Since Bitcoin began, blockchain technology has changed how we do business. Yield Farming makes it possible to earn a passive income from your cryptocurrency holdings. This guide will help you understand how Yield Farming works, its applications, benefits, and risks to help you make an informed decision.
Yield farming is a broad term for several ways to make money by putting crypto assets into crypto wallets, DeFi platforms, and other decentralized applications (dApps).
Becoming a Liquidity Provider: This is the method most people associate with yield farming. An investor typically deposits equal amounts of two different coins into a liquidity pool on a decentralized exchange, like https://pancakeswap.finance or https://traderjoexyz.com. Each time there is a trade between these tokens, the investor earns transaction fees.
A liquidity pool is a smart contract that has crypto deposited into it. Depositors, known as liquidity providers, earn rewards in exchange for putting their crypto into these pools. These rewards can come from transaction fees, interest paid by lenders, governance tokens, or other incentive programs.
Yield Farming Includes:
- Crypto Lending: Depositing your cryptocurrency into a lending pool, where other users can borrow your crypto, and you earn interest on the loans.
- Crypto Borrowing: Investors can borrow against the cryptocurrencies that they have deposited. For instance, you need a new refrigerator but don’t want to sell your cryptocurrency. You can borrow stablecoins using your crypto as collateral.
- Crypto Staking: Staking crypto allows you to earn interest by locking up your crypto with an exchange or DeFi platform.
Many investors focus on farming stablecoins like USDT, DAI, and USDC. However, DeFi platforms on most blockchains offer token rewards for liquidity mining. When yield farmers earn token rewards, this is called liquidity mining. These tokens can be held or traded for other cryptocurrencies. Liquidity mining became popular after Compound started giving out its COMP governance token. COMP skyrocketed, making users of its platform a lot of money. Yield farming is also often called liquidity farming.
How Does Yield Farming Work?
Yield Farming is closely linked to automated market maker protocols (AMMs). This model typically involves liquidity providers and liquidity pools. For AMMs to work, a group of people who offer liquidity must put money into a liquidity pool or reserve. These funds feed a marketplace where other users can grant loans, request loans, or exchange tokens. When people use these platforms, they must pay liquidity providers transaction fees. The fees earned are based on the percentage of the liquidity provided. But implementations can be very different; over time, you may see new versions or ways to do things.
Other reasons to put money into a liquidity pool besides earning transaction fees. One example is the allocation of a new token. Some tokens with high growth potential are not available on the open market. The only way to get them is to provide liquidity to a particular pool. Each protocol will have its own specific rules. Liquidity providers will always be compensated based on the amount of liquidity they contribute to the pool. Even though more money is usually deposited in stablecoins tied to the USD, this is becoming less of a requirement.
Some protocols even mint LP tokens representing the coins you deposit. For instance, if you deposit DAI into Compound, you may earn cDAI or Compound DAI, and if you deposit ETH, you may earn cETH. You could also deposit your cDAI into some protocol that mints a third token representing your cDAI. This last one would represent your DAI. As you can see, this can be extended as long as needed, resulting in very complex and hard-to-follow chains.
Collateralization in DeFi
You must present a guarantee to cover your loan request as a general rule when borrowing assets that are insurance for your loan. The relevance of this system or model will depend on the protocol you are supplying your funds to. Even so, it’s a good idea to keep a eye on your collateral ratio. If the value of your collateral falls below the threshold set by the protocol, it may be sold on the open market.
In addition, it’s also common for liquidity groups to be over collateralized, that is, deposit more value than they are borrowing. This is done to reduce the risk of violent market crashes due to many investors being liquidated. As a general rule, the more collateral you add, the lower your risk is for liquidation.
Low Yield Farming Platforms
There is no set way to get these YF rewards. In fact, strategies can change multiple times in the same day, especially when working with volatile crypto assets. Before starting, you need to know how decentralized liquidity protocols work. You already know the basic concept: putting money into a smart contract and receiving something in return. Remember that each platform and strategy has its own rules and risks.
Here is a small list with a collection of fundamental protocols for Yield Farming strategies.
Crypto.com – You can get an APY of over 10% on your deposits of stablecoins like Tether and USDC. However, specific rules apply, and APY can change during this writing. Most of the time, the rules involve depositing a certain number of tokens over a specific time or date.
Synthetix – A derivative protocol that lets users make crypto assets that can be tied to traditional financial assets. With Synthetix, you can stake crypto tokens as collateral and create synthetic assets tied to the price of items like silver, gold, or crude oil.
Uniswap – A DEX protocol that enables trustless token swaps. LPs deposit a minimum value of two tokens to create a market. Traders can then use that pool of liquidity to place their trades. LPs earn commissions for trades made in their pool to supply liquidity.
Aave – A decentralized lending protocol. Lenders can get “tokens” in exchange for their loans, which earn interest when the money is deposited. In Aave, interest rates change automatically based on how the market is doing. It also has several advanced loan features that help investors get the most out of their money.
Compound – A money market based on algorithms that enable people to lend and borrow crypto assets. Anyone with an Ethereum wallet can add assets to the liquidity pool of Compound and get rewards that start making money immediately. Commissions are algorithmically adjusted based on supply and demand.
Balancer – Another platform that works like Uniswap protocols and lets liquidity providers put assets into a common fund. But unlike Uniswap, Balancer doesn’t let liquidity providers get around fixed fund allocation and instead gives out custom funds.
Yearn Finance – This is a decentralized ecosystem of aggregators to provide other financial services. The service uses an optimized algorithm to find the most profitable loan services so its users can make the most money possible. This may be your best choice if you want a protocol that automatically chooses the best strategies.
Curve Finance – A decentralized exchange designed for swapping stablecoins. With Curve Finance, you can trade high-value stablecoins with low slippage. You could, for example, use a Curve token on Synthetix to join a staking pool and earn sETH. You could give the underlying token to another user who has staked funds.
The Benefits of Yield Farming
People participate in yield farming mainly to get a high return on their cryptocurrency savings. Suppose you are waiting for the price to increase before selling a cryptocurrency. In that case, you can also use “yield farming” to earn additional income from your crypto assets. This is an advantage over traditional banking savings accounts, which usually have very low-interest rates. However, there is also a debate about the profitability of yield farming. Keep in mind that yield farming returns are usually calculated annually. This means you need to wait an entire year to get an accurate calculation of your returns. This will also depend on the capital invested, the strategy used, and the risks of each platform or protocol. But it’s also true that some ways to farm cryptocurrency are very successful and can give their users profits of up to 100%.
Some of the benefits of high-yield farming are:
- It strengthens the blockchains on which it’s used.
- Increase liquidity through lending
- This will increase the efficiency of decentralized exchanges.
- Staking and lending provide a low-risk form of investment.
- It can be highly profitable.
- It makes the crypto ecosystem stronger.
The Risks of Yield Farming
Risk is inherent in all investments, and yield farming is no exception. Even though yield farming is profitable initially, it is hard to get good results without careful planning. Most of the time, the most profitable strategy is a somewhat complicated process that requires a lot of money. This is so that the different ways to invest can work well.
Some risks of yield farming include:
Impermanent loss – This term refers to the losses that liquidity providers may suffer due to the divergence in prices of the assets within a liquidity pool. That’s why it is also known as divergence loss. Impermanent loss occurs when the token price drops below its market price when deposited. This is called “impermanent” because an asset’s price can change over time, making a temporary loss more painful.
High probability of collateral liquidation – When an investor makes an asset loan, he must create a collateral deposit to guarantee that loan. Your money will be liquidated if the value of that deposit falls below the protocol’s preset value. Because of this, it’s essential to look at the guarantee ratio to avoid collateral liquidation. As a general rule, the higher the collateral ratio, the lower the amount you can borrow.
Losses due to failures in smart contracts – Smart contracts are used in yield farming to create deals between two anonymous parties without the need for a central authority. This means that an attack, a data error, or a programming mistake can affect yield farm investors. That includes the leak of financial information and the loss of funds.
The value of tokens could fall in the future – Farming a token means two things: its value could go up a lot, but it could also decrease. Even though DeFi is becoming more popular, it is hard to predict what will happen in the future. Ultimately, if the trend starts to fade or there is an oversupply of tokens in the market, the value will decline.
DeFi composability cancels collaterals – Composability means that each part is responsible for maintaining the necessary relationship to achieve a specific goal. This lets us eliminate the need for third parties and makes it so that the protocols can work without any problems. If one of the blocks breaks down, the whole ecosystem has to deal with the effects.
DeFi and yield farming are financial revolutions with so much potential that it’s hard to imagine what new ways they could be used in the future. But products and services related to yield farming are becoming more important in the financial sector and the crypto economy, not just in DeFi. Without a doubt, DeFi can help make the financial system more open and accessible, so anyone with Internet access can use it.