Liquidity mining is a DeFi (decentralized finance) mechanism in which participants supply cryptocurrencies into liquidity pools, and are rewarded with fees and tokens based on their share of the total pool liquidity. This focuses on incentivizing the injection of liquidity in the protocol in exchange for distributing among users a series of tokens that give access to the governance of the project and that can also be exchanged for better rewards or other cryptocurrencies.
These tokens may or may not give voting power within the protocol. Besides, they regularly offer access to interest or rewards that are paid regularly to their holders. In this way, the more money they block on the platform, the more tokens they receive and the more rewards they obtain, thereby making higher profits.
Yield farming is the practice of staking or lending crypto assets to generate high returns or rewards in the form of additional cryptocurrency. In short, yield farming protocols incentivize liquidity providers (LP) to stake or lock up their crypto assets in a smart contract-based liquidity pool. These incentives can be a percentage of transaction fees, interest from lenders or a governance token (see liquidity mining). These returns are expressed as an annual percentage yield (APY). As more investors add funds to the related liquidity pool, the value of the issued returns rise in value.
At its core, yield farming is a process that allows cryptocurrency holders to lock up their holdings, which in turn provides them with rewards. More specifically, it’s a process that lets you earn either fixed or variable interest by investing crypto in a DeFi market.
Simply put, yield farming involves lending cryptocurrency via the Ethereum or Binance Smart Chain networks. When loans are made via banks using fiat money, the amount lent out is paid back with interest. With yield farming, the concept is the same: a cryptocurrency that would otherwise be sitting in an exchange or a wallet is lent out via DeFi protocols (or locked into smart contracts, in Ethereum terms) to get a return.
Liquidity pools are pools of tokens that are locked in a smart contract. They are used to facilitate trading by providing liquidity and are extensively used by some of the DEXes (Decentralized Exchanges).
Liquidity pools use algorithms called Automated Market Makers (AMM) to provide constant liquidity for trading.
A single liquidity pool holds a pair of tokens and each pool creates a new market for that particular pair of tokens. The first depositor to the pool or liquidity provider sets the initial price of assets in the pool. Liquidity providers are incentivized to supply an equal value of both tokens to the pool. They receive special tokens called LP tokens in proportion to their contribution to the pool. When a trade occurs, a 0.3% fee is collected and distributed proportionally to all LP token holders.
When a token swap occurs through a pool, the supply of an asset decreases while that of the other increases. Therefore, price changes occur that are adjusted by an algorithm called an automated market maker (AMM). This is the time where liquidity pools play their best role as they do not need a professional, centralized market maker to manage the prices of assets. Liquidity providers simply deposit their assets into the pool and the smart contract takes care of the pricing.