Liquidity mining is a DeFi (decentralized finance) mechanism in which participants supply cryptocurrencies into liquidity pools, and are rewarded with fees and tokens based on their share of the total pool liquidity. This focuses on incentivizing the injection of liquidity in the protocol in exchange for distributing among users a series of tokens that give access to the governance of the project and that can also be exchanged for better rewards or other cryptocurrencies.
A liquidity pool is a collection of funds locked in a smart contract. Liquidity pools are used to facilitate decentralized trading, lending, and many more functions we’ll explore later.
Liquidity pools are the backbone of many decentralized exchanges. Users called liquidity providers (LP) add an equal value of two tokens in a pool to create a market. In exchange for providing their funds, they earn trading fees from the trades that happen in their pool, proportional to their share of the total liquidity.
Liquidity pools use algorithms called Automated Market Makers (AMM's) to provide constant liquidity for trading. When you add to a pool you will receive Liquidity Provider tokens (LP tokens). For example, if a user deposited $DFL and $KUSD-T into a pool, you would receive DFL-KUSD-T LP tokens.
Every time a user trades between $DFL and $KUSD-T, a 0.25% fee (KAIDEX) is taken on the trade. 0.20% of that trade goes back to the LP pool and 0.05% of that goes to RAY staking.
- Previously, if there were 100 LP tokens representing 100 DFL and 100 KUSD-T, each token would be worth 1 DFL & 1 KUSD-T.
- If one user trades 10 DFL for 10 KUSD-T, and another traded 10 DFL for 10 KUSD-T, then there would now be 100.020 DFL and 100.020 KUSD-T.
- This means each LP token would be worth 1.00022 USDC and 1.00022 RAY now when it is now withdrawn.
A liquidity provider is a user who funds a liquidity pool with crypto assets he owns to facilitate trading on the platform and earn passive income on his deposit.
Liquidity pools are leveraged by the decentralized exchanges that use automated market maker-based systems to allow the trading of illiquid trading pairs with limited slippage. Instead of using traditional order book-based trading systems, such exchanges use funds that are held for every asset in every trading pair to allow trades to be executed.
While trading illiquid trading pairs on order book-based exchanges could lead to suffering from great slippage and the inability to execute trades, the advantage of liquidity providers is that trades can always be executed as long as the liquidity pools are big enough. For this reason, liquidity providers are seen as trade facilitators and paid with the transaction fees paid for the trades that they enabled.
Implemented via Smart Contracts, a liquidity token is given to a depositor in exchange for that investor's deposit(s) to be used for other purposes such as yield farming. Examples of liquidity tokens include LP and a liquidity token can be exchanged back.