. If we decided to withdraw our assets, we'd get 1 BTC and 40,000 USDC. Merely looking at it, it seems we have made a profit of $40,000, but in reality, if we kept our 2 BTC and our 20,000 USDC, we would have $100,000.
But what would have happened if BTC dropped in price at the same rate it increased following this example? Then you'd lose a lot of money, this is the risk of providing liquidities to these AMMs DEXs. The idea is to manage your risk and be sure that your losses do not outperform your profits.
Is Liquidity Mining Profitable?
Yes, liquidity mining is profitable when done right. It is important to go for relatively stable markets that do not have many or major price swings but of course, that will not be easy given that crypto assets are by design, extremely volatile.
A solution to this would be to chase stablecoin pools, impermanent losses are limited here to some extent.
Is Liquidity Mining Risky?
Yes, liquidity mining is extremely risky given that crypto assets' market value or prices are extremely volatile as they are unregulated free markets, one can lose all his money in the process so it is advisable to do thorough research and understand the market and concepts before investing in them.
Having learned all that,
What is Yield Farming?
Yield farming is the process of offering crypto assets to protocol pools in exchange for interests that vary in percentage depending on the network. Surely, it is very similar to liquidity mining, the difference is that assets in yield farms do not rely on swap fees as a primary source for interest payments.
Instead, the smart contracts that hold these assets can lend them out for a profit that will be distributed to the providers. Yield farmers typically hunt for high APRs across multiple platforms to maximize rewards for their assets.
What Is Crypto Staking?
Crypto Staking is the process of locking up a crypto asset for a given period of time for diverse reasons including earning yields, participating in network governance, and validating blocks of transactions like on proof of stake blockchains.
What are DeFi Single Staking Pools?
DeFi single staking pools are basically pools that require individuals to provide a single asset to the protocol and earn yields that are either created as inflation to the tokens deposited and distributed to the participants or accumulated from loan interest payments, swap fees that are used for buybacks of the reward tokens that will be distributed to the users.
DeFi single staking pools have relatively high APRs given that assets are most often locked over a long period of time and users are incentivized with these high interest and sometimes higher governance influences.
In conclusion, Liquidity mining, yield farming, and crypto staking share a lot in common which is earning incentives for participating and the high risks of losses that compliments the high potential gains.