Summary

Liquidity mining refers to the practice of users leveraging their personal cryptocurrency assets to earn passive income or gains. Typically, in exchange for rewards, liquidity miners provide liquidity to DeFi protocols or lend or pledge their cryptocurrency assets. Some liquidity miners will adopt the above practices at the same time. As with all cryptocurrency investment opportunities, yield mining comes with risks. Liquidity miners face risks such as impermanent losses, smart contract or protocol vulnerabilities, and excessive gas fees.

Therefore, miners must conduct in-depth research before investing funds in liquidity mining. Common research methods include investigating the project team, security, token type, and timelines associated with the investment. While doing your own research (DYOR) won't completely prevent you from losing cryptocurrency, it can help reduce your risk.

Introduction

The simplest liquidity mining uses idle encryption Monetary assets to earn cryptocurrency interest. Relying on smart contracts, holders can lend their cryptocurrency to others and receive returns. In the decentralized finance (DeFi) ecosystem, users can earn cryptocurrency income through several methods, the most common of which are:

1. Lend assets using cryptocurrency lending protocols.

2. Pledge cryptocurrency to a protocol.

3. Become a liquidity provider (LP) of a DeFi protocol (such as a decentralized exchange (DEX)) and earn LP rewards (see the LP token section).

Many liquidity miners will use one or more of the above methods to build a passive income stream . However, like other DeFi investment opportunities, liquidity mining comes with risks. Whether you plan to become a liquidity miner or are simply interested in the mechanics of liquidity mining, it is necessary for you to conduct due diligence.

Risks of liquidity mining

Impermanent loss

Impermanent loss may be the most prominent risk in liquidity mining and even the entire DeFi field. When cryptocurrency holders participate in liquidity mining, they typically lock up their cryptocurrencies for a period of time, reducing the liquidity of these assets.

Impermanent losses will occur if the price of the tokens held changes compared to the price when deposited into the fund pool. No matter which way the price goes, the bigger the change, the bigger the loss.

Although liquidity mining gains can offset this part of the loss, this is not always the case, and liquidity miners may face uncertainties. Significant risk of loss. For more information, please see our help article "In-Depth Interpretation of Impermanent Loss".

Hacker attack

Since smart contracts are responsible for controlling DeFi protocols, if there is a vulnerability in the smart contract code, it may cause the value of the corresponding token to plummet to zero. This risk will be exacerbated if hackers exploit this vulnerability or security issue to maliciously manipulate the project.

Fraud

A bad actor with the right skills can create a DeFi platform and pass it off as a legitimate liquidity mining site. After all, DeFi projects are open source, transparent, and permissionless, that is, anyone can copy the underlying code and create a new project. While early adopters often get richer rewards, please think twice before participating because high rewards come with high risks.

For newly launched liquidity mining platforms, research may be difficult as relevant user reviews and information are often limited. higher. You need to be especially cautious with such platforms, as if you change your mind after investing your cryptocurrency holdings in such a platform, you may not be able to withdraw money or claim your rewards.

Fuel cost is too high

Usually In this case, network congestion will lead to higher fuel costs. This unprecedented price surge affects liquidity miners who have less capital to invest, as the revenue they earn may not be enough to cover gas fees. Even if they choose to park their assets in a pool, other risks such as impermanent losses and forced liquidations may still affect them.

Common DYOR methods

Security type

Ensuring the security of liquidity mining and DeFi protocols is crucial to preventing malicious attacks. To reduce the risk of such attacks, liquidity miners must ensure that the smart contract code has been audited by a trusted source, i.e. look for DeFi projects that have had their smart contracts fully audited.

Countless DeFi projects such as UniSwap originated from successful DeFi protocol forks. However, there are also many DeFi projects that fail due to network effects or lack of liquidity. To make matters worse, some projects are even deliberate scams. For example, a fraud team might create a fork to attract liquidity and then disappear with the newly absorbed tokens.

In addition, it is also important to understand the total value locked (TVL) of the project, which refers to the total amount currently locked in the protocol . If the TVL metric is suspiciously low, it indicates that less funds are currently locked in the protocol, which in turn means that liquidity miners can earn less.

Token

Different pools offer different investment opportunities in a variety of assets, including stablecoins and blue-chip tokens (i.e. tokens from established blockchain projects such as Bitcoin and Ethereum). Protocols can also allocate their own tokens to stakers and liquidity providers.

It is important to keep in mind that protocols can apply their tokens to services in a variety of ways. For example, a protocol could use its token as a marketing strategy to attract more users. Therefore, you need to always be clear about the coins you will receive from liquidity mining.

Timeline

To increase liquidity, new DeFi protocols tend to offer richer rewards to early adopters. This reward also acts as a risk incentive, motivating users to earn high rewards by investing in and using new or untested products or services.

However, while early adopters may earn greater returns, they may also face high risks, namely liquidity Risk that the mining protocol may fail. In this case, the money and time invested may not be recovered.

Liquidity miners should carefully weigh their options, taking all factors into consideration with other opportunities. Since token prices may fall due to inflation, new DeFi protocols are unable to provide consistently high rewards to miners in the long term, especially if they use native tokens as the reward currency.

Team

At When browsing project information, please pay attention to major liquidity mining websites for errors. If there are errors, it indicates that the team may be careless or even have fraudulent intentions. Ideally, your website should be well designed, have no typos or broken links, and look professional. Additionally, you can check whether the project team undergoes regular audits by an external independent auditor to assess whether the team is reliable.

A healthy and balanced project team should be composed of entrepreneurs, product managers, developers, software engineers, marketing specialists and financial experts composition. It would be even better if there are also well-known consultants on the project board.

If possible, you can also conduct research on individual team members. First, check their social media accounts to understand their past achievements and activity on platforms such as LinkedIn, GitHub, Reddit, TradingView, and YouTube.

How they interact on social media can demonstrate their skills, experience, and influence. Generally speaking, established teams with good reputations are less likely to commit scams.

Conclusion

Liquidity mining can be a viable passive income strategy for users who are good at effective risk management. However, given the high volatility of liquidity mining and the cryptocurrency market as a whole, developing a reliable liquidity mining strategy requires both vigilance and a lot of time and effort.

If you are considering participating in liquidity mining, the above methods can be used to reduce risk. Additionally, you should conduct thorough research and due diligence before investing in any financial opportunity.

Extended reading

• Decentralized Finance What exactly is liquidity mining in (DeFi)?

• "Decentralized Finance (DeFi) Beginner's Guide"

• Beginners using cryptocurrencies to earn passive income Guide

• Why and how to do your own research (DYOR) when investing in cryptocurrencies

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