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In the world of cryptocurrencies and any other investing activities, generating more and more profits is the purpose of any investor. Yield Farming, which is one of the hottest topics in the cryptocurrency world and DeFi in particular, is what you should know if you want to exploit potential benefits from this new way of trading.
In this article, we’ll go from the simplest to most complicated concepts of DeFi and Yield Farming. There’s also a comprehensive guide on how to earn money from this wonderful method.
What is DeFi?
Before getting into more details about Yield Farming, which is one important application of DeFi, we should first gain some understanding of what DeFI is.
Decentralized Finance (DeFi) is all about recreating traditional finance by transforming them into trustless and transparent protocols via smart contracts and tokens. This system aims to carry out traditional activities such as lending, borrowing, investing in platforms that are decentralized open-source and do not rely on big institutions.
According to DeFi Pulse, there are 50.6 billion dollars locked into the DeFi ecosystem and the three most popular lending protocols are Compound, Maker, and Uniswap.
Lending and Borrowing in DeFi
To know what it exactly is, you’ll need to know how borrowing and lending simply work in DeFi. We’ll take Compound as an example.
When you go to the Compound website, which is a protocol for borrowing and lending, you can earn interest and yield (not yield farming). There are two sections: supply and available to borrow. You can simply see the annual interest you will get for your crypto supply. The interest rate will vary day by day depending on the supply and demand for crypto.
In traditional banking, when you ask for a loan, it’s necessary to put up collateral. Similarly, in DeFi, you need to stake your digital assets as collateral, which are locked within a smart contract until the loan is repaid. For instance, you can lock ETH as collateral to take out a loan on DAI.
To use protocols such as Compound, you don’t need to sign up, make any contract, or wait for a majority of days to take out what you supply. As they’re decentralized, you can do that at your convenience.
What Is Yield Farming?
Yield Farming is just a small part of DeFi. It is the procedure of taking an initial investment to gain an annual interest and you can grow that investment without having to add new money.
To be more specific, Yield Farming is the process of trying to maximize a rate of return on capital by using DeFi apps, wallets, and protocols when you have idle assets available. More simply, it means locking up cryptocurrencies and achieving rewards.
It’s currently the biggest growth driver of the DeFi space and it often involves providing liquidity. Yield comes in many forms such as interest, marketing-making fees, and incentives or rewards allocated by the protocol.
How does yield farming work?
An investor will approach a DeFi platform like Compound, collecting crypto assets, and lending them to borrowers, paying back interest on the loan to the investor. Interest can be either fixed or variable with the rates decided by the individual platform.
To borrow some funds from the platform, a borrower will need to deposit double the borrowed amount as a form of collateral before proceeding to the deal. Using smart contracts, the value of the collateral can be checked at any point in time. If it is less than the borrowed amount, the contract can trigger to liquidate the borrower account, and interest is paid to the lender. This means the lender will never be at a loss, even if the borrower fails with repayment.
To understand how such high returns are plausible, you need to understand liquidity mining, leverage, and risk, which are the three core elements of yield farming.
Liquidity Mining
Liquidity mining is the token-based incentive that encourages users to partake in the protocol. When yield farmers provide liquidity for their trading pool, they will be rewarded with tokens. Sometimes, a farmer might be willing to forfeit their initial capital to gain rewards in the form of distributed tokens such as COMP. Their overall strategy will remain highly profitable.
Leverage
Leverage helps to make high returns possible. It is the strategy of using borrowed money to increase the likely returns on investment. A farmer will deposit their coins as collateral to one of the lending protocols and then borrow other coins. The borrowed coins are then used as additional collateral to borrow more coins. If the farmer keeps repeating the process, they leverage their initial capital multiple times and generate cumulative returns.
Risks
Everything above may sound amazing, but it would be irresponsible to assume that there are no risks involved. There is never a free lunch and you cannot generate more returns without accepting additional risks.
In the case of yield farming, one of the biggest risks comes from smart contract runner abilities. Hackers and other market participants study these smart contracts intently and if they spot an opportunity to attack a pool or manipulate a price, they’ll jump at it.
Moreover, given the interoperability between many of these protocols, they can use one tool against the other in a manner no one can predict. This has happened on quite a few occasions.
Strategies
A straightforward way of getting APY on your capital is through lending and borrowing. For example, the farmer can supply a stable coin like DAI on a lending platform and start to get some returns on their capital. With liquidity and leverage, they can then take that to the next level.
By supplying coins to one of the liquidity pools, a yield farmer can be rewarded with fees that are charged for swapping different tokens. With liquidity mining, they can boost that return again to gain extra tokens.
Some of the DeFi protocols will incentivize the farmer even more by allowing them to stake their liquidity provider or LP tokens representing their participation in a liquidity pool. It gets a bit more complicated here, and it is worth reading this more in-depth tutorial on staking to understand how it works.
Like most financial markets, a strategy can quickly become obsolete due to changes in protocols or incentives, so it is essential to keep on top of it every day and amend your tactics as appropriate.
Final Thoughts
The world’s traditional financial systems are changing since DeFi is building a smarter, more open financial system. Yield farming is a potential function of DeFi that allows participants to earn lucrative returns on their crypto.
There are many opportunities to find a high return rate compared to traditional finance. Despite that, we still have to remember that it is still a very new industry, so it’s full of risks. We hope this article has provided much useful information for you about DeFi and Yield Farming.
