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The Problem with Liquidity Mining
Covering the Basics of Liquidity Mining, Impermanent Loss
Looking at Telegram chats, Discord, and Reddit, it still seems that people are not aware of the full potential of such decentralization. We often read, โ€œWhat does yield farm XYZ provide, why dumping, why not moon, etc.โ€ It seems (and we only say it seems since it sounds better, but we mean it is a fact):
People use yield farming for quick money only.
Ok, many people. Nevertheless, all people want to earn money by providing liquidity. One thing that is undervalued is the reason WHY to provide liquidity. Like centralized exchanges, decentralized exchanges depend on liquidity. Without a certain amount of assets on Binance, Coinbase or Kraken, no one would be able to buy cryptocurrencies. Same states for decentralized exchanges. When founding a centralized exchange, it would be sufficient to get people to provide either side of the assets, and the exchange would work due to order books. Decentralized exchanges, on the other hand, rely on automated market makers (AMMs). The main concept is to have a pool that keeps two sides of assets that are tradable (such as ETH & BTC). Thus, liquidity providers need to provide both sides. This approach comes with certain risks. One of the most known ones is Impermanent Loss. Interestingly, most people providing liquidity do not really get it. Simply put, an impermanent loss (IL) is a difference between holding tokens in an AMM and holding them in a wallet.
Sounds complicated? Well, it is not, as can be seen in the formula below, since we want our community to finally understand their investment risk:
IL=AMMย valueHoldย valueโˆ’1=x0.5โˆ—y0.5xโˆ—0.5+yโˆ—0.5โˆ’1IL = \frac {AMM \space value}{Hold \space value} -1 = \frac {x ^{0.5} * y ^{0.5} } {x * 0.5 + y * 0.5} -1
Impermanent loss formula. (x, y = percentage change of asset X and Y, assuming a 50/50 liquidity pool)
People do not know: IL does not mean you have a loss! Think about it: An increase of two assets can still result in an impermanent loss. So, the only condition that counts is:
PROFIT>IMPERMANENTย LOSSPROFIT >IMPERMANENT \space LOSS
Fact: A decentralized exchange would not work without people providing liquidity. Thus, incentives are needed that fulfill the condition. Yield farming offers the most straightforward form of incentive: Liquidity. However, usually, the profit is eliminated by price dumps. Besides many scam projects, most yield farms are therefore anything but sustainable. Take Goosedefi, for instance. The concept of layered farming looks attractive at first glance, but still, people experience a dump after dump (> 80% by then, 66% TVL gone within weeks โ€” and we talk about 200 million $+).
The problem here is: Yield farming is not liquidity mining, but it is often confused. We rather distinguish between three terms:
๐Ÿ˜ข Liquidity Dumping
๐ŸŽ Liquidity Gifting
โ› Liquidity Mining
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