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What exactly is liquidity mining in decentralized finance (DeFi)?
2023-11-18 22:51 Update

Liquidity mining is a method of earning more digital currency through the digital currency you hold. It lends your funds to others through "smart contracts," magical computer programs. In return for your services, you will earn fees in the form of digital currency. Pretty simple, isn't it? But it’s not really that fast.

Liquidity mining miners use very complex strategies. They are constantly moving cryptocurrencies between different lending and borrowing markets to maximize returns. They will also keep the best liquidity mining strategies secret. why? Because the more people who know about a strategy, the less effective it will be. Liquidity mining can be thought of as the wild west of decentralized finance (DeFi), where farmers only have a chance to grow the best crops by competing with each other.

Do you find it interesting? Read on to read more.


  • Introduction
  • What is liquidity mining?
    • What gave rise to the boom of liquidity mining?
  • What is Total Value Locked (TVL)?
  • What is the principle of liquidity mining?
  • How to calculate the income from liquidity mining?
  • What is collateral in DeFi?
  • Risks of Liquidity Mining
  • Liquidity Mining Platforms and Protocols
    • Compound Finance
    • MakerDAO
    • Synthetix
    • Aave
    • Uniswap
    • Curve Finance
    • Balancer
  • Summary


Decentralization Financial (DeFi) activities have always been at the forefront of technological innovation in the blockchain field. What is unique about DeFi applications? Such applications require no permissions and can be interacted with by anyone (or any product, such as a smart contract) with an internet connection and a supported wallet. Additionally, DeFi applications typically do not require trust in any custodians or middlemen. In other words, they are trustless applications. So, what new use cases can these properties enable?

There are many emerging concepts currently emerging, and liquidity mining is one of them. This is a new way to earn rewards on your digital currency holdings using permissionless liquidity protocols. It allows anyone to earn passive income using the "Money Legos" decentralized ecosystem built on Ethereum. Therefore, liquidity mining may change the way investors hold digital currencies in the future. Since digital currency assets can be used to generate money, why leave them idle?  

So, how do liquidity mining miners mine? What kind of output do they expect? If you plan to become a liquidity mining miner, where should you start? We will explain all these concepts in this article.

What is liquidity mining?

Yield farming, also known as "liquidity mining" in Chinese, is a method of generating rewards through the digital currency held. Simply put, this means locking up cryptocurrencies and receiving rewards.

In a sense, liquidity mining can be compared with staking. However, the backend of liquidity mining is very complex. In many cases, it works with users called liquidity providers (LPs), who are responsible for injecting funds into liquidity pools.

What is a liquidity pool? It is basically a smart contract that holds funds. Liquidity Providers (LPs) inject liquidity into the fund pool and receive rewards in return. This reward may come from fees generated by the underlying DeFi platform or other sources.

Some liquidity pools pay out rewards in multiple tokens. These reward tokens can subsequently be deposited into other liquidity pools to continue to receive rewards, and the cycle continues. As I’m sure you’ve learned, even extremely complex strategies can come to light very quickly. The basic idea is that liquidity providers inject funds into liquidity pools and receive returns from them.

Liquidity mining is usually done using ERC-20 tokens in Ethereum, and rewards are usually issued in the form of some kind of ERC-20 token. However, things may change in the future. Why do you say that? Because currently most of this activity occurs in the Ethereum ecosystem.  

But cross-chain bridges and other similar technological innovations may push DeFi applications to break through the limitations of specific blockchains in the future. This means that they can run in other blockchains that support smart contract functionality.

Liquidity miners usually frequently transfer funds between different protocols in order to obtain high returns. Therefore, the DeFi platform will also provide other economic incentives to attract more capital into the platform. As with centralized exchanges, liquidity often brings more liquidity.

What gave rise to the boom of liquidity mining?

Users’ sudden strong interest in liquidity mining may be due to the launch of COMP token (the governance token of the Compound financial ecosystem). Governance tokens grant governance rights to token holders. However, if you want the network to be as decentralized as possible, how should these tokens be distributed?

Distributing governance tokens according to algorithms through liquidity incentives is usually a common method to start a decentralized blockchain. This method can attract liquidity providers to provide liquidity to the protocol and carry out "mining" of new tokens.

Although Compound did not propose liquidity mining, the launch of COMP made this model of token distribution model very popular.  Since then, other DeFi projects have come up with innovative plans to attract liquidity to their ecosystems.

What is Total Value Locked (TVL)?

What is a good way to measure the overall health of DeFi liquidity mining? The answer is "Total Value Locked (TVL)". This metric measures the amount of digital currency locked in DeFi lending and other money market types.

In a sense, the total locked value (TVL) is the total amount of liquidity in the liquidity pool. This indicator can effectively measure the overall health of the DeFi and liquidity mining markets. It can also be used to effectively compare the "market share" occupied by different DeFi protocols.

To track Total Value Locked (TVL), please visit Defi Pulse. Here you can see which platforms have the highest number of Ethereum or other digital currency assets locked in DeFi. Based on this, you can roughly understand the current status of liquidity mining.

Of course, the more value locked, the more liquidity mining is going on. It’s important to note that you can measure TVL in ETH, USD, or even BTC. Each method will provide you with a different outlook analysis on the state of the DeFi money market.

What is the principle of liquidity mining?

Liquidity mining is closely related to the automated market maker (AMM) model, which usually involves liquidity providers (LP) and liquidity pools. Let's take a look at the principles behind it.

Liquidity providers are responsible for injecting funds into the liquidity pool. The pool provides funding for a marketplace platform where users can lend, borrow or exchange tokens. Using these platforms generates royalties, and liquidity providers are compensated for their share. This is the basis on which automated market makers (AMMs) operate.

However, there may be big differences in actual use, not to mention that this is a new technology. There is no doubt that we will see many more ways to improve upon the current foundation.

In addition to handling fees, another reward for injecting funds into the liquidity pool is to obtain new tokens. For example, some tokens may not be available for purchase in small amounts on the open market, but can be accumulated by providing liquidity to a specific fund pool.  

Token distribution rules will depend on the unique implementation of the protocol. But all in all, liquidity providers are rewarded based on the amount of liquidity they provide into the pool.

Although not a regular requirement, funds deposited are typically in stablecoins pegged to the U.S. dollar. The most commonly used stablecoins in DeFi include DAI, USDT, USDC and BUSD, etc. Some protocols will mint their own tokens to represent the digital currency deposited by users in the system. For example, if you deposit DAI into Compound, you can get cDAI (Compound DAI); if you deposit Ethereum into Compound, you can get cETH.

As you can imagine, there can be multiple complexities with this approach. You can deposit cDAI to another protocol, which mints a third token to represent the cDAI used to represent DAI, and so on. The chain of funds can become very complex and difficult to trace.

How to calculate the income from liquidity mining?

Usually, the income from liquidity mining is calculated on an annual basis. This will give you an estimate of the expected profit you can expect to make over the course of a year.

Commonly used metrics are Annual Percentage Rate (APR) and Annualized Yield Ratio (APY). The difference between them is that APR does not consider the impact of compound interest, while APY does. In this case, compounding means reinvesting profits directly to generate more returns. However, please note that the terms APR and APY may be used interchangeably.

It should also be noted that these two values are only estimates and predictive indicators. Even short-term gains are difficult to estimate accurately. why? Because liquidity mining is a highly competitive and fast-paced market, its returns can fluctuate rapidly. If the liquidity mining strategy is effective, many miners will seize the opportunity, and the influx of large miners may cause high yields to decline rapidly.  

Since APR and APY are both products of the traditional market, DeFi may need to find its own indicators to calculate returns. Given the rapid development of DeFi, it may be necessary to calculate weekly or even daily returns.

What is collateral in DeFi?

Normally, if you choose to borrow assets, you must provide collateral to secure the loan, which essentially provides insurance for the loan. What's the connection? It depends on the agreement that receives the funds you borrow, but you have to pay close attention to the mortgage rate.  

If the value of the collateral falls below the threshold specified in the protocol, the position may be forced to be liquidated in the open market. How can you avoid forced liquidation? You can add more collateral.

It needs to be reiterated that each platform has specific rules for this, that is, it sets a platform-specific mortgage rate. Additionally, they are often used in conjunction with the concept of so-called "overcollateralization." This means that the borrower must deposit collateral worth more than what is being borrowed. Why is this? This is to reduce the risk of a vicious market collapse leading to the forced liquidation of a large amount of collateral in the system.

So, let’s say you’re using a lending agreement that requires a mortgage rate of 200%. This means that for every $100 worth of collateral you put in, you can simultaneously borrow $50. However, to further reduce the risk of forced liquidation, it is often safer to add more collateral than the required amount. Having said that, many trading systems will use very high collateralization rates (such as 750%) to control the forced liquidation risk of the entire platform to a relatively safe state.

Risks of Liquidity Mining

Liquidity mining is not simple. The most profitable liquidity mining strategies are very complex and are only recommended for advanced users. In addition, liquidity mining is generally more suitable for individuals or organizations with large amounts of capital at their disposal (i.e. whales).

Liquidity mining is not as easy as it seems, and if you do not fully understand your trading strategy, you are likely to suffer losses. We have just discussed the risk of collateral liquidation. So what other risks do you need to be aware of?

An obvious risk in liquidity mining is smart contracts. The nature of DeFi means that many protocols are built and developed by small teams with limited budgets. This increases the risk of smart contract vulnerabilities.

Even large protocols that are audited by reputable auditing firms have security holes and problems all the time. Due to the immutable nature of blockchain, users can lose large amounts of money. Therefore, you must consider the above risks when locking funds in smart contracts.

In addition, the biggest advantage of DeFi is the combinable operating ideas, but this also contains huge risks. Let’s see how it affects liquidity mining.

As we discussed before, DeFi protocols are permissionless and can integrate seamlessly with each other. This means that the entire DeFi ecosystem relies heavily on each building block. When we say these applications are  composable , we mean that they can work together easily.

Then why do you say this is a risk? Because once one of these building blocks fails to work as expected, the entire ecosystem can be disrupted. This will bring great risks to miners and liquidity pools. Not only do you need to trust the protocol you’re depositing funds into, but you also need to trust all other protocols that protocol may rely on.

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Liquidity mining platform and protocol

How can you earn income through liquidity mining? ? There is currently no fixed method of liquidity mining. In fact, the strategy for liquidity mining may change hourly. Each platform and strategy will have its own rules and risks. If you decide to start liquidity mining, you must become familiar with how decentralized liquidity protocols work.

Now that we understand it, the basic idea is that users deposit funds into a smart contract and earn rewards in return. However, various situations will be encountered in the specific implementation process. Therefore, it is not wise to blindly deposit your hard-earned funds in the hope of getting high returns. The basic rule of risk management is that you must always control your investment situation.

So, what is the most popular platform among miners? We have put together a collection of platform protocols here, these are not an exhaustive list, but these protocols are at the core of a liquidity mining strategy.

Compound Finance

Compound is an algorithmic money market that allows users to lend and borrow assets. All Ethereum wallet holders can inject assets into Compound’s liquidity pool, and the rewards earned will start compounding immediately. Interest rates will be adjusted algorithmically based on supply and demand.

Compound is one of the core protocols of the liquidity mining ecosystem.


Maker is a decentralized credit platform that supports the creation of DAI, which is a A stablecoin algorithmically pegged to the value of the U.S. dollar. Anyone can open the Maker Vault and lock collateral assets such as ETH, BAT, USDC or WBTC. They can generate DAI as a loan against the collateral locked against them. The loan accrues interest over time, called a stability fee, which is determined by MKR token holders.

Liquidity mining miners can use Maker to generate DAI for liquidity mining strategies.


Synthetix is a synthetic asset protocol. It allows everyone to lock (stake) Synthetix Network Tokens (SNX) or Ethereum as collateral and mint the corresponding synthetic assets. What do synthetic assets include? In fact, any asset with a reliable price source can be included. Therefore, almost any financial asset can be added to the Synthetix platform.

Synthetix may allow all asset classes to be used for liquidity mining in the future. Are you looking to use long-term value storage in your liquidity mining strategy? Synthetic assets may be ideal.


Aave is a decentralized lending and borrowing protocol. Interest rates will be adjusted algorithmically based on current market conditions. In return for lending funds, the lender receives "aTokens". These tokens start accruing interest immediately upon deposit and create compound interest. Aave also supports other more advanced functions, such as flash loans.

As a decentralized lending protocol, Aave is widely used among liquidity mining miners.


Uniswap is a decentralized exchange (DEX) protocol that can implement trustless Token exchange. Liquidity providers can create markets by depositing two tokens of equal value. Thereafter, traders can trade with the liquidity pool. In return for providing liquidity, liquidity providers earn fees from trades conducted by their pools.

Uniswap’s frictionless properties make it one of the most popular trustless token trading platforms. This property may work well for a liquidity mining strategy.

Curve Finance

Curve Finance is a decentralized platform designed for efficient exchange of stablecoins Transaction Agreement. Unlike other similar protocols such as Uniswap, the Curve protocol allows users to exchange high-value stablecoins with relatively low sliding spreads.

As you can imagine, due to the large number of stablecoins in liquidity mining, the Curve mining pool is a key component of the infrastructure.


Balancer is a liquidity protocol similar to Uniswap and Curve. However, the key difference is that it supports the allocation of custom tokens in liquidity pools, allowing liquidity providers to create custom Balancer pools instead of a 50/50 split like Uniswap requires. Just like Uniswap, liquidity providers can also earn commission income from transactions that occur in their own liquidity pools.

Balancer is an important innovation in liquidity mining strategies because it brings flexibility to the creation of liquidity pools. is a decentralized aggregate business ecosystem for Provide loan services for Aave, Compound and other protocols. It aims to optimize the lending of tokens by algorithmically finding the most profitable lending services. Funds are converted into yToken immediately upon deposit and then rebalanced regularly to maximize profits. is very useful for miners who want to automatically select the best strategic trading protocol.


Now, we have learned about the latest craze in the digital currency field - liquidity Mining.

What else can this decentralized financial revolution bring? We cannot predict what new applications will be born based on these existing components in the future. Nonetheless, trustless liquidity protocols and other DeFi products are undoubtedly at the forefront of digital currency economics and computer science.

There is no doubt that the DeFi money market will help build a more open and accessible financial system that can be used by any user who can connect to the Internet.

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