Liquidity mining is a DeFi mechanism where users provide their crypto token holdings to DEXs (decentralized exchanges) and receive LP tokens (liquidity pool tokens) in return. As part of the exchange, the LP tokens are used to calculate a reward based on the fees accumulated by the pool which is divided among all the LP token holders.
After some time, the user can exchange the LP tokens for their assets inside the liquidity pool. Once this is done, the fees accumulated by the pool are also redeemed, these are based on the amount of liquidity provided proportional to the total inside the pool. Also, the fees generated depend on how often people use the pool to swap tokens, popular token pairs generate more fees for the liquidity providers.
Users looking to borrow funds access these DeFi platforms and liquidity pools and pay an interest fee.
There is a trade-off between providing liquidity and the popularity of a pool. Pools that have a large number of liquidity providers and popular token pairs provide small fees. On the other hand, pools that are small with relatively unknown tokens and few liquidity providers give high reward fees. The latter is contingent on the pool being used, if no one is using the pool no fees are generated.
This means liquidity providers have to constantly weigh the size and popularity of the pool versus the rewards it can potentially offer.
A DEX cannot operate without users adding liquidity to the different pools and token pairs. That’s why the DEX is willing to split the fee rewards with the liquidity providers and attract more into a pool.
The share of the pool owned by a single liquidity provider is what’s used to calculate rewards. So, to understand the revenue, a user has to multiply the percentage owned by the individual pool by the amount of fees generated in a period. This gives an estimate of the gains when providing liquidity.
This is only an estimate since a pool can become more active in the future. If a pair of tokens sees a lot of trading then the amount of fees generated will also increase. There is a timing component to liquidity mining, as users can gain more fees when they provide tokens to pools not yet popular but with the potential to become popular shortly.
The balancing act between the two poles determines the success of a liquidity provider. It’s important to constantly check the performance of a pool and search how other pools are performing. Allocating assets accordingly will maximize the returns.
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