Liquidity Mining

Liquidity mining is a process in which users deposit cryptocurrencies into a Liquidity Pool (LP) and are rewarded from the platform's fees. LPs consist of pairs of tokens / coins that form liquidity for a decentralized exchange (DEX).

DEXs trade 24/7 using AMMs (Automated Market Makers) and liquidity pools. The underlying liquidity pool creates a market for a specific asset pair; e.g., ETH / USDC. When the LP has been created, the liquidity provider sets an initial price and a ratio, referring to the market in order to ensure an equal supply of both assets. This concept of equal supply of both assets remains the same for everyone else who is willing to provide liquidity.

Liquidity providers receive remuneration that is proportional to the assets they provide.

Once the trade (exchange) has been completed, the transaction fee is split among all liquidity providers. Each exchange leads to a price adjustment through smart contracts.

Protocol types used for liquidity mining

These can be divided into 3 types according to their solution:

1. Fair decentralization: A fair decentralization protocol is a concept that tries to level the playing field for all parties involved. Therefore, governance tokens / coins are distributed equally to all active users. Unlike ICOs, which require investors to purchase governance tokens / coins, the fair decentralization protocol approach does not sell native currency. Instead, it uses various criteria to ensure that tokens / coins are distributed evenly. Once the fair decentralization protocol starts, powers are immediately handed over to the community.
2. Progressive or programmatic decentralization: These protocols allow the progressive transfer of powers to the community. The distribution of tokens / coins is a slow process in this solution and requires creation of a governance model once the project has started. Programmatic decentralization is a concept that seeks to avoid imbalances in the distribution of governance tokens / coins. It prevents whales and institutions from owning a large number of the protocol’s assets.
3. Growth marketing: This type is different from the previous two, and developers using this technique reward community members for promoting the platform or DeFi protocol in order to earn governance asset. Protocols guided by growth marketing reveal their plans and the entire ecosystem’s function several weeks before launch. Their main goal is to maximize publicity.

Protocols dealing with liquidity mining:
- Compound
- Balancer
- Uniswap
- Curve

PROs

• Fair distribution of governance tokens / coins
• Low entry costs
• Passive income opportunities
• High profits

CONs

• Impermanent Loss (IL)
• Fraudulent protocols
• Smart contract vulnerability

Conclusion

Liquidity mining is a method of passive income generation that helps many cryptocurrency holders make a profit by using their cryptocurrencies without the need to sell them. Assets are lent to a decentralized exchange (DEX) and in return, each liquidity provider is rewarded with a percentage of the fees earned from trading on the platform.