What is Liquidity Farming?

BeginnerNov 21, 2022
Liquidity Farming is a new trend in Decentralized Finance (DeFi), which enables crypto investors to fully utilize their crypto assets and obtain high returns.
What is Liquidity Farming?

The History of Liquidity Farming

Glossary

Pros & Features

Cons & Risks

How to Participate in Liquidity Farming?

Future Outlook & Conclusion


Liquidity Farming is a way to gain interest based on the amount of cryptocurrencies staked by providing liquidity to a blockchain. Before the advent of Decentralized Finance (also known as DeFi), you had only three ways to obtain cryptocurrencies: you could purchase hardware that provides computing power to participate in PoW networks, stake cryptocurrencies to PoS networks, and buy from exchanges.

The application of smart contracts on Ethereum contributed greatly to the development of decentralized exchanges (also known as DEX). With the code running automatically on the blockchain, users can deploy their own crypto assets in the fund pools, providing liquidity and earning transaction fees and reward tokens. Liquidity Farming is an important milestone in the development of decentralized finance. It not only opens up new income streams for participants but also quickly and efficiently meets people's needs for transactions between different tokens. Liquidity Farming has injected a lot of energy into the market, leading the DeFi summer in 2020.



The History of Liquidity Farming


The term Liquidity Farming can be traced back to October 2019. The development team of Hummingbot (an open source automated trading program) pointed out in their white paper and blog post that most cryptocurrencies are facing the problem of lacking liquidity, and proposed to reward users who place orders as a means to narrow down the bid-ask spread and increase trading volume and token circulation. The Hummingbot team achieved great success in several experimental coins. Only a dozen of participants can create a trading volume comparable to that of professional market makers, and participants were paid well for providing liquidity.

However, the currently well-known Liquidity Farming mechanism may be first proposed by Synthetix, a synthetic asset protocol on the Ethereum blockchain. The way to participate is to pledge SNX tokens in the Synthetix protocol in exchange for sUSD, which will then be used to buy sETH. Then put the same amount of ETH into the sETH/ETH fund pool of Uniswap (a decentralized exchange) to get LP tokens. Finally, pledge the LP tokens back to the Synthetix smart contract to receive the newly issued SNX token rewards. Although this process is rather cumbersome, it successfully created a flywheel effect, and also laid the foundation for the later development of DeFi Lego.

Another major contributor to the popularity of Liquidity Farming is Compound. Its team announced in the summer of 2020 that governance tokens will be issued to users of the protocol, either for deposits or for borrowing COMP tokens. As one of the leading protocols for cryptocurrency lending, this decision sparked widespread discussion online and led other DeFi protocols to realize that governance tokens can be used as a tool to boost the growth of the protocol’s liquidity. Although Compound did not call it “liquidity mining” at that time, it made projects such as Uniswap, Balancer, Yearn Finance, etc. follow suit, making the term “liquidity mining” a hot topic. Services in traditional finance such as deposit, lending, exchange, financial management, insurance and derivatives also took root in the world of blockchain along with this wave, opening the summer of DeFi in 2020.



Glossary


Yield Farming:

Liquidity Farming is a type of yield farming. Users hand crypto assets over to smart contracts on the blockchain to conduct operations including staking, exchange and transfer, where users are able to acquire more cryptocurrencies. Yield farming is an important part of decentralized finance. It allows people to use various financial tools without turning to traditional brokerages, exchanges, banks and other institutions.

Smart Contract:

Smart contracts are the framework for building decentralized finance. It is an application deployed on the blockchain. It eliminates the demand and trust for intermediaries as required in traditional finance, and lowers costs greatly.




Liquidity Pools & Liquidity Providers:

Liquidity Farming is usually a pledge of cryptocurrencies in the liquidity pool of a decentralized exchange. Users who provide crypto assets are called liquidity providers, and they can earn transaction fees and protocol rewards in the pool. Unlike centralized exchanges, decentralized exchanges are run automatically by algorithms and smart contracts. Decentralized exchanges allow users to directly use their personal wallets for transactions without going through the deposit and withdrawal processes like on centralized exchanges.


Automated Market Maker (AMM): 

Decentralized exchanges generally use the AMM, which is a protocol, an algorithm or a formula that helps in pricing assets. In traditional finance, the quotation of commodities is created using the order book. The buyer and the seller each put forward the price and wait for the order to be matched. The market price is the latest price. In automated market makers, you don’t need to match counterparties to make a trade happen. Instead, you can directly buy or sell cryptocurrencies from the liquidity pool. The price is determined by the algorithm. The Constant Product Market Maker is the most common algorithm, whose formula is x * y = k, the number of two currencies in the liquidity pool “x” times “y” is a fixed value.


Order Book Trading vs. Liquidity Pool Trading:

There are a few major differences between order book trading and liquidity pool trading. First of all, the liquidity in order book trading is provided by pending orders from buyers and sellers, while the liquidity of the liquidity pool trading is provided by users who pledge cryptocurrencies in the protocol. In addition, the quotations in order book trading are non-continuous quotations, and there will be a price difference between the buy order and the sell order, while liquidity pool trading uses mathematical formulas, and as long as there are crypto assets in the liquidity pool, continuous quotations will be generated, so that the possibility of being unable to trade because the order cannot find a match does not exist. Finally, transaction fees for order book trading are usually charged by centralized exchanges that operate the markets, while transaction fees in liquidity pool trading are given to liquidity providers.


Return Calculation Methods: APR & APY:

There are two commonly used metrics for Liquidity Farming returns, namely Annual Percentage Rate (APR) and Annual Percentage Yield (APY). The main difference is that APR uses simple interest calculation and only considers the ratio of interest to the principal. APY uses compound interest calculation. In addition to interest and principal, it also directly reinvests profits to generate more returns. Due to the fierce competition in the Liquidity Farming markets and the rapid capital flow, the return fluctuates greatly. As a result, APR or APY can only represent the current valuation as a reference.



Pros & Features


Earn a variety of income

As an innovation of DeFi, Liquidity Farming not only solves the problem of token circulation but also brings revenue to its participants and project teams. For participants of the liquidity pool, the fast asset exchange saves time, and there is no waiting time for pending orders. The role of a liquidity provider is equivalent to the role of a market maker. In addition to earning transaction fees, LPs may also receive additional token rewards from the DEX’s protocol, which has big revenue potential and gives incentives for people to become LPs. Holding protocol tokens is equivalent to acquiring shares of a company and becoming a member of the team to jointly decide the future direction of the project or company. The liquidity pool that allows assets to be added or redeemed at any time gives great flexibility to fund management. There is almost no limit on the size of an investment in Liquidity Farming, which can be dynamically adjusted at any time depending on personal preferences and market changes.


Easier to operate

For project teams that issue tokens, Liquidity Farming allows projects to raise funds from the market without an Initial Coin Offering. Only a very small amount of capital is required to create a trading market, and there is no need to spend a fortune on hiring professional quantitative market makers. Users who participate in Liquidity Farming are usually supporters of the project. Therefore, creating a liquidity pool of their own project tokens can help the project team identify their target user group. The subsequent token distribution and event operations can also have a clearer direction. In addition to promoting the circulation of tokens in the market, the liquidity pool can also generate cash flow and income for the project team if the team also decides to put their own tokens in the pool. This can create a variety of business models for the future.


Cons & Risks


Impermanent loss

Although Liquidity Farming has brought huge funds and popularity to crypto, it is not without problems and flaws. After LPs put their assets into the liquidity pool of two different currencies, huge price fluctuations may significantly skew the proportion, causing the number of one currency to surge and the other to increase. Since adding and redeeming liquidity is based on a 1:1 ratio, LPs may have different numbers of invested and withdrawn currencies. Such changes in the number of coins and net asset value caused by price changes are called impermanent losses. You won’t lose your funds permanently, but the profits will reduce significantly.



Dangers in ecosystems

LPs must also bear the risks of the DEX protocol itself. The management of liquidity pools relies on self-executing smart contracts. When there are loopholes in the program code and hackers attack, pledged assets in liquidity pools could be stolen.

The project team that created the liquidity pool is also a potential source of risk. Fraudulent project teams may maliciously issue a large number of tokens, diluting the shares held by community members and giving themselves the power to manipulate the price. They may also just drain the assets in the liquidity pool and disappear.

Arbitrage bots on the blockchain are another hidden risk. When users exchange assets, the arbitrage bots will look for opportunities to create price slippage to gain profits, making on-chain transactions expensive and inefficient.


Could be a bubble

For the project team, although introducing a liquidity pool can quickly raise funds from the market, many liquidity providers are speculators who have no loyalty. When the economic incentives disappear, these investors will quickly withdraw and sell the tokens, sending prices plummeting. Also, if the project encounters problems, its liquidity pool may be depleted due to the simultaneous exit of a large number of participants. The lack of funds would only make the situation more difficult for the project team.


How to Participate in Liquidity Farming?


Liquidity Farming on the blockchain 

With the development of DeFi, the process of participating in Liquidity Farming has been greatly simplified. Taking Uniswap (the decentralized exchange with the highest total locked value) as an example, users only need to enter the Uniswap Dapp website and link their wallet (such as Metamask) before they can exchange on-chain tokens and participate in Liquidity Farming. Currently, Uniswap supports Ethereum and Polygon networks. Users must first have some of the corresponding currency to pay the miners on the blockchain. After adding two cryptocurrencies to the liquidity pool, you will get liquidity pool tokens. The transaction fees in the liquidity pool will be automatically returned to the liquidity pool and can only be redeemed together with the added liquidity after the user returns and destroys the liquidity pool tokens.




Liquidity Farming in exchanges


Users can also participate in Liquidity Farming on centralized exchanges. Take Gate.io as an example, click on “Earn” on the upper navigation bar on the Gate.io website and find “Liquidity Mining”. Liquidity Farming on Gate.io is easy. Adding redeemable assets takes only one click. There are more than 1,400 cryptocurrencies available for trading on Gate.io, where cross-chain participation is not restricted by any blockchain protocol. Moreover, the coins listed on Gate.io have already been audited by this platform, thus the risk of code loopholes and projects going bankrupt is very low. Users do not have to deal with problematic miner fees on the blockchain. All above are advantages of participating in Liquidity Farming on a centralized exchange.



Future Outlook & Conclusion


The good and bad about being on the frontier of innovation

The emergence of Liquidity Farming started the revolution of DeFi. In the development of DeFi, there were other amazing ideas that inspired people to explore various financial instruments and give imagination free rein. Liquidity Farming solves the problem that many currencies are difficult to circulate and convert. It improves efficiency and helps the project team to raise funds while creating business opportunities. It allows anyone to become a liquidity provider and profit. However, Liquidity Farming has its own risks and flaws. Liquidity providers may lose assets due to impermanent losses caused by price fluctuations or lose all assets to hackers. Project teams may also suffer a collapse in token prices due to speculative flows in the market.


The future

For the development prospects of Liquidity Farming, many novel ideas have been proposed and discussed, such as liquidity as a service and protocol-owned liquidity. The former is that the project team leases liquidity for a certain period of time from the market to fund their operations and earns liquidity pool fees. The project team bears all impermanent losses after expiration and pays the lease fee. The latter is that the project team issues bonds to sell tokens at a discount, and permanently obtains the ownership of the liquidity pool tokens, so as to avoid the problem of funds drying up due to a large number of redemptions when emergencies occur.

The blockchain industry has become so diverse thanks to Liquidity Farming. Various derivative financial products have also been introduced to build the Lego castle of the DeFi world. Although it has created many attractive income opportunities, it also made the flow of funds more complicated and difficult to understand. If you do not understand where the Liquidity Farming revenue comes from, your assets may be the source of revenue in the eyes of others. It is necessary to have a good understanding and awareness of risk in order to move forward in this revolution of decentralized finance.


Author: Piccolo
Translator: Yuanyuan
Reviewer(s): Hugo, Echo, Piper
* This article represents only the views of the observers and does not constitute any investment suggestions.
*Gate.io reserves all rights to this article. Reposting of the article will be permitted provided Gate.io is referenced. In all other cases, legal action will be taken due to copyright infringement.