What Is Yield Farming and Why Is It So Popular?
Yield farming is the emerging trend in the crypto world that has grabbed the attention of a number of cryptocurrency enthusiasts. It looks very promising and is now considered one of the most popular ways of generating rewards with cryptocurrency holdings.
In recent years we’ve been witnessing how the previously unknown and mysterious crypto space has shaped almost every aspect of our lives and caused a shift in our mindsets. Those who used to perceive bitcoin as a come-and-go trend now seem to be bitterly regretting not buying it earlier. On the other hand, those luckies who managed to buy bitcoin at a reasonable price are anxiously waiting for its value to go up every single day.
However, crypto space is not only about bitcoin. New multiple strategies and techniques have appeared within the decentralized finance (DeFi) infrastructure aimed at providing users with more opportunities to generate larger incomes. Currently, one of the hottest crypto trends is yield farming, which seems to have taken DeFi by storm.
Yield farming is about lending your funds to others with the help of ingenious computer programs called smart contracts. As a result, you earn fees in the form of cryptocurrency in exchange for your services. Sounds simple enough, right? But let’s not rush — there are a lot of pitfalls and complexities that you might encounter during the process. That’s why it’s important to ensure you have enough background knowledge before you get started.
Read this article to discover all the ins and outs of yield farming, how it differs from other crypto strategies, and how to farm cryptocurrency correctly.
Ready — steady —
What is yield farming?
Yield farming is one of the latest trends that has rapidly forced its way into the decentralized finance (DeFi) world. It’s viewed as an effective strategy that investors turn to when they want to increase their profits. According to CoinMarketCap data, the total locked value of liquidity pools in yield farming projects exceeded $13 billion as of 10th March 2021 (note that the statistics are constantly updated).
Thanks to yield farming, crypto holders can lock up their holdings in return for rewards in the form of additional cryptocurrency. To be more specific, this process allows investors to earn fixed or variable interest by investing cryptocurrency in a DeFi market.
Nowadays almost all yield farming transactions are carried out within the Ethereum ecosystem and its ERC-20 standard, as the rewards usually belong to the Ethereum ecosystem too. However, it’s expected that cross-chain advancements will soon allow DeFi apps to run on other blockchains, as the demand in yield farming is constantly increasing.
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How does yield farming work?
First of all, it’s worth noting that to function, yield farming requires liquidity providers and liquidity pools.
To become a liquidity provider, all you have to do is to add your funds to a liquidity pool (smart contract), which is responsible for powering a marketplace where users carry out several procedures with their tokens, including borrowing, lending, and exchanging. Once you’ve locked up your funds in the pool, you’ll get fees that have been generated from the underlying DeFi platform or reward tokens. In addition, some protocols can even provide payouts in the form of multiple cryptocurrencies, allowing users to diversify their assets and lock those cryptocurrencies into other protocols in order to maximize yields.
As well as this, since professional yield farmers are knowledgeable about the Ethereum network and its technical aspects, they prefer to move their funds around various DeFi platforms with a view to getting the highest possible returns. This can prove to be a tall order. Those who provide liquidity receive rewards too, depending on the amount of liquidity provided — that’s why those who obtain the highest rewards possess the largest amounts of capital.
What should you remember?
Before getting into yield farming, make sure that you’re fully aware of the following basics:
- Liquidity providers deposit their funds into a liquidity pool.
- Deposited funds are stablecoins related to the USD such as DAI, USDC, USDT, etc.
- Your returns depend on how much you invest and what rules the protocol is based on.
- You’re able to create complex chains of investment once you decide to reinvest your reward tokens into other liquidity pools, which in turn offer various reward tokens.
- You should be aware that simply investing in ETH itself, for instance, isn’t considered to be yield farming. Lending out ETH on a decentralized non-custodial money market protocol and receiving rewards afterwards — that’s yield farming.
What makes yield farming so popular?
It goes without saying that the key advantage of yield farming is that it can bring investors a good profit. As of today, yield farming has the capacity to provide more attractive interest rates than traditional banks, though there’s no denying that there are some potential risks too.
What’s more, 2020 witnessed a surreal upsurge in yield farming’s popularity. A huge amount of money was made via the Ethereum network, as yield farming platforms run on Ethereum and even DeFi tools tend to use the Ethereum platform too. In addition, yield farming grants benefits to various protocols, most of which are just nascent. When they have an active and growing base of enthusiasts, it’s much easier for them to draw stakeholders’ attention.
On the whole, yield farming is becoming immensely popular nowadays as it’s able to help a wide range of projects gain initial liquidity and is useful for lenders and borrowers. Yield farming also contributes enormously to greater efficiency when it comes to taking out loans.
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What is DeFi and what role does it play?
DeFi stands for “decentralized finance”. The term is used to describe a variety of financial apps in the blockchain and/or cryptocurrency domain aimed to disrupt financial intermediaries. DeFi is often referred to as an unconventional financial system that functions independently, without relying on banks, insurance funds, or credit unions. It enables users to carry out various financial procedures with cryptocurrencies and other digital assets, including transferring, trading, investing, transacting via automated smart contracts, and so on.
DeFi runs on blockchain technology that will inevitably upend the existing financial order and contribute to a more transparent and secure financial system. As well as that, DeFi can boast another distinct feature — it’s able to expand blockchain capabilities to include more sophisticated financial use cases, like lending, derivatives, flash loans, and crypto yield farming.
Thanks to DeFi users are able to conduct trades and transactions whenever and wherever they wish. The only essential is a stable internet connection. Among the other substantial benefits of DeFi are blazing fast transfers and significantly reduced fees and charges. And not only that — DeFi lending protocols provide higher interest rates for deposits along with lower fees and more encouraging terms on loans as well as credit lines.
It’s also worth noting that DeFi grants equal and free access to financial services to a wider range of users who otherwise wouldn’t be able to participate due to lack of funds or political, social, and economic issues. Furthermore, DeFi allows for high yield trading — yield farming — that enables investors to borrow and lend their cryptocurrencies at considerably higher rates compared to traditional banking and investments.
Yield farming vs. other strategies
Those who’ve just entered the cryptocurrency world may not be able to differentiate yield farming from other concepts such as liquidity mining, crypto mining, and staking. Even though they all have something in common and may look the same, in reality, they differ from one another and follow totally different complex algorithms. We’re here to ensure that you won’t mix these concepts in the future and will be able to tell them apart.
Yield farming vs. liquidity mining
Sometimes yield farming can be confused with liquidity mining. Though they can be used interchangeably, differences do exist.
First, it’s necessary to clarify that both yield farming and liquidity mining operate on the DeFi sector that is able to increase returns on governance tokens. Yield farming uses several DeFi apps like fund leveraging, whereas liquidity mining operates on the Proof-of-Work (PoF) algorithm.
When dealing with liquidity mining, miners normally manage to earn a dividend swap equal to 0.3% as well as newly minted tokens once the transaction of each block has been successfully completed. In yield farming, though, liquidity providers resort to different DeFi platforms where they move their funds around in order to maximize yields. In addition, they can use DeFi mechanisms such as fund leveraging through both the borrowing and lending of stablecoins. As well as this, yield farmers can sometimes increase their gains by applying different strategies when moving their funds.
Yield farming vs. crypto mining
The key difference between crypto mining and yield farming is that the former runs on the Proof-of-Work consensus algorithm, while the latter is predicated on DeFi and heavily relies on the Ethereum network. In comparison with crypto mining, yield farming is viewed as an advanced way of earning rewards with crypto holdings via special permissionless liquidity protocols.
It’s also important to remember that both of them involve mining pools. However, liquidity providers belong to the yield farming process only.
Another fundamental difference between the two concepts lies in the fact that yield farming resembles the borrowing and lending plan that involves governance tokens, which enable you to yield rewards. As for crypto mining — it allows for the introduction of new coins and offers miners to earn their rewards by creating new blocks via verified transactions that occur in the mining pool.
Yield farming vs. staking
Staking chiefly operates on the Proof-of-Stake, or PoS, consensus mechanism, where a validator is responsible for creating a block via a random selection process and earning rewards that are paid by the platform’s investors. In this case, the higher the stake, the bigger the staking rewards. By contrast, yield farming enables token holders to generate passive income by locking their funds into a lending pool and earning interest in return.
What’s more, staking typically involves a more substantial amount of crypto in order to increase the chances of being chosen as the next block validator. And depending on how mature the coin is, it can take up to a few days to get the staking rewards.
Yield farmers, for their part, can move digital assets more efficiently and actively whenever they wish, with the purpose of earning new governance tokens or sometimes smaller transaction fees. Compared to staking, yield farming enables you to deposit different coins into liquidity pools across a number of protocols.
All things considered, yield farming is a more complicated process than staking, yet it brings a higher return rate.
As you can see, all the strategies outlined above may look the same, but each is based on its own unique complex algorithm.
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Total Value Locked (TVL): what is it?
If you wish to assess the overall condition of the DeFi yield farming scene, then you should pay attention to Total Value Locked (TVL). This measures the amount of crypto locked in DeFi lending as well as other money marketplaces.
TVL is sometimes thought of as a smart and efficient way of aggregating liquidity in liquidity pools. It’s also a helpful indicator that reflects the state of the DeFi and yield farming worlds. What’s more, TVL is a powerful metric used to make comparisons between market shares of various DeFi protocols.
At DeFi Pulse you can track TVL and even take a look at the platforms with the biggest amount of ETH or other cryptoassets that are locked in DeFi. Thanks to TVL you can easily get the most relevant information about the current state of yield farming. Normally, the more value that’s been locked, the better the crypto yield farming will get. In addition, you also have an opportunity to measure TVL in ETH, BTC, and USD. Each of them provides you with its own outlook for the state of the DeFi money markets, thus enabling you to assess the situation and help you make the right decision.
How to calculate yield farming returns
Estimating the returns from yield farming can be a bit complicated even in the short term because volatile fluctuations and intense competition create uncertainties. So, for instance, if one crypto yield farming strategy is too widely used, the returns will naturally decrease, and high returns can dry up.
But it’s still certainly possible to try and predict your returns. When you wish to calculate yield farming returns, you should use the most common metrics, which are Annual Percentage Rate (APR) and Annual Percentage Yield (APY).
Compared to APY, APR doesn’t involve compounding, which actually means that the calculation comprises simply multiplying the periodic interest rate with the number of periods within one year. The annual return rate is normally imposed on borrowers and is paid out to the capital investors. As far as APY is concerned, its return rate is imposed on capital borrowers but paid to the capital providers instead of investors.
All in all, the key difference between the two metrics is that APR takes compounding into account, whereas APY just describes the return rate with interest on interest.
Collateralization in DeFi: what is it?
Whenever you’re borrowing assets, you’ll have to provide collateral, which has to cover your loan and act as insurance for it.
Collateralization is when a borrower pledges their asset as a way for the lender to compensate their capital in case the borrower fails to pay back the loan according to the initial agreement. Lenders sometimes ask borrowers to put up their valuable assets as collateral, which lenders can possess if the loan defaults.
In DeFi, collateralization plays a huge role depending on the type of protocol you use. If the value of your collateral isn’t up to the standard required by the protocol, the collateral may then be liquidated on the open market. To prevent this from happening, you can simply add a bit more collateral. What’s more, to diminish the risk of severe market crashes, borrowers can deposit more value than they intend to borrow.
How risky is yield farming?
Yield farming can be enormously complex and sometimes risky. It also involves high Ethereum gas fees but can be worth trying if a relatively large investment capital has been provided. As well as this, there are other risks associated with crypto yield farming, including liquidation risk, impermanent loss, and smart contract risk. Let’s find out more about each and learn how to deal with them.
Liquidation normally occurs when a user’s collateral is insufficient to cover the amount of their loan. This can, unfortunately, result in a liquidation penalty charged to the collateral, which happens if the collateral value plummets or the loan value increases.
To reduce the likelihood of liquidation, it’s advisable to use less volatile assets and always track market conditions. Sometimes it’s better to use stablecoins for both the collateral and the loan, e.g. you can borrow USDC against DAI — their value is normally stable as they’re pegged to fiat currencies. Also remember that the more volatile the asset is, the bigger the chances of liquidation. That’s why it’s important to make sure that the collateral and the loan are less volatile assets or stablecoins — and you’ll considerably reduce the liquidation risk.
A lot of automated market makers (AMMs) order users to put their funds into liquidity pools so as to earn rewards and gain trading fees that are paid out by decentralized exchange users. It’s widely regarded as a nice way of earning passive income independently of market fluctuations. Nevertheless, when the market experiences sharp moves, users may lose their money. This risk is called impermanent loss, and liquidity providers should be aware of it.
DeFi has been going strong for almost a year already but there’s still no solution that would be able to entirely eradicate the problem of impermanent loss. A number of developers, though, have been doing their best to create new Decentralized Exchanges (DEXs) or make changes in the existing popular protocols to offer an efficient way of avoiding losses.
When participating in the liquidity pool, users can be faced with a problem when AMMs don’t automatically update their prices based on market movements. This leads to arbitrage opportunities and entails some risks for liquidity providers.
When a token price on centralized exchanges decreases by 50%, for example, this change won’t be reflected immediately in the decentralized platforms. Arbitrage traders, in their turn, can use this time to sell their ETH on DeFi platforms for an inflated price. The difference in pricing is then covered by liquidity providers who suffer losses when the price goes down and cannot benefit when it goes up since their capital has been locked in the pool.
To prevent impermanent loss issues, liquidity providers are advised to choose pools wisely and be aware of how they function. Besides, it’s worth asking other users’ opinions about the protocol and their experience of working with it. Some protocols can provide a solution to mitigate impermanent loss risk, and, as the industry is fully aware of the problem, quite a number of projects are working on various solutions that will help overcome this challenge.
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Smart сontract risk
Smart contracts are a secure and reliable way of processing various deals and transactions. They assist in fighting corruption and avoiding human error as everything is carried out automatically in accordance with the terms and conditions provided to the smart contract in advance.
Still, like any other computer code, smart contracts may have bugs. Even though developers work hard to ensure that everything functions as intended, they could overlook some errors that can later be exploited by hackers to withdraw money from the project. In the long run, users are likely to lose their capital. Additionally, cybercriminals take advantage of loopholes to outdo algorithms and steal money. For instance, in 2020, hackers managed to steal about $100 million from the DeFi sector.
But once you hire a team of professional developers with extensive experience in smart contract development, you can be sure that all these issues will be successfully resolved. Moreover, ensure that your smart contract is audited. Audits may not guarantee that there are no errors in the code but they do significantly reduce the risk of smart contract failure.
Examples of yield farming protocols
Several yield farming protocols are in existence, and each of them has its own risks and rules. Let’s take a look at the protocols outlined below and study their peculiarities.
Being an algorithmic money market and one of the main protocols of the yield farming ecosystem, Compound enables its users to lend and borrow assets. Those who have an Ethereum wallet can provide assets to Compound’s liquidity pool and gain rewards that instantly start compounding. The rates are settled algorithmically depending on supply and demand.
MakerDAO is considered to be one of the first DeFi projects. It’s a decentralized lending platform that supports the creation of DAI — a stablecoin pegged to the value of the USD.
MakerDAO also utilizes the Maker Protocol that provides users with an opportunity to borrow against collateral. The platform is built on the Ethereum blockchain and its crypto loans are managed by Ethereum smart contracts.
Synthetix is a synthetic protocol that allows for the issuance of synthetic assets on the Ethereum blockchain. It also supports different types of synthetic commodities including gold, silver, synthetic cryptocurrencies, synthetic fiat currencies — in other words, anything with a reliable price feed. Synthetix also enables anyone to lock up Synthetix Network Token (SNX) or ETH as collateral and mint synthetic assets against it.
Aave is an open-source and non-custodial decentralized lending protocol, which is widely used by yield farmers. Depending on relevant market conditions, interest rates can be adjusted algorithmically. Once lenders have contributed their funds, they receive aTokens in return, which can earn and compound interests when deposited.
Uniswap is a decentralized exchange protocol that grants users an opportunity to handle trustless token swaps. With this protocol, it’s possible to conduct automated transactions with cryptocurrency tokens on the Ethereum blockchain with the help of smart contracts.
To establish a new market, Uniswap also allows liquidity providers to deposit an equivalent value of two tokens. Afterwards, traders are enabled to trade against that liquidity pool, and LPs can gain fees from the trades that take place in their pool.
Curve Finance is an Ethereum-based DEX protocol designed to enable users to efficiently carry out high-value swaps with stablecoins. Curve also supports DAI, USDC, TUSD, and BTC pairs, and allows users to trade swiftly and efficiently between these pairs.
Balancer is a multi-token automated market-making protocol. It provides custom token allocations within a liquidity pool and offers liquidity providers the opportunity to establish customized Balancer pools and earn fees for the trades carried out in their pools. Due to its flexibility, Balancer has been widely adopted by yield farmers to optimize their work.
The prospects for yield farming
Right now, it’s almost impossible to accurately and reliably predict the prospects for yield farming. It’s undeniable that high rewards remain the chief motivating factor that makes investors and crypto enthusiasts embrace the liquidity mining market. For sure, large gas fees in the Ethereum network along with numerous risks may frighten inexperienced players. But despite this, most DeFi participants — 70% to be exact — express a strong desire to keep on yield farming, and their positive experience is bound to attract many more new players.
These days, yield farming is expected to become the new star of the DeFi universe and contribute enormously to the expansion of the industry as well as attracting financial capital and new participants to the field.
The yield farming sector is gradually getting more robust and its architects are coming up with various approaches to enhancing liquidity incentives and guaranteeing better security to all users. But as of today, we’re yet to carry out the necessary research and risk assessments to ensure the smoothness, safety, and efficiency of yield farming and provide the desired levels of confidence in it.
Yield farming is a new financial incentive within the DeFi infrastructure, capable of both incentivizing liquidity and enabling fair distribution of tokens. This activity has also brought significant benefits to DeFi stakeholders, by decreasing the slippage for token swaps across multiple DeFi apps and bolstering the growth of strong communities, which otherwise wouldn’t exist. In addition, yield farming has allowed numerous projects to get off the ground, which can now secure billions in users’ funds at short notice.
It’s evident that yield farming will continue to evolve. Technological advances and breakthroughs within the DeFi infrastructure have become a common occurrence, and yield farming is bound to stay with us, though it may undergo some transformation and change.
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