The year 2020 is slowly coming to an end and here is a winner — DeFi! While the US dollar value of many DeFi governance tokens has fallen sharply, the Total Value Locked has reached a new high.
Decentralized Finance has seen tremendous growth over the past few months. This was largely driven by liquidity mining and yield farming. But what is behind these trends? And how sustainable are they?
Liquidity mining and yield farming are often mentioned in the same context or used as synonyms. But if you look closely, you can see a difference. Without liquidity mining, the term yield farming would probably not have emerged. So what’s behind liquidity mining? Let’s consider some key definitions which provide clarity!
Liquidity Mining & Yield Farming: Key Definitions
Liquidity mining is a decentralized mechanism in which participants use their cryptocurrencies in a pool to increase liquidity for certain tokens on a market. Accordingly, liquidity providers are rewarded for this activity. The reward usually includes a part of market fees incurred. In addition, there are often rewards in the form of governance tokens that are distributed to all users — providers and consumers — of a particular platform.
The rewards for liquidity mining in the form of fees (ETH) and governance tokens can in turn be used as liquidity on other platforms in order to generate additional income. The demand for liquidity can be high, especially with new governance tokens. With the reasonable use of various DeFi platforms, users can achieve very high returns on the assets used.
This phenomenon is known as yield farming. In this context, there was also a place for a new Agricultural Revolution. ‘Seeds’ spread on different DeFi platforms and allow a farmer to enjoy a good ‘harvest’ after a while. Quite a few borrowers on lending platforms manage to use yield farming to settle their interest debt with farming returns.
Liquidity mining rewards participants for providing liquidity and using certain services. With Yield Farming, rewards received can be used on other DeFi platforms to obtain additional rewards. Yield farming, therefore, consists of several different uses of liquidity mining.
Where Does the Term Liquidity Mining Come From?
The idea for liquidity mining was born to make cryptocurrency trading more efficient and democratic. In the whitepaper of 2019, the overall concept, as well as the project’s background, were described in detail. In principle, the aim is to remunerate so-called market makers for providing sufficient liquidity for cryptocurrency trading.
Trading can only take place at any time and under the expected conditions only in case of sufficient liquidity. Market makers should ensure this liquidity. The specific task is to place limit orders in the order book of a swap exchange and to adjust them if necessary. This creates binding offers to buy and sell a certain amount at a certain price.
The history of market makers is long and goes back to the 1970s of the New York Stock Exchange (NYSE). Even then it was common practice to compensate market makers for providing liquidity. The remuneration took place directly or indirectly through discounts.
Market makers also play an important role in the cryptocurrency market. Exchanges and new token issuers pay millions in US dollars to large hedge funds in order to provide liquidity.
This is exactly where the concept of liquidity mining comes in. The provision of liquidity should become easier, more efficient, and more accessible. Every trader should be able to provide liquidity and be appropriately rewarded for the risk.
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