In the world of decentralized finance, market making is a vital component of development. Without that there is no new growth. However, the present form of generating liquidity is not efficient enough. The market solution to this issue is liquidity mining. Specifically, this creates a data driven community based system to generate liquidity in the market. Miners get rewards for offering liquidity to the sector.
The process needs lending or deposition of designated assets of the blockchain. These systems employ a mining mechanism to offer liquidity for the fund pool of a product. Along with that, one feature that all these platforms share is that they enable users to earn interest for their participation. Primarily, you earn rewards for functioning a market making bot.
Liquidity Mining: Similar to Proof-of-Work Mechanism
The real term “Liquidity Mining” is obtained from the addition of the mining mechanism. This is the same as a proof-of-work mining system in that miners operate open-source software on their own computers and use their own scarce resources. In this scenario, it is their inventory of crypto assets.
Unlike Proof of Work (PoW) blockchains such as Bitcoin, users use more than just computational power. They also use their token inventory. This strategy is more democratic as it does not need expensive mining equipment. Crucially, liquidity miners get their rewards in a specific native token of a project.
Governance Rights In Liquidity Mining
There are also scenarios when they can get the governance rights the token portrays. These platforms can use various cross-chain abilities. Some of these systems do not need you to trade into the direct asset of the blockchain that you desire to use. Features like atomic swaps make this happen today. As such, atomic swaps are famous in the decentralized finance sector.
The main point is that these tokens offer voting rights to the user. Every platform may have varied minimum token volume needs before these rights are available. Be sure to review all your terms of service. Most platforms base the rewards on three main parameters.
The bigger your order is, the more rewards you will receive. The aim here is to maintain a high amount of participation from the average user.
The spread is the total distance to the mid-price of your orders on the platform.
The Timeframe You Keep Orders On The Order Book
The longer you keep up with your order open, the more rewards you receive. Presently, most governance tokens also serve a speculative aim. Since the DeFi space is just starting to receive momentum, investors purchase these tokens with the notion to resell for a higher value as the popularity of the platform increases. Some of these platforms will succeed. Sadly, most will not. The difference between failure and success is often transparency.
What Issues Does This Attempt to Fix?
This type of mining helps fix a few areas of issue in the DeFi world presently. Specifically, it enhances liquidity for the latest projects. Access to funding is crucial to the cold start of a project. Unlike traditional sectors, the DeFi sector lacks the self-built capital pool that start-ups need to attain stable liquidity. Presently, exchanges and token issuers pay quantitative funds of millions to offer liquidity in the sector.
This uniquely solves this issue. It enables regular users to offer the missing liquidity. Users give out their crypto and earn interest. In liquidity mining vs yield farming what makes the former one more enhanced than previous yield farming approaches is that it formed user incentives via an interest rate mechanism.
These systems operate similarly in that the more any user lends, the more interest they receive. The liquidity mining profitability is huge. Consequently, the liquidity pool increases because of these actions. As the liquidity pool broadens, the profits of the user grow as well. In this way, this mining effectively bridges value islands in a decentralized dimension. This strategy increases the frequency of value exchange. The end aim is to promote price discovery.
How Does It Work?
Every liquidity mining site differs slightly, but the basic operations remain the same. You lock up your crypto in a smart contract on the DeFi platform. These funds then go to a lending pool. This pool is the place where people borrow from. You get an interest in participating. It is that simple.
Benefits And Risks Of Liquidity Mining
With that, we have come to almost the last part of this article. But before we end it is important for us to know the benefits and risks of this mining. So without any further delay, let us begin.
There are many advantages to this mining that make it so famous. For one, it allows regular users to receive a passive income without prior needs. Most liquidity pools offer a frictionless onramp to the market. The platforms are convenient to sign up for, and they do not need any special equipment such as traditional mining. Keenly, the ideal platforms enable you to start earning interest instantly.
There are some liquidity mining risks that the investors should be aware of. These risks span the spectrum from technical risks to even a market collapse. Primarily, bugs or computer errors are the largest threat to the success of these platforms. In June 2021, miners from the platform Compound lost tens of thousands of dollars when they were unexpectedly liquidated. The culprit came out to be an improper pledge rate setting.
Another important risk that is faced by participants of liquidity mining is inventory risk. Sudden negative price shifts can eat away at the inventory value of your platform. You can also have an instance where a market maker needs too large of a project stake. Users must stay vigilant in their market analysis to ignore these concerns. Invest at your own risk.
Since then, the crypto space has exploded. Every week latest DeFi platforms enter the space with more aggressive incentive programs. Presently, anyone can earn a healthy ROI, lending out their crypto through these liquidity mining platforms. At this time, the primary thing is to be cautious and DYOR to ignore major losses.
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