The world of DeFi is complicated, but some users have figured out how to get the most out of their cash. If you want to enhance the profits on your cryptocurrency investments, you might be interested in yield farming. Yield farming is the practice of generating additional revenue from your crypto assets by utilizing DeFi technologies. So, what exactly is it?
What is Yield Farming?
Yield farming is a method of generating extra cryptocurrency with your existing cryptocurrency. It entails you lending your money to others through the power of computer programs known as smart contracts. In exchange for your services, you will be compensated in the form of cryptocurrency. Isn’t it simple? Not so soon, though.
Yield farmers will employ highly complex tactics. They constantly shift their cryptos across loan platforms in order to optimize their earnings. They’ll also keep the top yield farming practices a closely guarded secret. Why? The more individuals who are aware of a plan, the less successful it becomes. Yield farming is the wild west of Decentralized Finance, with farmers competing for the opportunity to cultivate the greatest crops.
How Does Yield Farming Work?
Yield farming entails depositing currencies or tokens into a decentralized application, or dApp, in order to receive a return. Crypto wallets, decentralized exchanges, and other dApps are examples.
Decentralized exchanges are commonly used by yield farmers to lend, borrow, or stake coins in order to earn interest and speculate on price volatility. Smart contracts, which are pieces of code that automate financial agreements between two or more people, make yield farming possible through DeFi.
Types of Yield Farming.
1. Liquidity Provider.
To provide trading liquidity, users deposit two coins to a decentralized exchange. To switch the two tokens, exchanges charge a modest fee, which is paid to liquidity providers. This charge might be paid in fresh liquidity pool (LP) tokens on request.
Coin or token holders can use a smart contract to lend crypto to borrowers and receive interest on the loan.
Farmers can use one token as security for a loan with another token. The borrowed coins can be put to use in yield farming. This enables the farmer to keep their initial investment, which may grow in value over time, while simultaneously paying interest on the borrowed coins.
In the world of DeFi, there are two types of staking. On proof-of-stake blockchains, a user gets paid interest in exchange for pledging their tokens to the network as security. The second option is to stake LP tokens obtained by providing liquidity to a decentralized exchange. Users can earn yield twice since they are compensated in LP tokens for supplying liquidity, which they can then invest to gain more interest.
Calculating Yield Farming Returns.
In most cases, expected yield returns are annualized. Over the course of a year, the potential returns are computed.
Annual percentage rate (APR) and annual percentage yield (APY) are two often used measurements. Compounding (reinvesting gains to generate bigger returns) is not taken into account by APR, but it is by APY.
Remember that the two measurements are just predictions and guesses. Even short-term benefits are difficult to predict with precision. Why? Yield farming is a fast-paced, highly competitive industry with constantly changing incentives.
If a yield farming approach works for a while, more farmers will want to use it, and it will eventually stop producing big profits.
DeFi will have to create its own profit calculations because APR and APY are outdated market measurements. Due to DeFi’s quick speed, weekly or even daily predicted returns may make more sense.
Popular Yield Farming Protocols.
- Curve Finance.
Curve has almost $17 billion in total value locked on the platform, making it the 2nd largest DeFi platform in terms of total value locked. The Curve Finance platform, with its unique market-making algorithm, makes more use of locked money than any other DeFi platform, which is a win-win strategy for both swappers and liquidity providers.
Curve offers a huge number of stablecoin pools with competitive APRs that are linked to fiat currency. Curve maintains a high APR, which ranges from 1.9% to 32%. Stablecoin pools are relatively safe as long as the tokens do not lose their peg. Impermanent loss can be avoided altogether because their costs do not differ much from one another. Curve, like all decentralized exchanges, is vulnerable to short-term losses and smart contract failure.
Curve also has its own coin, CRV, which is utilized for Curve DAO governance.
With over $10 billion in value locked up and a market cap of over $1.6 billion, Aave is one of the most extensively used stablecoin yield farming platforms. AAVE, Aave’s native token, is also available. This token encourages users to use the network by offering benefits such as fee savings and voting power in governance.
Yearn.Finance is the highest-earning coin on Aave, with a deposit APY of 19.42% and a borrow APY of 53.70%.
Uniswap is a decentralized exchange that allows for no-trust token exchanges. To build a market, liquidity providers invest the equivalent of two tokens. The liquidity pool can then be traded against by traders. Liquidity providers receive fees from trades that take place in their pool in exchange for providing liquidity.
Uniswap has become one of the most popular platforms for trustless token swaps due to its frictionless nature. This is beneficial in agricultural systems with large yields. UNI, Uniswap’s own DAO governance token, is also available.
PancakeSwap functions similarly to Uniswap, however instead of Ethereum, it runs on the Binance Smart Chain (BSC) network. It also has a few other gamification-related features. On PancakeSwap, you can find BSC token exchanges, interest-earning staking pools, non-fungible tokens (NFTs), and even a gambling game in which users guess the future price of Binance Coin (BNB).
PancakeSwap faces the same risks as Uniswap, including temporary losses as a result of large price changes and smart contract failure. Many of the tokens in PancakeSwap pools have small market capitalizations, placing them at risk of losing value.
PancakeSwap has its own token, CAKE, which can be used on the platform as well as to vote on platform proposals.
Risks of Yield Farming.
Yield farming is a complex procedure that puts both borrowers and lenders at danger of losing money. Users are at greater risk of temporary 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 takes money from investors for a project and then abandons it without repaying the money. Rug pulls and other exit scams, which are particularly vulnerable to yield farmers, accounted for nearly all large fraud in the second half of 2020.
- Regulatory Risk.
The future of cryptocurrency regulation is still up in the air. Some digital assets have been labeled securities by the Securities and Exchange Commission, bringing them under its authority and allowing it to regulate them. State regulators have previously issued cease and desist orders against BlockFi, Celsius, and other centralized crypto lending services. If the SEC declares DeFi lending and borrowing to be securities, the ecosystems could be harmed.
The degree to which the price of an investment moves in either direction is known as volatility. An investment that exhibits a high price swing over a short period of time is considered volatile. While tokens are locked up, their value may decline or rise, posing a significant risk to yield farmers, particularly during a bad market.
- Smart Contract Hacks.
The smart contracts that enable yield farming are responsible for the majority of the risks. Although increased code vetting and third-party audits are improving the security of these contracts, DeFi hacks are still frequent. Before using any platform, DeFi users should undertake research and due diligence.
What are your thoughts about Yield Farming? And what’s your preferred yield farming protocol? Let us know in the comment section down below.
Disclaimer – I’m not a financial advisor. The article is for informational and educational purposes only.