What are the benefits of liquidity mining?

Benjamin D. - Founder

Liquidity mining can earn you extremely high returns in the form of interest on your assets. The interest rates are often significantly higher than with staking or lending. You become the capital provider (also Liquidity Miner) of a decentralized exchange and help to increase the pool of liquid funds.

How you can earn additional income from liquidity mining?

In liquidity mining, you provide liquid funds to a smart contract. This smart contract regulates, among other things, when supply and demand meet on a decentralized exchange. In order for assets to be available for purchase on the exchange, they must be provided externally. The same applies to a traditional centralized exchange. For providing this liquidity you receive interest. The higher your individual share of assets in the total liquidity is, the higher your interest will be. For this, your assets are held in custody by the smart contract and you receive a token in return, from these provided assets. Even the token of your pool share can be traded later.

For a decentralized exchange to fill its liquidity pool, it always needs trading pairs, two assets at a time. This means that if, for example, Bitcoin is traded against the US-Dollar on the exchange, both parts of the pair are needed. For exactly this pair you will then receive your interest and also your token.

How does the smart contract of a decentralized exchange work?

Feel free to read the article about decentralized exchanges. First of all a small explanation:

The smart contract of a decentralized exchange ensures for you as a liquidity miner that your deposited assets are stored safely and that you can get them back at any time. In order for traders to be able to trade on the exchange, trading pairs of all kinds are provided. The trading pair you provide must be equal in value at that time - similar to a scale. So if you want to provide the pool with $2000 in assets to trade between bitcoin and dollars, you need to commit $1000 in dollar tokens and $1000 in Bitcoin to the smart contract.

For example, if someone wants to trade Ethereum in addition, the same Dollars cannot usually be used for this as from the trading pair for Bitcoin. In reality, there are some ways to achieve this. But exceptions prove the rule.

Advantages of Liquidity Mining for your Assets

The main advantage of liquidity mining is definitely the much higher returns. Returns of 100 - 400% on the year are not uncommon here. Especially in still small pools of decentralized exchanges your trading pair can generate enormous returns. This is because the exchange receives more traders the more trading pairs it can offer. Without the Liquidity Miners nothing would work.

What are the risks of Liquidity Mining?

In Liquidity Mining, unlike Staking or Lending, your assets do not remain in their original form. By trading on the exchange, prices fluctuate like on any other common market. These fluctuations also influence your input trading pair. This can lead to a so-called "impermanent loss", which can be very irritating for many investors, especially in the beginning.

How can an Impermanent Loss happen?

The loss cannot necessarily be understood as a loss in main sense. There is only a shift of your assets taking place. Let's say you provide the pool with the aforementioned $1000 US-Dollar tokens and an equivalent of $1000 in Bitcoin. For this, let's assume that you are the only one who has provided this trading pair. If a trader now comes onto the platform, the entire pool consists of assets worth 2000$. This trader now buys Bitcoin worth 500$, i.e. half out of the pool.

Now there is an imbalance in the price. Because now the only 500$ in Bitcoin is opposed by 1500$ in US-Dollar-Tokens. Like a scale, the pool is now no longer balanced. This creates a different price for the Bitcoin that are still on offer. They are now more expensive than they might be on the rest of the market.

At this point, traders will very quickly use this circumstance for themselves and try to compensate for this imbalance (arbitrage traders). In this case, they have the opportunity to sell Bitcoin at a premium and receive more US-Dollars. The system of the decentralized exchange always strives to maintain the balance between the pairs. Since there are permanent price movements, it may happen that at certain times you own more of one asset than the other.

If you want to pay out the trading pair again and want to stay at your ratio of 1:1, the time for this should be chosen favorably. Some smart contracts therefore have a time window for your request to cash out, in order to choose the most stable time that is closest to the 1:1 ratio. However, no matter how much you temporarily lose, your returns are still much higher.

What is the risk of liquidity mining?

The risk is much higher with liquidity mining in comparison to staking or lending digital assets. Therefore, you also get a much higher return. Especially in small pools, it can happen that someone buys out such a large amount from a trading pair that the balance becomes so large that there is a very high instability.

The biggest risk, however, is still the "impermanent loss" and the smart contract itself. Because this can be from an untrustworthy source that wants to defraud users. You won't find such smart contracts at our platform, but you can never rule out an error in the contract itself.