If in August 2020 they had asked me to describe cryptocurrencies using a picture, I would have used the image of an Italian beach: crowded in summer and empty in winter. During the bull markets, everyone competes to find the most exotic crypto, but when the dark season arrives, everyone disappears. Understandable, given that making money in a shrinking market is difficult and requires advanced trading skills. However, the advent of DeFi changed everything: it turned cryptocurrencies into a market for all seasons.
As we mentioned in the previous article, DeFi has introduced the possibility of using crypto to generate passive income. There are various strategies, but today I will show you the most common method by far: liquidity mining, or how to "earn" through liquidity.
The process is quite simple and requires only two ingredients: your digital wallet, with your cryptocurrencies inside, and a decentralized platform to exchange crypto, also called DEX (Decentralized Exchenge).
Three steps are required:
Step 1: Provide liquidity
To allow us to trade cryptocurrencies, every decentralized platform needs liquidity: the peculiarity of DeFi is that anyone is able to provide it, thus being remunerated. Once our wallet is connected, all we have to do is deposit the cryptocurrencies of our preference on the platform. Please note that in most cases we will be required to choose between a pair of supported cryptocurrencies and deposit an amount of equivalent value for both coins. If you are taking your first steps in the world of DeFi this requirement may seem strange to you, but it is only a way to make trading more efficient.
Once the liquidity has been deposited, you will receive in return a sort of receipt, more commonly known as a Liquidity Provider Token (LP Token), which certifies your right to withdraw liquidity from the platform. Completing this step allows you to start receiving commissions collected from users who trade on the platform, which are then redistributed to liquidity providers.
Step 2: Multiply your income
As mentioned above, liquidity is the lifeblood of any decentralized platform: for this reason, very often ad-hoc incentive programs are created, which allow you to also put your LP Token into income. Yes, you got it right: not only can you earn from your cryptocurrencies, but also from the receipt you obtained by depositing the liquidity. All you have to do is check if the DEX you are using has an active incentive program, find the crypto pair that corresponds to your receipt and deposit it.
The most interesting aspect of this step is that in most cases these rewards far exceed the income obtained from the commissions of the first step, with returns that can even exceed the three-digit percentage.
Step 3: Reap the rewards
You should know that, if the income produced in the first step is directly reinvested by the platform, increasing your share of provided liquidity, the same mechanism does not apply to the second step. As the days go by, on the page where you deposited your LP Token you will see your rewards count grow and it will be up to you to collect them. Be careful though, these are usually paid with a cryptocurrency issued by the platform itself. This is a not negligible detail, since it can jeopardize the value of your rewards: for this reason, one of the most common strategies is to redeem and sell them as soon as possible.
The beauty of DeFi is that each step reuses the result of the previous one, allowing us to increase our earnings. However, it must be remembered that all this is not without risks, including, but not limited to, the possibility of a hacker attack, a malfunction of the platform, as well as the phantom "impermanent loss." In future articles, we will explore all types of risk: for now, it is enough to know that the opportunity is real, but requires awareness and attention.