What is Yield Farming?
Yield farming is the technique of leveraging decentralized financing (DeFi) to boost profits. On a DeFi platform, users can lend or borrow cryptocurrency and receive cryptocurrency in exchange. It is also known as "liquidity mining".
Whenever users get short of Funds or want to lend some to the DeFi platform, people look for the Yield farming features. But wait, “What is Yield farming?” that’s your question, right?
Yield farming refers to the method of creating profits on cryptocurrency assets by storing them in smart contracts on decentralised platforms. In other words, yield farming entails supplying liquidity to a DeFi network in exchange for rewards such as additional tokens or fees.
With the rise of DeFi platforms and the growing popularity of yield farming, it's critical to grasp the fundamentals of this new concept. So let's take a closer look at what yield farming is, how it works, and what you need to know to get started.
What is Yield Farming? Is it Like Bank Loans?
What’s Yield farming is the approach of maximising returns through the use of decentralised financing (DeFi). On a DeFi network, users lend or borrow cryptocurrency and receive cryptocurrency in exchange for their services. Not at all it’s a Bank loan. Both work differently.
Yield Farmers that desire to boost their crop production can use more complex strategies. Yield farmers, for example, might continually shift their cryptos between several lending platforms to maximise their profits. Some of the key points are:
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Yield farming is the technique by which token holders maximise benefits across numerous DeFi platforms.
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Yield farmers give liquidity to multiple token pairs while earning cryptocurrency rewards.
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Aave, Curve Finance, Uniswap, and other high-yield farming methods are among the best.
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Yield farming can be risky owing to market fluctuation, rug pulls, smart contract hacks, and other factors.
As of now you got agist of What is Yield Farming but just don’t go out to flaunt it. Let’s look at its works first.
How Does Yield Farming Work?
Now as you know “What is Yield Farming” let’s check out how it works. An investor will stake their crypto tokens through a dApp's (decentralized app on DeFi) 'lending protocol. Now that their liquidity is in, other investors might opt to borrow it for their own investments, hoping to capitalise on huge price movements in the staked coins.
As yield farming is utilised to reward early investors, governance tokens of that blockchain are frequently distributed in order to keep them as users and their liquidity in the system.
Governance tokens aid in the decentralisation of a project by allowing real users to vote on new legislation. Governance tokens are at the heart of every DAO or project that aspires to be run entirely by its users.
Source: Blockworks
Yield farming is currently carried out on the Ethereum blockchain and its ERC-20 standard, as the benefits are derived from the Ethereum ecosystem. However, as the need for high-yielding agriculture grows, this may change in the future. Some experts expect that the yield farming approach will eventually become blockchain-independent and supported by many types of blockchains.
Types of Yield Farming
Liquidity Providers
Users who deposit two coins to a DEX are known as liquidity providers. On a decentralized exchange, whenever someone trades these two tokens or coins, the liquidity provider receives a small portion of the transaction fee.
Staking
In the DeFi ecosystem, there are two types of staking. The primary implementation is on blockchains using proof-of-stake, where a user receives interest in exchange for committing their tokens to the network as security. The second is to stake LP (Liquidity Provider) tokens obtained by providing liquidity to a DEX.
Because they are compensated for providing liquidity in LP tokens, which they may later stake to earn more interest, this enables users to earn yield twice.
A prime example would be ERC-20 tokens built on Ethereum are used by Uniswap V2 as liquidity provider (LP) tokens. These LP tokens serve as evidence that you are a member of the liquidity pool, and you may use them to withdraw your crypto tokens at any moment.
Lending
Coin or token owners can use a smart contract to lend cryptocurrency to borrowers, earning yield from the interest that is charged.
Borrower
Investors can use their money as collateral to lock up their money and borrow money against another token. Then, you can increase farm yield with this borrowed token.
Yield Farming Vs Staking
Yield farming and staking are both means of generating rewards on Bitcoin investments, but they work in different ways.
|
Aspect |
Yield Farming |
Staking |
|
Definition |
Earn rewards by lending or borrowing cryptocurrencies on DeFi platforms. |
Earn rewards by holding and locking up a certain amount of cryptocurrency in a specific wallet or smart contract. |
|
Rewards |
Variable and based on market conditions and demand for liquidity. |
Fixed and predictable based on staking duration and the size of the stake. |
|
Risk |
Higher risk due to market fluctuations and managing multiple assets. |
Lower risk due to fixed rewards and less involvement in market fluctuations. |
|
Network Security |
Not directly related to network security, but may indirectly contribute to it by providing liquidity. |
Directly contributes to network security by staking and helping to validate transactions. |
|
Liquidity |
Can provide liquidity to DeFi platforms and earn rewards. |
Does not provide liquidity, but may require locking up assets, which can impact liquidity. |
|
Complexity |
Can be more complex due to the need to manage multiple assets and constantly monitor market conditions. |
Generally more straightforward and easier to understand. |
|
Examples |
Providing liquidity on Uniswap, Sushiswap, or Pancakeswap. |
Yield Farming Metrics
These are the primary 3 measures you may encounter when working with yield farming.
Total Locked Value (TVL)
Total Value Locked, or TVL refers to the total amount of crypto locked in a specific protocol. It is simply the number of funds that users have currently put on the Defi network and is typically stated in USD.
Annual Percentage Yield (APY)
The annual percentage yield, also known as APY, is the potential rate of return on investment over the course of a year.
Annual Percentage Rate (APR)
The annual percentage rate, or APR, represents the expected rate of return on a specific investment over 12 months. It excludes compound interest, unlike APY.
How to Calculate Yield Farming?
The first thing you should know is that yield farming returns are often annualized, which means they are computed for a year. Annual percentage rate (APR) and annual percentage yield (APY) are commonly used to calculate yield returns (annual percentage yield). Please keep in mind that, in contrast to the latter, the former does not take compound interest into account.
APR = (Annual Return / Investment) * 100%
Calculating the APY is a bit more challenging. You must first understand how frequently returns will be reinvested into the liquidity pool, or how often your interest will be compounded. The formula is as follows:
APY = Invested Amount * {(1 + Rate / Number of Compounding Periods) ^ Number of Compounding Periods – 1}
Top Yield Farming Protocols
Compound Network
A compound is an algorithmic money market protocol. It focuses on making it possible for users to borrow and lend digital assets in exchange for security.
Investors have the chance to earn COMP, the company's governance token, in addition to adjustable compound interest rates. Rates for compounds are automatically modified based on supply and demand. It has numerous marketplaces, including BAT, ETH, and USDC but not only.
Curve Finance
The Curve Finance is the DeFi platform with the biggest total value locked with around $19 billion on the network. The Curve Finance platform utilizes locked money more than any other DeFi platform thanks to its unique market-making algorithm, which is advantageous for both swappers and liquidity providers.
Curve offers a comprehensive list of stablecoin pools with reasonable APRs that are connected to fiat money. With APRs ranging from 1.9% (for liquid tokens) to 32%, Curve maintains its high rates.
Stablecoin pools are quite secure as long as the tokens don't lose their peg. Because their expenses won't change significantly about one another, the impermanent loss can be completely avoided. Like all DEXs, Curve poses the risk of momentary loss and failed smart contracts.
Aave
Aave, with over $14 billion in value locked up and a market valuation of over $3.4 billion, is one of the most popular stablecoins yield farming platforms.
AAVE, Aave's native token, is also available. This coin encourages users to use the network by offering advantages like fee reductions and voting power for governance.
Uniswap
A DEX system called Uniswap facilitates untrusted token trades. To establish a market, liquidity providers put in the equivalent of two tokens. Then, traders can make transactions using the liquidity pool. Liquidity providers receive fees from trades that occur in their pool as payment for their services.
Uniswap has emerged as one of the most widely used platforms for frictionless token swaps as a result of its frictionless design. For high-yield agricultural systems, this is helpful. Additionally, Uniswap features a DAO governance token called UNI.
Risks of yield farming
Yield Farming is a complex operation that puts both borrowers and lenders at risk. Users incur a higher risk of momentary loss and price slippage when markets are volatile. The following are some of the risks linked with yield farming:
Rug pulls
Rug Pulls are a type of exit scam in which a cryptocurrency developer obtains investor funds for a project and then abandons it without repaying the investors' monies. According to a CipherTrace study report, rug pulls and other exit scams, to which yield farmers are particularly vulnerable, contributed to around 99% of large fraud during the second half of 2020.
Regulatory risk
The regulation of cryptocurrencies remains hazy. The Securities and Exchange Commission has decided that certain digital assets are securities, bringing them under its jurisdiction and granting it the authority to regulate them. State regulators have already issued cease and desist orders to centralised cryptocurrency lending platforms such as BlockFi, Celsius, and others.
Volatility
The degree to which the price of investment changes in either direction is referred to as volatility. A volatile investment is one that has a significant price swing in a short period of time. While tokens are locked up, their value may fall or rise, posing a significant risk to yield farmers, particularly during a bear market in the crypto markets.
Yield Farming FAQs
What is an impermanent loss in yield farming?
Impermanent loss occurs when the value of the tokens in a liquidity pool changes due to market volatility, resulting in a loss for liquidity providers. This is because liquidity providers receive a proportionate share of the pool's value, which can fluctuate with the market price of the tokens.
What are governance tokens in yield farming?
Governance tokens are tokens that are issued by DeFi protocols and give holders the right to vote on proposals related to the protocol's governance and development. Users can earn governance tokens as rewards for providing liquidity in yield farming.
What is staking in yield farming?
Staking in yield farming involves holding a cryptocurrency in a wallet and locking it up for a period of time to earn rewards. Users can stake their tokens in a DeFi protocol and earn rewards for providing liquidity to the protocol.
What is liquidity mining in yield farming?
Liquidity mining is a process of providing liquidity to a liquidity pool and earning rewards in the form of governance tokens. Users can participate in liquidity mining by depositing tokens into a liquidity pool and earning rewards based on the proportion of liquidity they have provided to the pool.
What is a yield aggregator in yield farming?
A yield aggregator is a platform that automatically maximizes the returns on yield farming by routing funds to the highest-yielding DeFi protocols. Yield aggregators use algorithms to optimize yield farming strategies and earn the best returns for users.
How do I get started with yield farming?
To get started with yield farming, you need to have some cryptocurrency that you can deposit into a liquidity pool. You can then choose a DeFi protocol that offers yield farming and deposit your cryptocurrency into the liquidity pool to start earning rewards. However, it is important to carefully analyze the risks associated with yield farming before investing.
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