Liquidity mining is an innovative way to earn passive income by using DeFi applications, typically by providing liquidity.

Although liquidity mining offers investors exceptionally high yields, the various risks involved in the process cannot be ignored. These risks include, but are not limited to:

Smart Contract Risk

Smart contract code is immutable and operates exactly as programmed. However, precisely because of this, if a smart contract has a human or non-human error, it can be exploited with no recourse. While such incidents are not common, they do happen—and they keep happening.

Smart contract audits mitigate the risk of vulnerabilities in the contract code to some extent. Major players in the contract audit space include Trail of Bits, Zeppelin, and Quantstamp. However, it’s important to note that even audited contracts are not 100% secure, so it’s crucial to carefully assess the risks before investing.

Collateral Liquidation Risk

If you use collateralized loans on platforms like Compound, MakerDAO, or Aave, your collateral may be automatically liquidated (sold off) if it no longer covers your loan amount due to the volatility of the borrowed asset or collateral. This process may also incur additional fees.

Impermanent Loss Risk

If you provide funds to an automated market maker (AMM)-based decentralized exchange like Uniswap, sudden and drastic market movements or extreme price fluctuations may cause you to lose a significant amount of capital. (Simply put, the quantity of the higher-value asset will rapidly decrease.)