We’ve got quite a number of articles now, so we’re going back over certain topics with more information/more thorough explanations. This weeks topic is Liquidity Mining, Yield Farming, AMM (Automated Market Makers)
There is an incredible amount of money to be made in crypto. If you own crypto and aren‘t earning interest on it, you‘re leaving money on the table. When even the most uninformed of people make exponential returns on their investments, it (rightfully so) raises a lot of red flags for outsiders. Where does it come from?
Liquidity mining is only one method of putting your money to work. There’s a million other topics we could cover but I don’t want to make this one too long 😉
What is Liquidity Mining?
Liquidity mining is a feature of certain exchanges (AMM). You deposit 2 different tokens and you earn a profit from the exchange fees collected, as well as some handouts like governance tokens.
How do Exchanges Work?
Before we get into how liquidity mining works, we should discuss exchanges in general. There are traditional exchanges, like the stock market that some may be familar with. You need one to buy and sell shares of stock. There are centralized exchanges for cryptocurrency as well (Coinbase). These work very much like the stock market. Cryptocurrency is special though because there‘s an alternative. It introduces the concept of decentralized exchanges (DEX).
When you buy something on a centralized exchange you go through a broker. The broker has the connections you need to find someone looking to sell what you’re wanting to buy (electronically, this is done with a matching engine). Then they take their fee somewhere in there for providing you with that service. This is centralized because you rely on this broker in order to trade. If you wanted to buy shares of Google stock without a broker, you’d walk door to door asking your neighbors. Even if you found someone to trade, you don’t have too many options to get the best price. A broker can limit what you can do with your assets if they wanted to. They could also charge you unreasonable amounts of fees if they think they could get away with it.
Decentralized exchanges are built using smart contracts. The centralized method of matching buyers and sellers is unfeasibly expensive to run on the blockchain, where computational power needs to be conserved (This has been achieved but is not common).
When you buy a token from a DEX like Uniswap, you are talking directly to a smart contract instead of a broker. The smart contract uses an algorithm to determine how much you should pay vs what assets it has stored in it’s liquidity pool. This is the automated market maker (AMM).
Liquidity Pools and Liquidity Mining
To facilitate trades between users in a DEX, the AMM smart contract manages liquidity pools. Liquidity pools are exactly as they sound: big piles of different tokens. Where do these tokens come from? People just like you!
By depositing 2 tokens in equal amounts together in a DEX liquidity pool, you are making it possible for people to trade assets. Users pay small fees for on every trade and that money goes towards you, the liquidity provider, proportionally to the amount of money you’ve deposited. Earning from these fees is called Liquidity Mining (and is a form of earning yield, so thus Yield Farming).
It’s also common for DEX to distribute additional rewards to liquidity providers. This can often be in the form of governance tokens. The idea behind this is that the people with money invested in the DEX should get a proportional amount of “governance tokens“ representing their say in future decisions/changes to the DEX.
How This Returns Profits to the Users
The decentralization of DEXs like uniswap completely changes the economics vs the centralized model. There are no brokers as middlemen who’s best interest is charging you high fees. There are no people involved in market making, it’s completely algorithmic.
Liquidity miners can really “set it and forget it” by earning passive income on their assets. Anyone who wants to withdraw can still do so at any time (although your assets may be a little mixed around)
DEX and AMM are very complex subjects (like a lot of other decentralized services). This is getting to be pretty long, so part 2 will have to discuss more about how to put your crypto into liquidity pools.