Liquidity mining: mercenaries or infrastructure supplier?

Liquidity mining is an instrumental however mysterious power within the decentralized finance (DeFi) world. Liquidity miners don’t get almost as a lot publicity as utility builders or enterprise capital however DeFi protocols can not operate with out them. With out liquidity — or sufficient tokens to help easy transactions — Defi protocols are simply traces of codes somewhat than functions that folks can use. 

Liquidity miners are DeFi contributors whose funding technique facilities on offering liquidity to DeFi protocols. In doing so, they will seize the vast majority of the DeFi protocol income and a major proportion of the protocols’ governance tokens at a value that could be even decrease than enterprise capital.


This text will analyze the distinctive position that liquidity miners play within the DeFi ecosystem and what their subsequent evolution would possibly seem like.

What’s liquidity mining?

The marvel of DeFi protocols is that they permit basic monetary actions similar to sending cash, lending, borrowing and buying and selling with out the standard intermediaries of conventional finance. In essence, they’re sensible contracts that allow peer-to-peer transactions that anybody can take part in. For instance, main decentralized exchanges (DEXs) largely use the AMM mannequin (computerized market maker) by which customers swap tokens through liquidity swimming pools product of tokens offered by different customers. In conventional inventory exchanges, capital provision is extremely centralized in massive institutional gamers.

For transactions to occur easily with little value slippage, DeFi protocols have to have deep liquidity — sufficient amount and number of tokens. That’s the reason the emergence of liquidity mining, a mechanism of incentivizing liquidity suppliers, performed a vital position in kicking off 2020’s DeFi summer time, when complete worth locked in DeFi exploded from US$800 million in April 2020 to US$10 billion in September 2020. These days, virtually all DeFi protocols supply liquidity mining packages throughout their bootstrap stage.

Liquidity mining packages usually supply two sorts of rewards: transaction charges and the protocols’ governance tokens. First, the vast majority of the transaction charges {that a} DEX costs its customers really goes to liquidity miners. Take the main DEX SushiSwap for instance, it costs a 0.3% payment for each transaction, 0.25% of that payment goes to liquidity suppliers, 0.05% goes to token holders. Furthermore, liquidity suppliers are also rewarded with Sushi tokens. Sushi doesn’t also have a token sale that’s open to enterprise capital, all of its tokens are distributed by the liquidity mining program. 

Some protocols do divide their tokens among the many founding group, early traders and liquidity suppliers. Sometimes these protocols reserve 30-40% of their tokens for liquidity mining packages. Take XY Finance — a cross-chain swap aggregator that simply launched its token publicly on Dec. 9 — for instance. It allocates 35% of its tokens to liquidity mining, whereas its VC traders from seed spherical to technique spherical received 24% in complete. 

Liquidity miners are actually getting an excellent deal from protocols. They will even undertake a market impartial technique by solely offering secure cash like USDC and USDT, or hedging the tokens they maintain, whereas nonetheless taking away an enormous a part of DeFi protocols’ income and get their tokens without spending a dime.

The key of being elite liquidity miners

Liquidity mining is open to anybody, however there may be definitely no free lunch. DeFi continues to be an unregulated Wild West. If the DeFi protocol you work together with seems to be a rip-off or will get hacked, there may be little likelihood that you could get your funds again. In the meantime, liquidity mining is such a singular mechanism that solely exists in DeFi that conventional finance gamers can hardly perceive the way it makes cash.

Having the prospect to work with a number of the most skilled liquidity mining groups which were on this recreation since 2020, the very best on this recreation already developed wealthy know-how that assist them take advantage of liquidity mining, which embody:

  • Find out how to audit sensible contracts to determine potential scams or bugs
  • Find out how to consider the danger of being hacked
  • Find out how to monitor on-line information to trace the monetary well being of the protocol
  • Find out how to observe the wallets of “DeFi whales” with giant quantities of capital whose actions can have an effect on the market
  • Find out how to allocate capital throughout totally different protocols to handle threat and return
  • Find out how to maximize capital effectivity by leveraging lending protocols and auto-compound
  • Find out how to arrange multi-layered multi-signature wallets that permits group collaboration and quick response

All the above crypto-native experience stays very overseas to conventional traders. Although just lately we’re seeing billions of conventional capital flowing into crypto belongings, funding alternatives round liquidity mining are largely uncared for and stay a uncommon blue-ocean.

The top of mercenary capital

The image with liquidity mining just isn’t all rosy, it’s removed from an ideal answer for DeFi’s liquidity downside. If a protocol retains rewarding liquidity miners with a big amount of its personal tokens, the worth of its tokens will certainly be diluted, if a protocol reduces or stops the token rewards, liquidity miners would possibly transfer to different protocols which can be providing excessive token rewards. 

In truth, liquidity miners used to behave as mercenary capital largely. They preserve shifting to the protocols that supply the best rewards, they usually typically dump the tokens they earned rapidly in case the token worth is diluted with the continuing incentive packages. 

This unstable relationship typically results in a lose-lose scenario for the protocols and the liquidity miners: when liquidity miners begin to dump the earned tokens of a protocol, the token value goes down, which makes the liquidity mining incentives much less engaging, so extra liquidity miners depart, depleted with liquidity the protocol turns into unusable. 

The failings of the liquidity mining mechanism led to a sequence of improvements from the protocol facet. Olympus Dao, referred to as a pioneer of DeFi 2.0, invented the idea of POL (protocol-owned liquidity). It designed a bonding mechanism by which it presents its personal token at a reduction in alternate for liquidity tokens. Protocols that undertake this mannequin will management their liquidity somewhat than renting it from liquidity miners. In the meantime, many protocols are adjusting their incentive packages to require liquidity miners to lock up the tokens they earn for a interval.

An increasing number of liquidity miners additionally perceive {that a} long-term win-win relationship with the DeFi protocols is the important thing to maximise their return. In order that they begin to instantly talk with DeFi protocol builders, and focus on learn how to work collectively to assist the protocols develop. They already personal governance tokens, now they’re more and more lively in governance actions from voting to proposal writing. This implies liquidity miners are taking over some enterprise capital qualities, making bets on the protocols they imagine in, and supporting their development.

The shifting dynamics additionally makes increasingly more liquidity miners acknowledge the benefit of pooling capital and information collectively. Certainly, liquidity mining is popping into group sports activities. When liquidity miners manage, naturally they lean in direction of the crypto-native type — DAO (decentralized autonomous group), we already see early examples like Don-key Finance—a social platform that permits newcomers to repeat veteran’s methods, or AladdinDao — a group that co-invest in protocols curated by DeFi gurus. Each tasks really issued their very own tokens to incentivize lively DAO members.

Since DAO is already the dominant type of group behind DeFi protocols, we will count on extra DAO-to-DAO collaborations between protocols and liquidity miners.

Liquidity miners as infrastructure suppliers

Liquidity mining is in some ways just like Bitcoin mining — each liquidity miners and Bitcoin miners present necessary infrastructure for the blockchain world. Bitcoin miners contribute their computing energy to allow the transactions on the Bitcoin blockchain, in return they’re rewarded with bitcoins. Liquidity miners contribute their capital to allow the transactions on DeFi protocols, in return they’re rewarded with the protocols’ governance tokens. We now have seen a number of Bitcoin mining firms go public as mainstream traders now perceive their enterprise mannequin. Nonetheless, the potential of liquidity mining continues to be underestimated. 

One of the vital compelling visions for blockchains is “the web of worth.” For worth to be transferred, liquidity is an indispensable piece of infrastructure.

Many functions in DeFi are simply on-chain replicas of what we’re accustomed to in conventional finance from lending, buying and selling to derivatives. Holding or buying and selling tokens just isn’t that totally different from what individuals do with belongings in conventional finance. However DeFi won’t simply have such issues to supply, liquidity mining is a real innovation that’s distinctive to DeFi. Its emergence reminds us that DeFi will result in new types of funding that can’t match into the frameworks of conventional finance.

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