Liquidity Mining – Definition:
Liquidity mining, a pivotal concept in the realm of decentralized finance (DeFi), is a community-driven mechanism designed to incentivize individuals to provide liquidity to specific cryptocurrency pools within decentralized exchanges (DEXs). This innovative approach allows participants to contribute their assets, lock them into these liquidity pools, and, in return, earn interest or rewards typically distributed in the form of native tokens native to the DeFi platform.
Traditional financial markets rely on market makers, such as brokerage houses, to furnish liquidity by offering buy and sell solutions to investors. These market makers are compensated both for the risk they assume in holding assets to provide liquidity and for the profit generated from the spread between asset bid and ask prices. For instance, when a stock has a bid price of $100 and an ask price of $100.20, the market maker profits $0.20 by buying at $100 and selling at $100.20.
In stark contrast, decentralized exchanges operate differently. They are continuously accessible for trading via automated market makers (AMMs) and liquidity pools. A fundamental liquidity pool, for instance, establishes a market for a specific asset pair, such as USDC/RIN, within a DEX. When initiated, a liquidity provider sets the initial price and proportion to create an equal supply of both assets. This equitable supply concept remains consistent for all liquidity providers interested in contributing to the pool.
Liquidity providers are incentivized according to the amount of liquidity they furnish to the pool. As trades occur, transaction fees are proportionally divided among all liquidity providers, governed by smart contracts that manage the liquidity pool. Each asset swap, facilitated by these smart contracts, triggers a price adjustment to maintain market equilibrium.