Author: Gate.io Researcher: Charles. F
Following the rise of DeFi, liquidity mining has become a hot form of
investment in the cryptocurrency world. Where does liquidity mining come
from, how are the returns generated from liquidity mining, what risks
do you need to face, and what are the advantages of liquidity mining
projects led by centralised exchanges? This article will provide answers
to these questions that investors must know before making a liquidity
The History of Liquidity Mining
Mining first became well-known in mid-2020. With the application of
blockchain technology to decentralised financial products, an increasing
number of cryptocurrency investors got familiar with it. In turn, the
term “liquidity mining” was used by the developers of Hummingbot, an
automated trading contract, at the beginning of 2020. In the original
setup of the Hummingbot developers, liquidity mining was a product
providing funding (token) liquidity for automated transactions.
the whitepaper, “Liquidity Mining”, published by the Hummingbot team,
liquidity mining is described as a service mechanism similar to PoW
mining. In a blockchain product that uses PoW as a validation mechanism,
the miner uses electrical energy and applies its own arithmetic power
to validate operations on the blockchain, making the blockchain
constantly applicable. In blockchain products with liquidity mining,
participants provide token liquidity to the blockchain product by
pledging their own token holdings. Typically, liquidity mining is used
in DeFi projects, which are essentially smart contracts. The vast
majority of financial transactions and actions running under DeFi rely
on the predefined rules of the DeFi contract, eliminating the need for
brokers and proxy orders. In other words, there are no trading agents
like human market makers in the DeFi project. All financial actions
depend on fixed rules. Whenever a transaction involves a financial
asset, liquidity issues have to be addressed.
instance, there is a currency trading pair, UNI/USDT, on an automated
trading platform. To exchange USDT for UNI, a user must find a suitable
counterparty willing to accept USDT and pay UNI at the rate offered by
the user. However, finding a suitable counterparty is a tedious task. It
requires the user to ask potential counterparties one by one. If each
user had to consult all the other potential counterparties about their
willingness to trade, it would cause a great time consumption, and the
user may fail to conduct trade in time or even cannot start a trade. The
reason why market makers have emerged is to solve such a problem.
constantly acting as a counterparty to bilateral user trades, market
makers receive user orders and facilitate conducting trades. In a
centralised exchange, a market maker is a qualified institution. In
decentralised financial products, on the other hand, market makers are a
class of trading rules and therefore also named automated market makers
(AMMs). The rules vary from DeFi market makers to market makers, but
the general approach is to solve the problem of users finding
counterparties by siphoning off the currency and creating currency
liquidity pools. And it was liquidity mining that provided currencies to
the currency liquidity pools.
taking UNI/USDT as an example. Investors can choose to mine this
trading pair, that is, deposit their own UNI and USDT holdings into the
liquidity pool. When someone makes a transaction to exchange UNI for
USDT on this automated trading platform, the platform will automatically
siphon off their UNI and withdraw the ETH provided by the liquidity
provider from the UNI/ETH pool.
the explosion in the DeFi project in 2020, now the application of
liquidity mining has been extended. Liquidity mining appears not just in
decentralised exchange applications but also in lending contracts (such
as Compound) and other contracts.
the different project properties, the nature and operating approaches
of liquidity mining on DeFi projects are essentially the same.
Where do the earnings come from?
(also known as liquidity providers, LPs) who conduct liquidity mining
do not pledge their digital currency to a platform without compensation.
The platform must pay the appropriate compensation as the liquidity
miners’ earnings. Decentralised trading platforms pay the miners
transaction fees and collateralised lending platforms pay interest on
loans to miners. At the same time, miners who conduct liquidity mining
can redeem the trading pairs they have invested in at any time without
having to lock up their positions. The collateralising and lending
platform will pay the loan interest to the miners.
Risks of liquidity mining
losses are the most common losses in liquidity mining. Each time
liquidity mining is performed, users have to invest in two digital
currencies. When users unlock their currencies, the relative proportion
and total value of the unlocked currencies may change, even though what
they unlock are still both currencies. In some cases, it will be more
profitable to hold the currency directly than to put it into a liquidity
pool. The difference between the two choices is named the Impermanent
Loss. Impermanent losses are usually unavoidable, but the income
layering provided by the platform provider to liquidity investors
usually substantially exceeds the impermanent losses. Therefore, users
can still earn a higher return by liquidity mining than by holding a
Image: Impermanent Loss Function
Project security risks
mining comes with decentralised financial projects. The vast majority
of liquidity mining relies on decentralised financial projects. Compared
to centralised financial projects, decentralised financial projects are
generally small, technically weak and vulnerable to attack. In the
past, when people discussed liquidity mining risks, they focused more on
impermanent losses, assuming that the DeFi project with the liquidity
mining would function constantly and properly. In reality, however, DeFi
projects are inherently exposed to a relatively high risk of
operational anomalies. According to PeckShield, there were 43 DeFi
security incidents in merely the first quarter of 2021, causing losses
of over $612 million, a 94% year-over-year increase.
Three common forms of attacks in DeFi projects: oracle attacks, re-entrancy attacks, and code attacks
Image: Potential Attack Forms in DeFi projects
Source: the author
discussing oracle attacks, several concepts need to be explained in
advance. One is oracle. The vast majority of DeFi contracts do not have
access to the price information on digital currencies besides their own
contracts but require another protocol to hand over external price
information. An oracle is a protocol responsible for importing digital
currency price information. Another one is flash loans. Flash loan is a
form of lending without collateral and allows users to lend large
amounts of funds quickly and without collateral. However, the lender is
required to return the loan to the borrower in the same transaction.
the other hand, an oracle attack is an arbitrage attack in which an
attacker tampers with the oracle’s quotes and interferes with the
applications of other DeFi projects.
this type of attack, the attacker usually uses a flash loan to obtain a
large amount of currency from other projects, performs various
financial operations in DeFi projects, and uses the altered price
information to achieve arbitrage. Valley, Cheese Bank, and Wrap Finance
have all been subject to oracle attacks.
contracts enable the invocation of internal and external contract
functions. During the invocation, the attacker can tamper with the
content and parameters of the contract and enables the recipient of the
invoked function to perform the behaviour set by the attacker.
Re-entrancy attacks are more damaging and cause a loss on a larger scale
than oracle attacks. A re-entrancy attack can easily steal all assets
within a contract. Projects such as Akropolis and OUSD have been subject
to re-entrancy attacks and have suffered massive losses.
attacks are also called contract vulnerability attacks or code
vulnerability attacks. An attacker takes advantage of a vulnerability in
the code left by the project developer to attack the contract. One
common type of code attack is to exploit a vulnerability in a contract,
extract liquid currency from the liquidity pool of the contract, and
finally cause the contract to be frozen. UNISWAP, the largest
decentralised exchange, was subject to a code attack in which attackers
stole 1,278 ETH with a code vulnerability in this exchange.
risk of project losses is more costly to investors than the risk of
impermanent losses. Impermanent losses make liquidity miners lose a
portion of the earnings they deserve, while project losses are likely to
make liquidity miners earn nothing. Therefore, the project security
risk of liquidity mining is the biggest risk investors face when they
undertake liquidity mining.
Gate.io Liquidity Mining Project Advantages
has always taken security as the core of its services. It is ranked
second in security by a third-party security testing laboratory that has
tested the security of 100 cryptocurrency exchanges around the world.
Relying on a highly secure platform for liquidity mining investments,
investors can effectively avoid project risks and increase the
steadiness of their returns.
applies an automated market maker approach to liquidity mining similar
to UNISWAP V2. Compared to UNISWAP V2, however, Gate.io has a much
higher trading volume, which means that the Gate.io platform is able to
provide more transaction fee revenue allocated to liquidity providers.
Richer Portfolios of Assets
not only serves as a simple cryptocurrency trading platform, but also
offers a wide range of cryptocurrency-related financial services and
financial products. Taking advantage of the feature that liquidity
mining can be exited at any time, investors can exploit the services and
products offered by Gate.io to dynamically adjust their portfolios and
investment solutions, so that they can save the extra time and capital
costs of trading across platforms. For example, when the market becomes
increasingly volatile and impermanent losses rise, investors can
withdraw the currency deposited into the liquidity mining pool at any
time for volatility arbitrage. On the contrary, when the market moves
smoothly and currency prices are stable, investors can inject their own
currency holdings into the liquidity mining pool to earn excess returns.
Considerate and Thoughtful Guidelines
mining on a decentralised project requires a lot of preparation from
investors, which is cumbersome and requires investors to calculate their
own expected returns. However, Gate.io offers investors an easy way to
invest in liquidity mining products. Once users follow the guidelines,
they can pledge and unlock currencies for liquidity mining. Gate.io has
also designed an impermanent loss daily return ratio to quantify the
impermanent loss compensation cycle. Please go to the Gate.io
announcement, “Gate.io Launches BTC, ETH, UNI, SHIB, DOGE, GT, FIL, LTC, XRP, DOT and ETH-BTC Liquidity Mining,” for details.
The Setting of a Reward Pool
will set up a reward pool as part of the initial implementation of
liquidity mining, based on its own financial strength. Users who
participate in the pool will receive additional rewards besides the
regular fees. At present, GT/USDT, BTC/USDT and ETH/USDT trading pairs
are the first to open a reward pool. Users will receive 100% of the fees
and an additional share of the bonus pool GT. 200 GT per day for 7 days
will be paid to users as the first liquidity bonus. The overall
annualised rate of return could reach 50%, as estimated conservatively.
1． Gate.io Help Center: FAQs for AMM Liquidity Pool
2． Gate.io Cryptopedia: How to Obtain Liquidity Mining Earnings?
Author: Gate.io Researcher: Charles. F
* The article only represents the researcher’s views and does not constitute any investment advice.
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