What is Liquidity Mining?
TLDR: A Decentralized Finance user is said to engage in Liquidity Mining when he deposits assets in Liquidity Pools, in order to earn rewards and tokens which can grant holders governance rights.
Definitions matter – they matter generally, but they matter especially in the realm of Decentralized Finance. Definitions shape our understanding of the processes that are specific to this sector. And therefore it becomes a duty for any writer worth his salt to provide clear definitions – in order to conceptually circumscribe notions and ideas specific to DeFi, but also to differentiate them from other notions that are so similar in nature that they might be causing a certain amount of confusion.
In this article, we will define Liquidity mining, which is often confused with Yield Farming. As we will see, Liquidity mining and Yield farming are extremely similar in terms of mechanics.
What is Liquidity Mining?
Decentralized exchanges such as Uniswap and 1Inch do not rely on order books. And therefore, to enable trading, these platforms have to provide liquidity for their users.
How is this accomplished?
These platforms allow users to deposit assets in Liquidity Pools. In return, users receive a share of the platform’s trading fees. This is a powerful incentive that allows platforms to bootstrap liquidity very quickly.
Liquidity pools serve as “warehouses” for traders, ensuring that when someone offers to swap a token, the asset they want is available. And therefore, the more liquidity there is on a platform, the better the experience is for traders: a good amount of liquidity will ensure that the tokens users demand are available, and that the buying and selling will not cause sharp changes in asset prices. A good amount of liquidity will also have a positive impact on transaction speed and prices (the higher the liquidity, the closer assets trade to their fair market price, and the slippage will be lower).
In addition to receiving trading fees, users also receive tokens, usually the platform’s native token.
What we have written so far describes the processes known as Liquidity Mining and Yield Farming. Liquidity miners and Yield Farmers deposit liquidity in pools to earn fees and tokens. However, Yield Farmers distinguish themselves from Liquidity Miners in how they reinvest the tokens that they earn. They are known to reinvest these tokens multiple times across multiple platforms, creating multiple chains of investments. This is possible thanks to Decentralized Finance’s characteristic interoperability and composability, that makes it possible for a platform’s native token or governance token to be used as collateral or staked on other platforms.
The difference between Liquidity Mining and Yield Farming, which are strikingly similar and can easily be confused, is the fact that Yield Farmers will reinvest the tokens they earn multiple times across platforms, creating stacks or “Crops” of Yields.
Liquidity mining was first introduced by the venerable IDEX in 2017. The Liquidity mining experience was fine-tuned by the Synthetix team, in collaboration with Chainlink back in 2019. The practice gained in popularity after Compound kicked off DeFi Summer (Summer of 2020).