Liquidity Mining
A DeFi incentive mechanism that rewards liquidity providers with governance tokens in addition to trading fees.
What is Liquidity Mining?
Liquidity mining (also called yield farming via protocol incentives) is a strategy in decentralized finance where users provide liquidity to a protocol's pools or markets and receive newly issued governance or utility tokens as additional rewards, on top of normal trading fees. Protocols use liquidity mining to bootstrap liquidity and distribute governance tokens to active participants. The practice was popularized in mid-2020 by Compound's COMP token distribution and subsequently by Uniswap, Curve, Sushiswap, and dozens of others. While liquidity mining can generate high short-term yields, the rewards are often denominated in volatile governance tokens whose price can decline rapidly as new tokens are emitted. Liquidity miners also face impermanent loss — the risk that the value of their deposited token pair changes relative to simply holding the tokens outside the pool. The combination of token price decline and impermanent loss can result in net losses despite high advertised APYs.
Example
In 2020, Compound distributed 2,880 COMP tokens per day to users who supplied or borrowed on the platform. At peak COMP prices, this translated to annualized yields exceeding 100% on some assets. Many users 'mined' by borrowing one asset with another as collateral to maximize COMP earnings — a risky recursive strategy that amplified both yields and liquidation risk.
Source: Compound Protocol Documentation