Liquidity mining is dead, said Coindesk.
Of course, this clickbait statement is too far from reality: the death of liquidity mining would mean the inevitable end of the whole DeFi sector.
But DeFi is still there…🤷♀️
However, in light of all those inefficiencies and scams that the current liquidity mining model has revealed so far, it’s become necessary to rethink this concept and give it another shape.
In this article, I will walk you through the current state of liquidity mining and why it’s been so profoundly criticized. I will also explain the innovative approach offered by Yellow Network that will not only fix the existing flaws of this concept but will also make it more valuable to the growth of the whole crypto finance industry.
Let’s get started.
The current state of the crypto liquidity
Before we dive into liquidity mining, let’s briefly look at crypto liquidity as a whole.
Essentially, crypto liquidity has one giant issue — fragmentation.
The crypto trading market is segregated into hundreds of discrete exchanges (CEXs and DEXs) — each with its own local fiat/crypto supply and demand, prices, and access limitations.
I discussed the crypto fragmentation problem in more detail in the blog post “What is Web3 Liquidity Aggregation?”— check it out.👌
Unlike conventional stock exchanges, almost all crypto trading platforms, even “blue chips,” lack such professional-grade capabilities as
- global price discovery — for example, prices from global markets normalized for local currency;
- global best bid and offer — global order book normalized for foreign exchange and fees in local currency; and
- global liquidity access, i.e., not just that of one exchange.
In other words, the crypto trading market is severely siloed and far from efficient for professional players. Those who wish to trade globally are compelled to open and manage multiple accounts across various exchanges and take all security, legal and technical risks arising from that.
Then if we go more granular and group the crypto liquidity into CEX and DEX categories, here is what we’d have:
On CEXs, except for the “blue chips,” liquidity can often be thin or even faked, which inevitably incurs the risk of higher slippage.
With the “blue chips” (leading centralized exchanges), there is another problem. Giants, like Coinbase or Gemini, accept users from limited regions (the U.S. only) with limited fiat currency trading pairs (the United States dollar only). They close the doors to all others, severely limiting price discovery and liquidity, which leads to higher spreads, lower fill rates, higher slippage, and, generally, inefficient markets.
With DEXs, things go even worse.
DEX liquidity is often thin, and prices of digital assets are highly vulnerable to any market fluctuations.
Furthermore, DEX liquidity is expensive and mercenary (i.e., it can be withdrawn at any time by liquidity providers).
Now onto liquidity mining.
What is liquidity mining?
Many resources define liquidity mining as an investment strategy where users (so-called “liquidity providers”) generate some passive income by temporarily lending their crypto assets to a DeFi protocol.
For that, liquidity providers participate in the distribution of trading fees, can stake protocol tokens, and get various extra rewards set forth by a particular liquidity mining program.
While this definition is indeed relevant to liquidity mining, it doesn’t give the whole picture.
To understand more comprehensively what liquidity mining is, we should look at why it was invented.
Why did liquidity mining actually emerge?
The primary purpose of the liquidity mining concept was to propose an alternative to the conventional order-book model of centralized exchanges and eliminate market makers as unnecessary intermediaries in trading.
Fierce proponents of decentralization perceived market makers as non-transparent players that unfairly earned on every trade.
So to make the idea of decentralized finance fly, there had to be a solution enabling automated peer-to-peer trading.
This is how we’ve come to liquidity mining and automated market makers (AMMs).
Now let’s get back to the question of how to define liquidity mining.
First, it is a technological solution for automated P2P digital asset trading. It is the fundamental carrier of DeFi. There is no DeFi without liquidity mining.
And only in the second place can liquidity mining be seen as an investment strategy or an incentive program.
How does liquidity mining work?
Here is how liquidity mining works at a glance:
- A liquidity provider (LP) deposits some amount of a token pair (for example, ETH-DFI or DAI-ETH) to a liquidity pool. The latter means a pool of tokens locked in a smart contract.
- A liquidity pool is usually composed of two tokens that create a market for anyone wishing to exchange between the two. Some protocols, like Balancer, also offer multiple crypto asset pools, though this is not a common practice.
- When liquidity is supplied to a pool, a liquidity provider gets a protocol’s tokens (LP tokens) in proportion to how much liquidity they deposited to the pool. Some protocols allow for staking LP tokens while the liquidity is locked up in the contract.
- Any trade (a swap) facilitated by the pool incurs a fee which is then paid to LPs as per their contribution to the pool. Some liquidity pools pay rewards in multiple tokens.
- When an LP wants to withdraw the liquidity it provided, they burn the LP tokens and get the underlying liquidity plus all accrued fees and incentives they’ve earned by that moment.
If everything goes right, and a liquidity provider doesn’t face impermanent loss (see below what it means), the profits can be pretty sexy.
However, “if” is the keyword here…
What’s wrong with the current model of liquidity mining?
Remember, we mentioned in the beginning that many intensely criticize liquidity mining, and some even say it’s dead?
There are three primary reasons for that:
1. Security issues
There’s been a lot of hacks and scams around Defi liquidity mining.
One of the most popular fraudulent tactics is a “rug pull.”
In essence, scammers create a liquidity pool with a pair of worthless token and a trustworthy one — for example, ETH. With the help of massive promotional activities and promises of crazy rewards, they convince investors to supply ETH to the pool. Sometime later, they would steal all ETH and leave the investors with a bunch of tokens that cost nothing.
2. Volatility issues
High exposure of liquidity providers to the risk of impermanent loss.
The latter means that the liquidity provider will get less dollar value of their liquidity at the time of withdrawal than at the time of deposit.
3. Mercenary nature of capital supplied to liquidity pools.
In simple words, this means that liquidity providers can at any time withdraw their liquidity and dry the pool because they found another protocol with higher yields.
It also means that if a protocol keeps rewarding liquidity miners with a large number of its own tokens, the value of its tokens will surely be diluted.
Furthermore, when liquidity miners leave a protocol, often they would immediately sell the earned tokens and therefore dump their price down.
All these factors dramatically destabilize the whole DeFi sector.
This is why many projects now work towards figuring out new mechanisms that would help make liquidity mining more balanced and valuable for the future development of DeFi.
Liquidity mining — Yellow Network approach
Before diving into the new liquidity mining concept suggested by Yellow Network, here are a few words about Yellow’s overall approach to crypto liquidity and trading.
A few key moments here:
- Yellow believes there must be a unified global trading market for crypto. Market participants shall have one-gate access to all existing crypto liquidity. Also, they should be able to execute global strategies across multiple crypto exchanges with one account, one set of APIs, and one onboarding.
- Such unified trading will enable market participants to seamlessly and safely move and swap digital assets without maintaining reserves on many platforms.
- Traders shall be actively involved in improving the crypto trading ecosystem, motivated to do it in the long term, and get fairly rewarded.
Based on this vision, Yellow Network addresses current crypto liquidity issues from multiple angles simultaneously.
Essentially, here is what Yellow offers to the crypto market:
- The technology that allows aggregating all existing fragmented crypto liquidity in one place by interconnecting exchanges, brokers, pools, and all possible liquidity providers;
- The infrastructure that gives one-gate access to crypto liquidity of multiple independent sources and facilitates fast-speed and cheap multi-chain trading;
- The variety of tools allowing market participants to connect and trade with each other in a safe, cheap, and high-speed manner, and
- Many ways of being engaged in ecosystem development and rewarded for that, regardless of capital amount.
And now we’ve come to the liquidity mining part 🥳.
Yellow’s concept of liquidity mining is way more flexible and multi-optional than the standard DeFi one.
Unlike DeFi liquidity mining, which implies only passive income generation, Yellow’s approach suggests that users actively help the Network by doing work and get rewarded for that.
This is why we believe the term “mining” is more relevant here than in DeFi passive income strategies.
Now let’s dissect how Yellow’s liquidity mining works.
What is a Yellow liquidity miner?
A Yellow liquidity miner is someone who:
a) Supplies the liquidity to the Network for incentives (like classical a classical liquidity provider in DeFi);
b) Moves liquidity around the Network to help Network’s participants make trades on the best-working terms for them (if this sounds unclear, below I’ll give an example); or
c) Does both “a” and “b.”
Now let’s look closer at each of those scenarios.
Scenario 1: Liquidity Provider
Everyone with some liquidity can supply it to Yellow Network and get Yellow tokens.
The tokens will enable participating in the distribution of trading fees and earning some interest through their staking.
In this scenario, the liquidity miner’s role is similar to that in DeFi liquidity mining.
However, there is one crucial differentiating factor:
unlike a standard DeFi liquidity pool, Yellow operates as an overlay mesh network, connecting multiple liquidity sources and market participants.
In other words, Yellow has an entirely different architecture that allows X-time deeper liquidity than on any stand-alone DEX protocol and excludes any risk of rug pulls and other types of scams immanent to DeFi liquidity mining.
Scenario 2: Middleman helping liquidity move around the Network
In this scenario, liquidity mining implies an active role of a miner.
Essentially, a miner is well-connected to different liquidity sources and participants who do not directly communicate with each other but can potentially have a mutual trading interest (i.e., to buy/sell a particular asset).
To understand how it works, let’s jump right onto the example.
Let’s say there is a Broker A who probably doesn’t have enough clients yet on both BUY and SELL sides to match their bids effectively.
Some of Broker A’s clients want to sell BTC but can’t find someone willing to take the other side of the trade at their price. This is where a liquidity miner can help our Broker. The miner will get this SELL liquidity from Broker A at a price best fitting Broker A’s clients.
In exchange, Broker A will reward the miner with fees.
This begs the question: what will the miner do next with the obtained liquidity?
A few possible options here.
The liquidity miner can:
OPTION 1: Keep the liquidity and use it for trading;
OPTION 2: Redistribute liquidity to another Yellow Network participant, i.e., a broker or liquidity miner interested in BUYing BTC at a particular price but struggling to find a counterparty.
For helping such a participant, the miner will again get a fee.
In OPTION 2, the miner makes no money on an asset price change. Instead, they’re rewarded with fees from both BUY/SELL sides for “making the market” for them.
Therefore, by moving liquidity from one participant to another, the liquidity miner, performs the role of the network market maker.
However, unlike classical market making, which implies enormous capital and tough commitments to a platform, the one offered by Yellow Network is easy and flexible.
All you need is to have SOME liquidity and be well-connected to the network participants.
How to get those connections?
Yellow Network offers tools that allow miners to discover available liquidity and non-connected traders interested in it easily.
Sign up for the Yellow Network blog to learn how it all works. We will explain all the mechanics in future articles.
However, if you are impatient and unwilling to wait until the articles come out, join the Yellow Network telegram group and ask anything about liquidity mining.
What are the advantages of liquidity mining with Yellow Network?
The biggest advantage of Yellow’s liquidity mining concept is that it’s flexible and allows users to define how exactly they want to capitalize on crypto liquidity and what degree of risk they are willing to take.
As mentioned, a user can make money on liquidity provision, trading, market-making activity, and/or combining any of those tactics.
- No extensive capital is required.
- Safe infrastructure. The architecture of Yellow Network excludes any possibility of standard DeFi liquidity mining scams.
- One-gate access to global crypto liquidity aggregated from multiple exchanges and brokers.
Liquidity mining is definitely not dead.
Like anything in crypto, it’s just a new concept that needs further development and improvement.
As we all know, the crypto industry is the fastest to progress. And Yellow Network is among those industry players strongly committed to driving this progress.
Learn Web3 with Yellow Network. We can’t wait to see you driving this movement!
- Check out OpenDAX v4 cryptocurrency exchange software stack on GitHub
- Follow Yellow Twitter
- Join the public Yellow Network Telegram
Stay tuned as Yellow Network unveils new developer tools, brokerage nodes stack, and community liquidity mining software!