Liquidity Mining refers to a type of token distribution program in which a user provides liquidity to a protocol in return for that protocol’s native token.

One popular type of liquidity mining program is distributing governance tokens to users who bring liquidity to a DeFi protocol. The governance tokens give holders the right to vote on changes to these networks as well as ownership. ^[1][2]

Trivia

• IDEX, an Ethereum-based decentralized exchange, introduced the concept of liquidity mining in October 2017.
• Synthetix refined the concept launching their liquidity mining program in March 2019.
• Compound, Balancer, yEarn, Uniswap, and SushiSwap popularized the concept of liquidity mining in 2020.
• Liquidity mining is the act of providing liquidity via cryptocurrencies to decentralized exchanges Decentralized Exchange (DEXs). Since the primary goal of an exchange is to be liquid, DEXs seek to reward users willing to bring capital to their platform.
• A "yield farmer" provides liquidity but gets not just the return, but also a new token.

Introduction

Liquidity mining is a type of yield farming. It is an incentive program created by a DeFi protocol to attract liquidity. The process involves DeFi users receiving tokens as a bonus beyond typical fees from contributing to liquidity pools. Liquidity mining programs launched by DeFi protocols can be put into three categories: fair launches, programmatic decentralization, and marketing-oriented (growth marketing). ^[3][4]

Liquidity mining is when a yield farmer gets a new token as well as the usual return (that’s the “mining” part) in exchange for the farmer’s liquidity. ^[5]

Governance tokens play an essential role in liquidity mining, as they are often given to liquidity providers. In 2020, a number of DeFi protocols decided to reward Liquidity Providers (LPs) with the traditional yield rates as well as governance tokens. This incentivized liquidity mining even further, as LPs earn an additional stream of income. Moreover, they receive a stake in the protocol by being able to participate in governance. By doing so, they can change the protocol, how it works, and even add more liquidity pools.  ^[6][7]

Fair Launches

The primary goal of a fair launch is to distribute the majority of tokens via some objective criteria other than a direct sale and ensure that everybody has equal access to that distribution. Think of this as Uber being owned by its drivers and riders from day one. ^[8]

Programmatic decentralization

The goal of programmatic decentralization is to gradually community ownership and minimizing treasury management. Think of this as Uber signing a legally binding agreement to distribute the majority of its stock to drivers and riders over the next few years. ^[9]

Growth Marketing

The primary goal is to incentivize specific user behavior over a pre-defined period. Think of this as Uber rebating a portion of their customers’ rides in Uber stock. ^[10]

Popularity

June 2020

Compound is an algorithmic money market that allows users to lend and borrow assets. Anyone with an Ethereum wallet can supply assets to Compound’s liquidity pool and earn rewards that immediately begin compounding. The rates are adjusted algorithmically based on supply and demand. ^[11]

In June 2020, Compound announced that the protocol would give out COMP tokens to users over a four-year period, a fixed amount every day until all of the tokens have been distributed. These COMP tokens control the protocol, just as shareholders ultimately control publicly traded companies. ^[14]

Any user holding a supported cryptocurrency can deposit it into a Compound smart contract where it joins a liquidity pool and starts generating interest. The interest comes from other users that borrow funds and pay interest for the loans. ^[15]

Balancer was the next protocol to start distributing a governance token, BAL, to liquidity providers. Ren, Curve Finance, and Synthetix also collaborated together to promote a liquidity pool on Curve. ^[12]

Frax Finance

At the end of 2020, Frax Finance, an algorithmic stablecoin project founded by Everipedia's Sam Kazemian launched a liquidity mining campaign centered around its FXS governance token. This incentivizes newcomers to support the project by distributing FXS rewards across Frax’s key Uniswap liquidity pools. ^[16]

Overview

Liquidity mining allows users to earn cryptocurrencies passively and receive income higher than the interest on deposits. However, this method has its own risks, which are not found in other types of mining, so users of these DeFi protocols should always be careful while providing tokens to the protocol's liquidity pool, especially if the project promises high returns. ^[13]

Pros and Cons

Pros

Liquidity mining on the decentralized exchanges offers many benefits compared to just holding cryptocurrencies or tokens in the wallet or holding them on the centralized exchanges. These benefits are -^[17][18]

1. High Yields - It gives much better rewards compared to centralized exchanges and gives rewards in proportion to the investments. Rewards are generally based on trading activity, and if there are more traders, there are chances of higher yields for liquidity providers. Since the LP's share of the liquidity pool dictates what the LP's yields are, the LPs can essentially estimate rewards before investing it in the pool.
2. Minimum capital needed for Entry : As rewards are proportionate to investments and total investment in the pool , anyone can take part in the liquidity mining and, generally, pools have low barriers for entry, which gives anyone a chance to take part in the decentralized ecosystem.
3. Builds a trusting and loyal community : Since investors are fully responsible for their investment, they become active participants in the mining programs, which helps to build an active and loyal community for a longer period of time. It also helps LPs receive additional benefits by continuing to engage with the protocol.
4. Distribution of governance and native tokens : Prior to the existence of DEX and cryptocurrency liquidity mining, developers favored institutional investors over small investors, which hampered projects' ability to achieve full decentralization. DeFi liquidity mining offers all an equal opportunity to obtain native tokens. These Native tokens give additional powers to participate in the governance and vote on the development and fee distribution proposals. implementing changes in the UI etc.

Cons

There are projects that have suffered exploits and rug-pulls, and an LP has to do extensive research before dealing with these types of risks.

1. Impermanent Loss : The LP needs to take into account all the factors before investing in the liquidity program. Impermanent loss can make their capital look very bad if they do not time their entries well. Impermanent loss occurs when the price of the tokens changes in comparison with the initial price at the time of investment . A substantial price change makes it very likely to encounter an impermanent loss. If the invested tokens have a lower price at the time of withdrawal, there are chances that LP will lose money. One way to deal with this is to offset this particular risk with the gains that are obtained from trading fees.
2. Project Risks : There will always be risks associated with the projects since they are open source and run on complex code. The projects can suffer from exploits, and it results in draining large amounts of funds from the pools. The LPs need to be aware of this and should perform an in-depth audit of the code or DYOR and take help to check the reliability scores of projects by security firms such as Certik.
3. Potential Rug Pulls : Despite the many advantages that come with decentralized investing, the nature of the system does have some loopholes. Rug pulls are types of fraud committed when liquidity pool developers and protocol developers decide to shut the protocol down and run away with all of the money by withdrawing liquidity that’s been invested in the project.