For Cryptocurrencies there is a huge number of financial products. Liquidty mining is one of these products and certainly sounds very special to investors at first.
In this article you will learn everything you need to know about liquidity mining:
Let's go, into the depths of the crypto-verse.
Liquidity mining is for risk-tolerant, advanced investors only and is subject to increased risk.
This is not an investment recommendation. A total loss is not excluded for investments in cryptocurrencies.
Liquidity mining is a Investment form in the field of Decentralized Finance (DeFi) in cryptocurrencies. With this you can create a passive income generate with your cryptocurrencies.
The central function is to provide liquidity for trading on decentralized platforms. One of these platforms is Cake DeFi. To Cake DeFi there is already at this point a Field report. Spoiler: The platform is really good and serious.
In liquidity mining you invest capital, in so-called liquidity pools. As a rule, these are trading pairs (e. g. BTC-USDT). This means that two different cryptocurrencies must always be deposited in the pool.
When you deposit capital, you get a return or interest. This is paid from the fees. Whenever someone takes their trading pair out of the pool, a fee is charged.
Capital providers are often referred to as Liquidity Provider denotes. When someone trades a trading pair on the DEX (Decentralized Exchange), a fee is also due. It is divided among the Liquidity Providers on a percentage basis.
In addition to fees, Liquidity Pools are rewarded with rewards per solved block on the respective blockchain.
Here is an example: In the BTC-DFI trading pair, DFIs are awarded per solved block and the fees are paid out as BTC.
So far I use Cake DeFi for Liquidity Mining. Besides Cake, this type of investment is available at Binance, FTX and other big Exchanges. My trading pairs are BTC-DFI and ETH-DFI. I have been gathering my personal Liquidity Mining experience for 2 years.
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Unfortunately, income from liquidity mining is subject to tax. The Gains are considered capital income for tax purposes.
How to declare your income correctly and what information you need to do so, you will learn in the large Crypto Tax Guide for Swiss.
My personal Liquidity Mining experience was in the beginning with unbelievably high returns. Now the Yields between 30% and 50%.
There are pool pairs that yield small single-digit returns. The counterpart are pools that promise thousands of percent. Logically, there are also pools between these two sizes.
Thousands of percent?! That literally screams scam and fraud. I will explain to you why this is not (always) the case.
Nevertheless, caution is advised! It should be said that there are many scams in cryptocurrencies, and I do not want to deny that. But not everything is a scam, sometimes it's pure mathematics.
Some liquidity mining pairs have more participants than others. The logical consequence is that the Fees divided among more liquidity providers become. The return on investment will be smaller.
Mostly, these pools are the well-known cryptocurrencies such as Bitcoin, Ethereum, Ada, Litecoin and others.
Liquidity pairs, which are rather unknown, have fewer participants. Ergo, the return increases because it is divided among fewer participants.
That is the first aspect. The second are the Blockrewards of the cryptos itself. If the rewards for a solved block are very large, the return is also larger. More ends up with the individual liquidity provider.
Liquidity mining is not a perfect form of investment. It also has risks. The greatest risk is a total loss. This is either due to poor research, greed-eats-brain phenomenon (FOMO) or a scam.
Funnily enough, you can (almost) rule out the last two causes if you turn a poor research into a thorough one.
Of course, there is still the Risk of a cryptocurrency running to zero. However, you can reduce this risk to a minimum with good and established projects.
Furthermore, the Risk of the so-called Impermanent Loss.
"Intelligent people learn from the mistakes of others".
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The Impermanent Loss is, as the name suggests, primarily non-permanent. You're probably wondering where the risk is if it's a temporary loss. Or you can't do anything with it and wonder, what should be a temporary loss at all.
It depends! It is important to understand how the Impermanent Loss arises. It arises from massive price changes of one of the two trading pairs. To describe the following as simply as possible, my example pool consists of Coin A and Coin B.
Coin A has a price of CHF 1 and Coin B has a price of CHF 5. You become a Liquidity Provider and add both coins to the pool at a ratio of 1:1. The ratio of both coins must always be the same! So, if there are 500 A Coins (CHF 500), 100 B Coins (CHF 500) will be added to the pool.
A few days pass and Coin B has a price increase of 100% from CHF 5 to CHF 10. Now the ratio in the pool is disturbed. It is now 1:2.
You decide to remove your capital from the pool because you want to sell Coin B with big profits. However, instead of 500 A coins and 100 B coins, you receive 700 A coins and "only" 70 B coins.
Why?
The purpose of a liquidity pool is to ensure the Keep relationship of the couple stable. He must make sure that both coins have the same monetary value in the pool.
After you leave the pool, your capital has the following value:
700 A Coins worth CHF 700 and 70 B Coins worth CHF 700.
You have a big profit from 40% made and where is now finally the promised loss?
The loss only occurs when you make a direct comparison between simply holding Coin A & B and Liquidity Mining.
If you had held both coins, your capital would not be CHF 1'400, but CHF 1'500. Thus you have missed" a purely arithmetical profit of CHF 100, since you were a Liquidity Provider.
Why is it called Impermanent LossWhen it is only temporary and almost imaginary? Because the loss becomes real when you take your capital out of the pool.
It could have been that Coin A follows and also records a price increase of 100%. As a result, both coins would have a 1:1 ratio as at the beginning. If you had only then taken your capital from the liquidity pool, you would receive 500 A coins and 100 B coins as at the beginning.
In the Wealth Letter you get:
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If one of the two coins not 100%, but 1000% rises. Then you still make a profit if you take your money out of liquidity mining. But the return would be dramatically higher if you just held both coins.
The following calculation example should clarify this statement.
Scenario A: You are Liquidity Provider with 500 A Coins and 100 B Coins. Due to the price increase the ratio is disturbed and instead of 5 A Coins you now need 50 A Coins to buy 1 B Coin.
The ratio has now grown from 500 A Coins to 5000 A Coins to 100 B Coins. But since you only paid in 500 A Coins, the liquidity pool adjusts the ratio in the disbursement process.
You receive about 1500 A Coins and 30 B Coins at this time. Your total assets would have increased to CHF 3,000.
Scenario B: You Hodlst (hold) both coinswithout adding them to the pool. The number of your coins remains the same, only the value changes due to the price increase of coin B.
With 500 A Coins and 100 B Coins, you have a total asset of CHF 5,500 after the rate increase.
The result: Your "imaginary" loss is calculated as follows:
Total assets Scenario A - Total assets Scenario B:
CHF 3'000 - CHF 5'500 = CHF -2'500
"Intelligent people learn from the mistakes of others".
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The above calculation examples are intended as an idealized illustration. In reality, the returns and the duration of the investment period play a key role.
You will receive the returns every day. They are sent directly to your wallet and not to the pool. The longer you collect returns, the smaller the losswhen the impermanent loss is actively triggered.
Liquidity pools with stablecoins have the greatest potential for loss. A stablecoin does not rise or fall in value - it remains "stable". Its counterpart usually has sole scope - perfect for an impermanent loss.
If you put capital into the BTC-USDT pool, then Bitcoin may only go up a few percent at best.
An increase of 100% corresponds to an Impermanent Loss of approx. 5%. According to my Liquidity Mining experience, this small loss is compensated by the returns. Nevertheless, I personally would not play such a trading pair due to the described risk.
Liquidity Mining is a highly interesting but also complex topic. The mechanisms behind it are relatively simple to understand in the first place. However, the subject of the Impermanent Loss often with half-truths, half-knowledge or described to a minimal extent.
For this reason, I felt it was important to explain this area of the article in detail and as simply as possible.
Liquidity mining allows you to passively generate income as an investor, and it can be a great way to put your otherwise "dormant" cryptos in play in your wallet. Make your money work for you!
Hi Schwiizer Franke, great article. I am also with Cake Defi and for me the liquidity mining is going well. What Cake does much better than other providers is the weekly/monthly reporting. Without that, I find monitoring, especially in terms of taxation, is a pure nightmare. I was in LPs where I deposited two assets, and then many months, even though the coin prices were back at the same level as when I deposited, I got back less of both coins. Now how do you explain this to your swiss or dt tax advisor!!!? I find Thorchain via Thorswap still quite good, they put a good decentralized reporting with Thoryield z.V.. But Cake Defi is already a good start! Best regards from Singapore, Noah