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All You Want To Know About Yield Farming In DeFi

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In the blockchain space, Decentralized Finance (DeFi) has been creating a silent revolution of sorts. What distinguishes DeFi is its  permissionless nature, which means that you can transact with anybody with an Internet connection and a backed wallet without an intermediary. A host of financial applications in cryptocurrency are made possible through DeFi. What Is Yield Farming?

Yield farming is an investment strategy in DeFi. It is a method of generating more cryptocurrency from your existing crypto assets. It entails lending your crypto assets to others for interest, who in turn lock them up using smart contracts. In simple terms, it means locking up cryptocurrencies and getting rewards in return. Yield farming enables you to make a passive income by using the Ethereum-based open ecosystem. So how do high-yield farmers care for their crop? What kind of returns do they anticipate? And from where does one start as a yield farmer? In this post, we’ll address this and more..

Yield farming is the Wild West of Decentralized Finance (DeFi), with farmers competing for a chance to farm the burgeoning market. However, there are certain tactics that help farmers to optimize their returns. Before we move on, let us understand the process of yield farming. 

The crypto assets that you lend are locked by the DeFi platforms in liquidity pools where they are used for trading, lending and borrowing. And that’s the reason you, the liquidity provider (LP) is rewarded. The  reward may come from fees generated by the underlying DeFi platform, or some other source.

Payouts of  liquidity pools can be done through  a variety of tokens. These payout tokens can then be invested into other liquidity pools to receive further prizes, and so on. However, the fundamental concept is that a liquidity provider invests funds into a liquidity pool in exchange for benefits.

Yield farming is normally conducted on Ethereum with ERC-20 tokens, and the prizes are usually just ERC-20 tokens. However, this could change in the future. On the other hand, cross-chain bridges and other similar technologies may allow DeFi applications to be blockchain agnostic at some point. As a result, they may be able to operate on other blockchains that support smart contracts in the future.

In order to achieve high yields, yield farmers usually transfer their funds around quite frequently between various protocols. As a result, DeFi platforms provide attractive financial incentives in order to entice more capital to their platforms. Liquidity continues to draw more liquidity, just as it does on centralized markets.

Reason For The Boom In Yield Farming

The unexpected surge in interest in yield farming can be attributed to the arrival of the COMP token – the Compound Finance ecosystem’s governance token. Holders of governance tokens receive governance privileges, which means they can take part in the governance of the DeFi protocol. Distributing these governance tokens algorithmically, with liquidity bonuses, is a common way to kickstart a decentralized blockchain. Liquidity providers are enticed to ‘farm’ the new token by supplying liquidity to the protocol.

tThe COMP fuelled the popularity of this form of token delivery model. Meanwhile, DeFi ventures have devised other creative ways to draw liquidity to their environments too.

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 see how it works.

Funds are deposited into a liquidity pool by liquidity providers. This pool is used to run a platform where users can lend, borrow and trade tokens. A fee is charged for using these channels and is then distributed to liquidity providers in proportion to their share of the liquidity pool. This is the basis of an AMM’s activity.

Apart  from the fee, the issuance of a new token could be an additional reason to allocate funds to a liquidity pool. For eg, a token can only be available for purchase in limited quantities on the open market. It can be collected, on the other hand, by supplying liquidity to a given pool.

The propagation rules would be determined by the protocol’s special implementation. In the end, liquidity providers are compensated depending on the volume of liquidity they offer to the pool.

Stablecoins pegged to the US dollar are usually invested but this is not a prerequisite. DAI, USDT, USDC, BUSD and other stablecoins are among the most commonly used in DeFi. Some protocols can create tokens to signify the coins you’ve deposited in the scheme. For example, if you deposit DAI into Compound, you’ll get cDAI, or Compound DAI. You will get cETH if you deposit ETH into Compound.

However , there are several levels of complexity to this. You might end up  moving your cDAI to a protocol that creates the third token to represent your cDAI and your DAI. The list goes on and on. These chains can become extremely complicated and difficult to obey. You’ll learn the tricks as you transact more frequently.

How Are Yield Farming Returns Calculated?

Typically, the estimated yield farming returns are calculated annually. 

Some commonly used metrics are Annual Percentage Rate (APR) and Annual Percentage Yield (APY). . APR simply tracks how much interest a depositor will earn on their crypto over the course of a year, while tracks how much a deposit will earn in a yield farm over the course of the year if its interest earnings are reinvested continuously. The difference between them is that APR doesn’t take into account the effect of compounding, while APY does. Compounding, in this case, means directly reinvesting profits to generate more returns. However, be aware that there are possibilities of  APR and APY  being used interchangeably.

As APR and APY come from the legacy markets, DeFi protocols may have to find their own metrics for calculating returns. Due to the fast pace of DeFi, weekly or even daily estimated returns may make more sense.

Besides APR and APY, some also use Total Value Locked (TVL). 

TVL measures how much crypto is locked in 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’s a valuable metric for gauging the overall health of the DeFi and yield farming markets. It’s also a good way to compare the “market share” of various DeFi protocols.

Defi Pulse is a good 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 yield farming is right now.

Basically, the more value is locked, the more yield farming may be going on. It should be noted  that you can measure TVL in ETH, USD, or even BTC. Each will give you a different outlook for the state of the DeFi money markets.

It’s also important to understand  that these are only estimations and projections. Even short-term rewards are quite difficult to estimate accurately as yYield farming is a highly competitive and fast-paced market, and the rewards can fluctuate rapidly. 

Collateralization In DeFi

When you borrow money, you’ve to usually put up collateral to fund the debt. This actually serves as a security deposit that can be claimed if you fail to repay the loan.. 

Depending on the protocol from which you borrow, you may need to keep an eye on the collateralization ratio. If the value of the collateral falls below the protocol’s required threshold, it can be liquidated on the open market. In such cases, the only option would be to add additional collateral.

To reiterate, each platform has its own set of rules i.e., its own collateralization ratio. In addition, they commonly work with a concept called over-collateralization. This means that borrowers have to deposit more value than they want to borrow so as to reduce the risk of violent market crashes liquidating a large amount of collateral in the system. 

Risks Involved In Yield Farming

Farming for yield isn’t easy. The most profitable yield farming methods are very complex and should  only be attempted by experienced farmers. Furthermore, yield farming is advisable to those who have enough funds to invest. 

Yield farming isn’t as easyThere are possibilities that you’ll most likely end up losing money if you don’t have enough knowledge. 

We just went over how to liquidate the collateral. So what are the other dangers you need to be mindful of?

Smart contracts are an apparent challenge of yield farming. Many protocols are designed and developed by small teams with minimal budgets due to the nature of DeFi. This raises the possibility of smart contract glitches.

Vulnerabilities and glitches are found all the time, even in larger protocols that are audited by professional auditing companies. This will result in depletion of consumer funds due to the transparent nature of blockchain. When locking your funds in a smart contract, you must keep this in mind.

Furthermore, one of DeFi’s greatest benefits is also one of the greatest dangers. It’s the concept of reusability. Let’s take a look at how it affects yield farming.

DeFi protocols, as previously mentioned, are permissionless and can easily interact with one another. This ensures that each of the DeFi ecosystem’s building blocks are  hugely  dependent on the others. When we suggest that these programs are composable, we mean that they will easily fit together.

Why is this a risk?  If even one of the building blocks fail to function properly, the entire ecosystem can suffer. This is one of the most significant threats to yield farmers and liquidity pools. You must trust not only the protocol into which you deposit your money but also all others on which it is dependent.

Yield farming, while still in its infancy, has the potential to draw more users to DeFi protocols. It hasn’t yet matured into an efficient market, which means there are still plenty of ways to earn high returns on investment as opposed to conventional finance. It’s a complicated approach, so while we’ve included an outline here, you’ll need to delve before diving into the field of yield farming.

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