Liquidity mining is a decentralized finance (DeFi) mechanism where participants can supply their cryptocurrencies or other digital assets into liquidity pools, which are then used to allow traders to swap between currencies. Some buyers have employed it as a buying strategy because contributors to liquidity pools are rewarded with tokens and fees, note Dan Schatt and Domenic Carosa, fintech veterans and executives of DeFi startup Earnity.
Even though it can be a good source of passive income, liquidity mining carries many risks. Earnity’s Dan Schatt and Domenic Carosa believe the potential of crypto is worth the risk. This article will go over the possible risks attached to the protocol.
Smart Contract Risk
Funds placed in liquidity pools are locked or staked into smart contracts, which are self-executing programs stored on a blockchain and include the terms of the agreement between the two parties or traders. Because it is a program, there is always the risk that some bug is present in the smart contract code that bad actors can exploit. Fortunately, popular smart contracts undergo consistent reviews by independent experts. As a result, such contracts are less likely to have bugs.
One of the most prevalent threats to blockchain buyers’ funds is project risks. These include critical management risks when private keys are stolen because of buggy or malicious software. Another is performance and scalability risk, which can occur if a project is not optimized enough that too much increase in volume gets the network congested. There is also the potential of a privacy management risk when a liquidity mining project requires users to submit personal information that accidentally reveals the data to the public.
The most common and arguably complicated issue that liquidity mining faces is an impermanent loss. This transpires when the pool shifts so that the token loses value relatively, a buyer withdrawing funds from the liquidity pool at that moment will make a loss instead of a profit. It is essential to practice patience and due diligence when buying cryptocurrency.