In the blockchain space, Decentralized Finance (DeFi) has sparked a silent revolution of sorts. What sets DeFi apart is its permission-free nature, which means that you can transact with anyone with an internet connection and a secured wallet without an intermediary. A variety of cryptocurrency financial applications are enabled by DeFi. What is Yield Farming?
Yield farming is an investment strategy in DeFi. It is a method to generate more cryptocurrency from your existing crypto assets. It means that you lend your crypto assets to others for interest, who in turn lock them using smart contracts. In simple terms, this means that you lock cryptocurrencies and receive rewards in return. Yield farming allows you to earn passive income using the Ethereum-based open ecosystem. So how do high-yield farmers tend their crops? What kind of returns are they looking for? And where do you start as a yield farmer? In this post, we address these questions and more.
Yield farming is the Wild West of decentralized finance (DeFi), with farmers competing for the chance to farm the burgeoning market. However, there are certain tactics that can help farmers optimize their yields. Before proceeding, let us understand the process of yield farming.
The crypto assets you lend are locked into liquidity pools by DeFi platforms, where they are used for trading, lending, and borrowing. And that is the reason why you, the liquidity provider (LP), will be rewarded. The reward can come from the fees generated by the underlying DeFi platform or from another source.
Liquidity pools can be paid out through a variety of tokens. These payout tokens can then be invested in other liquidity pools to obtain more prizes, and so on. However, the basic concept is that a liquidity provider invests funds into a liquidity pool in exchange for benefits.
Yield farming is usually done on Ethereum with ERC-20 tokens, and the prizes are usually ERC-20 tokens only. However, this could change in the future. On the other hand, cross-chain bridges and other similar technologies could lead to DeFi applications becoming blockchain-independent at some point. This could make them work on other blockchains that support smart contracts in the future.
In order to achieve high yields, farmers usually transfer their funds between different protocols quite frequently. As a result, DeFi platforms offer attractive financial incentives to attract more capital to their platforms. Liquidity continues to attract more liquidity, just as it does in centralized markets.
Reason for the boom in yield-based agriculture.
The unexpected surge in interest in yield farming can be attributed to the introduction of the COMP token – the governance token of the Compound Finance ecosystem. Governance token holders receive governance privileges, which means they can participate in the governance of the DeFi protocol. Algorithmic distribution of these governance tokens with liquidity premiums is a common way to get a decentralized blockchain up and running. Liquidity providers are enticed to “govern” the new token by injecting liquidity into the protocol.
The COMP promoted the popularity of this form of token delivery model. Meanwhile, DeFi companies have also come up with other creative ways to bring liquidity to their environment.
How does yield farming work?
Yield farming is closely related to a model called Automated Market Maker (AMM). It typically involves liquidity providers (LPs) and liquidity pools. Let’s take a look at how it works.
Liquidity providers deposit funds into a liquidity pool. This pool is used to operate a platform where users can lend, borrow, and trade tokens. A fee is charged for using these channels, which is then distributed to liquidity providers in proportion to their share of the liquidity pool. This is the basis for the operation of an AMM.
Apart from the fee, the issuance of a new token could be an additional reason to allocate funds to a liquidity pool. For example, a token can only be purchased in limited quantities on the open market. On the other hand, it can be collected by providing liquidity to a specific pool.
The propagation rules would be determined by the specific implementation of the protocol. Ultimately, liquidity providers would be compensated based on the volume of liquidity they offer to the pool.
Usually invested in stablecoins pegged to the US dollar, but this is not a requirement. DAI, USDT, USDC, BUSD and other stablecoins are among the most commonly used in DeFi. Some protocols can create tokens that denote the coins you deposit. For example, if you deposit DAI into Compound, you will receive cDAI, or Compound DAI. You get cETH when you deposit ETH into Compound.
However, this is complex on several levels. It could be that you move your cDAI into a protocol that creates a third token that represents your cDAI and DAI. The list could go on and on. These chains can be extremely complicated and difficult to follow. You will learn the tricks as you perform transactions more frequently.
How Are Yield Farming Returns Calculated?
Typically, estimated yields from yield farming are calculated annually.
Some commonly used metrics are Annual Percentage Yield (APR) and Annual Percentage Yield (APY). APR simply indicates how much interest a depositor receives on their cryptocurrency over the course of a year, while the return on a deposit in a yield farm is determined over the course of the year as interest earnings are continuously reinvested. The difference between the two is that APR doesn’t take into account the effect of compound interest, while APY does. Compounding in this case means that the earnings are directly reinvested to generate further income. Note, however, that it’s possible that APR and APY are used interchangeably.
Since APR and APY are from legacy markets, DeFi protocols may need to find their own metrics to calculate returns. Because of the fast pace of DeFi, weekly or even daily return estimates may be more useful.
In addition to APR and APY, some also use Total Value Locked (TVL).
TVL measures how much crypto is locked into DeFi Lending and other types of money marketplaces. It is a good way to measure the overall health of the DeFi Yield Farming scene.
TVL is the total liquidity in liquidity pools. It is a valuable metric to measure the overall health of the DeFi and Yield Farming markets. It is also a good way to compare the “market share” of different DeFi protocols.
Defi Pulse is a great way to keep track of TVL. You will see which platforms in DeFi have the most ETH or other crypto assets locked up. This will give you a general understanding of where the yield farming is at the moment.
Basically, the more assets that are locked up, the more yield farming is going on. It should be noted that you can measure TVL in ETH, USD or even BTC. Each of these measures will give you a different outlook on the state of the DeFi money markets.
It is also important to understand that these are only estimates and projections. Even short-term profits are quite difficult to estimate accurately, as yYield Farming is a highly competitive and fast-moving market, and profits can fluctuate quickly.
Collateralization in DeFi.
When you borrow money, you usually have to put up collateral to finance the debt. These serve as collateral that can be called in if you’re unable to repay the loan.
Depending on the protocol you borrow from, you may need to keep an eye on the collateral ratio. If the value of the collateral falls below the threshold required by the protocol, it can be liquidated on the open market. In this case, the only option is to post additional collateral.
To reiterate: Each platform has its own rules, i.e. its own collateralization ratio. Moreover, they usually work with a concept called overcollateralization. This means that borrowers have to deposit more value than they want to borrow in order to reduce the risk of a large amount of collateral being liquidated in the system in case of a violent market crash.
Risks Involved In Yield Farming
Farming for yield isn’t easy. The most profitable yield farming methods are very complex and should only be used by experienced farmers. Moreover, yield farming is advisable only for those who’ve enough capital to invest.
Yield Farming isn’t that simpleThere is a possibility that you’ll end up losing money if you don’t have enough knowledge.
We’ve just discussed how to utilise the collateral. So what’re the other dangers you need to watch out for?
Smart contracts are an obvious challenge in yield farming. Many protocols are designed and developed by small teams with minimal budgets due to the nature of DeFi. This introduces the possibility of errors in smart contracts.
Vulnerabilities and errors are always found, even in larger protocols audited by professional auditing firms. Due to the transparent nature of the blockchain, this results in the loss of customer funds. If you are locking down your funds in a smart contract, you need to keep this in mind.
Moreover, one of the biggest advantages of DeFi is also one of the biggest threats. It is the concept of reusability. Let us take a look at how it affects yield farming.
DeFi protocols, as mentioned earlier, are permission-free and can easily interact with each other. This ensures that the individual building blocks of the DeFi ecosystem are highly dependent on each other. When we say that these programs are composable, we mean that they fit together easily.
Why is this a risk?
If even one of the building blocks stops working properly, the entire ecosystem can suffer. This is one of the biggest threats to revenue farmers and liquidity pools. You need to trust not only the protocol you put your money into, but also everyone else it depends on.
Yield farming, while still in its infancy, has the potential to attract more users to DeFi protocols. It’s not yet matured into an efficient market, which means there are still many opportunities to earn high returns as opposed to traditional financing. It’s a complicated approach that, while we briefly outline it here, you’ll need to familiarise yourself with before diving into the field of yield farming.
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