Liquidity Mining

Liquidity mining is a practice in decentralized finance in which a protocol distributes newly issued tokens, usually its governance token, to people who deposit assets into its pools or use its services. Participants earn these rewards on top of any trading fees or interest they would normally receive. The aim is to attract capital quickly, deepen markets and spread ownership of the protocol among its users.

The term borrows from crypto mining, since participants "mine" new tokens by providing a service, here liquidity rather than computing power. It is closely related to yield farming, which describes the wider practice of moving funds between protocols to chase the best returns, often including liquidity-mining rewards.

Imagine a new shopping centre that needs shops to open before customers will come. To get started, the owners give shopkeepers free shares in the centre for every month they stay open. The more stock a shop brings, the more shares it gets. Early on, the shares can be worth more than the shop's actual sales.

Liquidity mining works the same way. A new exchange or lending service needs money in its pools to be useful, so it hands out its own tokens to anyone who deposits. People join because the reward is attractive. The open question is whether they stay once the free shares stop, or move on to the next centre offering a better deal.

Token incentives for liquidity appeared in 2019, when the Synthetix project rewarded people who provided liquidity to a pool on Uniswap. The practice took off in June 2020, when the lending protocol Compound began distributing its COMP token to lenders and borrowers every day. Other protocols quickly copied the model, a period often called "DeFi summer". In September 2020, SushiSwap used liquidity-mining rewards to persuade users to move liquidity out of Uniswap, an episode known as a vampire attack, and Uniswap responded by launching its own UNI token with an airdrop and mining programme.

A protocol sets a reward budget for each pool, for example a number of tokens per block or per day, and divides it among participants in proportion to their share of the pool. Liquidity providers usually prove their share with a liquidity provider token, which they may need to stake in a separate rewards contract. The headline reward rate is often quoted as an annual percentage:

For example, if a pool worth 20 million dollars receives 1 million reward tokens a year and each token trades at 2 dollars, the reward rate is (1,000,000 × 2) ÷ 20,000,000 = 10% a year. That figure changes constantly: it falls as more capital joins the pool and moves with the market price of the reward token. Quoted figures are often shown as APY, which assumes rewards are reinvested, rather than simple APR.

• Bootstrapping liquidity. New exchanges and lending markets use rewards to overcome the chicken-and-egg problem of needing users to attract users.
• Distributing governance. Rewards hand voting tokens to active users rather than only to investors and founders.
• Competing for capital. Protocols use rewards to win deposits from rivals, raising their total value locked.
• Directing liquidity. Some systems let token holders vote on which pools receive rewards, creating markets for influence over incentives. Curve's vote-escrow model, in which users lock tokens to gain voting power over reward allocation, is the best-known example and was widely copied.

The biggest criticism is that liquidity mining attracts mercenary capital: funds that arrive for the rewards and leave as soon as they shrink. Many participants sell reward tokens as soon as they receive them, creating steady selling pressure, and the new issuance dilutes existing holders. When rewards end, liquidity and usage often collapse.

Participants also face impermanent loss in trading pools, smart-contract bugs, falling reward-token prices that can wipe out headline returns, and outright fraud, since some schemes promised very high rates only to drain deposits. Reward tokens may be treated as taxable income in many countries when received, and regulators have questioned whether some programmes amount to unregistered offers of securities.

Later designs try to reward longer commitment, for example by boosting rewards for users who lock tokens for months or years, or by tying rewards to fees actually generated rather than raw deposits. Whether these changes produce lasting usage, rather than temporary capital, remains debated.