Gate.io Blog Science: What You Need to Know About Investments in Liquidity Mining Products

Science: What You Need to Know About Investments in Liquidity Mining Products

25 June 10:23

Summary:
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 mining investment.

The History of Liquidity Mining

Liquidity 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.

In 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.

Image: Liquidity Mining Whitepaper
Source: https://hummingbot.io/liquidity-mining-whitepaper/

For 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.
By 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.

Image: A Typical AMM Algorithm
Source: https://www.readblocks.com/archives/73819

Continue 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.

With 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.
Despite 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?
Miners (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

Impermanent Loss
Impermanent 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 spot.

Image: Impermanent Loss Function
Source: TokenInsight

Project security risks
Liquidity 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

Oracle Attack
Before 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.

On 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.
In 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.

Re-Entrancy Attacks
Smart 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.

Code Attacks
Code 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.

The 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

Security
Gate.io 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 crypto coin 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.

High Liquidity
Gate.io 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
Gate.io 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
Liquidity 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
Gate.io 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.

Extended Reading:
1． Gate.io Help Center: FAQs for AMM Liquidity Pool
https://www.gate.io/help/lend/Margin_Lend/21060
2． Gate.io Cryptopedia: How to Obtain Liquidity Mining Earnings?
https://www.gate.io/cn/article/19849

Author: Gate.io Researcher: Charles. F
* The article only represents the researcher’s views and does not constitute any investment advice.
* 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.

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Science: What You Need to Know About Investments in Liquidity Mining Products

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