What is Yield Farming | The Next Big Thing in DeFi?

In recent years, we have witnessed the previously unknown and mysterious cryptocurrency space impact almost every aspect of our lives and bring about a shift in the way we think. Those who used to see bitcoin as a trend that would keep coming back seem to be bitterly regretting not buying it sooner. On the other hand, those who managed to buy bitcoin at a reasonable price are eagerly waiting for its value to rise every day.

The crypto space is not just about Bitcoin, however. Within the decentralized financial infrastructure (DeFi), several new strategies and techniques have emerged that aim to provide users with more opportunities to earn larger incomes. One of the hottest crypto trends at the moment is yield farming, which seems to have taken DeFi by storm.

Yield farming is all about lending your money to others using sophisticated 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 us not get ahead of ourselves – there are a lot of pitfalls and complexities you might encounter during the process. That’s why it’s important that 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 properly.

What is Yield Farming?

Yield farming is one of the latest trends that has quickly gained acceptance in the world of decentralized finance (DeFi). It is considered an effective strategy that investors resort to when they want to increase their profits. According to CoinMarketCap, the total value of liquidity pools in yield farming projects exceeded $13 billion as of March 10, 2021 (note that statistics are constantly updated).

Yield farming allows crypto holders to lock their holdings in exchange for rewards in the form of additional cryptocurrency. More specifically, this process allows investors to earn fixed or variable interest by investing cryptocurrency into a DeFi market.

Today, almost all yield farming transactions are conducted within the Ethereum ecosystem and its ERC-20 standard, as the rewards are usually part of the Ethereum ecosystem as well. However, cross-chain advancements are expected to soon make it possible to run DeFi apps on other blockchains as the demand for yield farming continues to grow.

How does yield farming work?

First of all, it should be known that yield farming only works if there are liquidity providers and liquidity pools.

To become a liquidity provider, all you need to do is add your funds to a liquidity pool (smart contract), which is responsible for running a marketplace where users perform various operations with their tokens, including lending, borrowing, and exchanging. Once you have deposited your funds into the pool, you will receive fees generated by the underlying DeFi platform or reward tokens. Moreover, some protocols can even offer payouts in the form of multiple cryptocurrencies, allowing users to diversify their assets and lock those cryptocurrencies into other protocols to maximize returns.

As professional return hunters become familiar with the Ethereum network and its technical aspects, they prefer to move their funds across different DeFi platforms to achieve the highest possible return. This can prove to be a difficult task. Those who provide liquidity also receive rewards based on the amount of liquidity provided – therefore, those who receive the highest rewards have the largest amounts of capital.

What should you pay attention to?

Before you get into yield farming, you should be aware of the following basics:

• Liquidity providers deposit their funds into a liquidity pool.
• The funds deposited are stablecoins linked to the USD, such as DAI, USDC, USDT, etc.
• Your return depends on how much you invest and what rules the protocol is based on.
• You can create complex investment chains if you decide to reinvest your reward tokens into other liquidity pools, which in turn offer different reward tokens.
• You should be aware that, for example, investing in ETH itself doesn’t qualify as yield farming. Lending ETH via a decentralized, non-pledgeable money market protocol and then receiving rewards – that’s yield farming.

What makes yield farming so popular?

The main advantage of yield farming is, of course, that it can bring a good profit to investors. Currently, yield farming can offer more attractive interest rates than traditional banks, although there are of course some potential risks.

Moreover, yield farming experienced a real surge in popularity in 2020. A lot of money was made via the Ethereum network, as Yield Farming platforms run on Ethereum and DeFi tools also usually use the Ethereum platform. In addition, yield farming offers benefits to several protocols, most of which are just emerging. If they have an active and growing base of enthusiasts, it is much easier for them to attract the attention of stakeholders.

Overall, yield farming is very popular today because it helps a variety of projects gain initial liquidity and is beneficial to both lenders and borrowers. In addition, yield farming greatly contributes to increased efficiency in the borrowing process.

What is DeFi and what role does it play?

DeFi stands for “decentralised finance.” The term is used to describe a variety of financial apps in the blockchain and/or cryptocurrency space that aim to disrupt financial intermediaries. DeFi is often referred to as an unconventional financial system that operates independently without relying on banks, insurance companies, or credit unions. It allows users to perform various financial operations with cryptocurrencies and other digital assets, including remittances, trading, investments, transactions via automated smart contracts, etc.

DeFi is based on blockchain technology, which will inevitably turn the existing financial order upside down and contribute to a more transparent and secure financial system. Moreover, DeFi can boast another unique feature: it is able to extend blockchain capabilities to include more sophisticated financial use cases such as lending, derivatives, flash loans, and crypto yield farming.

Thanks to DeFi, users can trade and make transactions at any time and from any place. The only requirement is a stable Internet connection. Other key benefits of DeFi include lightning-fast transfers and significantly reduced fees and costs. Not only that, but DeFi credit protocols offer higher interest rates on deposits, as well as lower fees and more favourable terms on loans and lines of credit.

It’s also worth noting that DeFi provides equal and free access to a wider range of users who’d otherwise be unable to participate in financial services due to lack of funds or political, social and economic problems. In addition, DeFi enables high-yield trading – known as yield farming – which allows investors to borrow and lend their cryptocurrencies at much higher interest rates compared to traditional banking and investing.

Yield farming vs. other strategies

Those who’ve just entered the world of cryptocurrencies may not be able to distinguish yield farming from other concepts such as liquidity mining, crypto mining, and staking. Even though they may all have something in common and look the same, they’re actually different from each other and follow completely different complex algorithms. We’re here to make sure that you won’t be able to confuse and distinguish between these concepts in the future.

Yield Farming vs. Liquidity Mining

Sometimes yield farming is confused with liquidity mining. Although they are interchangeable, there are differences.

First, it is important to clarify that both Yield Farming and Liquidity Mining operate on the DeFi sector, which is capable of increasing returns on governance tokens. Yield farming uses various DeFi apps such as fund leveraging, while liquidity mining uses the proof-of-work (PoF) algorithm.

In liquidity mining, miners typically receive a 0.3% dividend swap and newly mined tokens once each block’s transaction is successfully completed. Yield farming, on the other hand, involves liquidity providers accessing various DeFi platforms where they move their funds to maximize returns. In addition, they can use DeFi mechanisms such as leveraging funds by lending and borrowing stablecoins. In addition, yield farmers can sometimes increase their profits by using different strategies when shifting their funds.

Yield Farming vs Crypto Mining

The main difference between crypto-mining and yield farming is that the former is based on the proof-of-work consensus algorithm, while the latter is based on DeFi and relies heavily on the Ethereum network. Compared to crypto mining, yield farming is considered an advanced method of earning rewards with crypto holdings via specific permission-free liquidity protocols.

It is also important to remember that mining pools are involved in both cases. However, liquidity providers are only part of the yield farming process.

Another fundamental difference between the two concepts is the fact that Yield Farming is similar to the borrow and lend plan, which uses governance tokens that earn you rewards. As for crypto mining, it enables the introduction of new coins and gives miners the opportunity to earn their rewards by creating new blocks via verified transactions that take place in the mining pool.

Yield Farming vs Staking

Staking is mainly based on the proof-of-stake or PoS consensus mechanism, where a validator is responsible for creating a block via a random selection process and receives rewards paid by the platform’s investors. In this case, the higher the stake, the greater the rewards for the stake. In contrast, yield farming allows token holders to earn passive income by contributing their funds to a loan pool and receiving interest in return.

Moreover, staking usually requires a larger amount of cryptocurrency to increase the chances of being selected as the next block validator. And depending on how mature the coin is, it can take up to a few days to receive the stakes.

Yield farmers, for their part, can move digital assets more efficiently and actively whenever they want to earn new governance tokens or sometimes smaller transaction fees. Compared to staking, yield farming lets you deposit different coins into liquidity pools through a variety of protocols.

All in all, yield farming is a more complicated process than staking, but it yields a higher return.

As you can see, all the strategies described above look the same, but each is based on its own complex algorithm.

Total Value Locked (TVL): What is it?

If you want to assess the overall state of the DeFi yield farming scene, you should pay attention to Total Value Locked (TVL). This value measures the amount of cryptocurrencies locked up in DeFi Lending and other money marketplaces.

TVL is sometimes considered a smart and efficient way to aggregate liquidity into liquidity pools. It is also a useful indicator that reflects the state of the DeFi and Yield Farming world. In addition, TVL is a meaningful metric for comparing the market shares of different DeFi protocols.

At DeFi Pulse, you can follow TVL and even take a look at the platforms with the largest amount of ETH or other crypto assets locked in DeFi. Thanks to TVL, you can easily get the most important information about the current state of yield farming. Usually, the more assets are locked, the better crypto yield farming becomes. Moreover, you have the option to measure TVL in ETH, BTC, and USD. Each of them provides you with its own outlook on the state of the DeFi money markets, allowing you to assess the situation and make the right decision.

Calculation of returns from yield farming

Estimating yield farming returns can be somewhat complicated, even in the short term, due to volatile fluctuations and intense competition. For example, if a crypto-yield farming strategy becomes too widespread, returns will naturally decline, and high returns may dry up.

But it’s quite possible to try to predict the returns. If you want to calculate returns for agriculture, you should use the most common ratios, namely APR (APR) and APR (APY).

Compared to the APY, APR doesn’t include compound interest, which means that the calculation simply consists of multiplying the periodic interest rate by the number of periods within a year. The annual interest rate is usually imposed on the borrowers and paid to the capital investors. As for the annual percentage rate of charge, this is imposed on the capital borrowers but paid to the capital providers and not to the investors.

All in all, the main difference between the two ratios is that APR takes into account the compound interest effect, while APY only describes the return with interest on interest.

Collateralization in DeFi: What’s it?

When you take out a loan, you must put up collateral to cover your loan and act as insurance.

In collateralization, the borrower pledges his or her asset so that the lender can recover its principal if the borrower fails to repay the loan according to the original agreement. Lenders sometimes require borrowers to pledge their valuable assets as collateral, which the lenders can dispose of if the loan cannot be repaid.

With DeFi, collateral plays a big role depending on the type of protocol you use. If the value of your collateral doesn’t meet the standard required by the protocol, the collateral can be liquidated on the open market. To prevent this, you can simply add a little more collateral. Also, to reduce the risk of a severe market crash, 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 ?

Risk of liquidation

Liquidation usually occurs when a user’s collateral is insufficient to cover the loan amount. Unfortunately, this may result in the collateral being charged a liquidation fee, which is the case when the value of the collateral decreases or the value of the loan increases.

To reduce the probability of liquidation, it’s advisable to use less volatile assets and always monitor market conditions. Sometimes it’s better to use stable coins for both collateral and loan, e.g. you can borrow USDC against DAI – their value is usually stable as they’re pegged to fiat currencies. Also, remember that the more volatile the asset, the more likely it’s to be liquidated. Therefore, it’s important that the collateral and the loans are less volatile assets or stable coins – this way you can significantly reduce the liquidation risk.

Impermanent loss

Many automated market makers (AMMs) mandate users to invest their money in liquidity pools to earn rewards and receive trading fees paid by users of decentralized exchanges. This is widely seen as a good way to earn passive income regardless of market fluctuations. However, when the market experiences severe fluctuations, users may lose their money. This risk is called volatile loss, and liquidity providers should be aware of it.

DeFi has been on the market for almost a year, but there is still no solution that could completely eradicate the problem of volatile loss. However, a number of developers have done their best to create new decentralized exchanges (DEXs) or make changes to existing popular protocols to provide an efficient way to avoid losses.

When participating in the liquidity pool, users may face a problem when AMMs don’t automatically update their prices based on market movements. This creates arbitrage opportunities and poses some risks for liquidity providers.

For example, if the price of a token drops by 50% on centralized exchanges, this change isn’t immediately reflected on decentralized platforms. Arbitrage traders, in turn, can use this time to sell their ETH on DeFi platforms at an inflated price. The price difference is then covered by the liquidity providers, who suffer losses when the price falls and cannot profit when it rises because their capital is tied up in the pool.

To avoid problems with volatile losses, liquidity providers are advised to choose pools wisely and be aware of how they work. It is also worthwhile to seek other users’ opinions about the protocol and their experiences with it. Some protocols can provide a solution to mitigate the risk of volatile loss, and as the industry is fully aware of the problem, numerous projects are working on various solutions to help address this challenge.

Smart сontract risk

Smart contracts are a safe and reliable way to conduct various business and transactions. They help fight corruption and avoid human error, as everything is executed automatically according to the terms communicated to the smart contract in advance.

Examples of yield farming protocols

There are several yield farming protocols, and each of them has its own risks and rules. Let us take a look at the protocols described below and examine their specifics.

Compound Finance

As an algorithmic money market and one of the most important protocols of the yield farming ecosystem, Compound allows its users to lend and borrow assets. Those with an Ethereum wallet can contribute assets to Compound’s liquidity pool and receive rewards in return, which start growing immediately. Rates are set algorithmically based on supply and demand.

MakerDAO

MakerDAO is considered one of the first DeFi projects. It is a decentralized lending platform that supports the creation of DAI – a stable coin value pegged to the value of the USD.

MakerDAO also uses the Maker protocol, which allows users to borrow against collateral. The platform is based on the Ethereum blockchain and its crypto loans are managed by Ethereum smart contracts.

Synthetix

Synthetix is a synthetic protocol that enables the issuance of synthetic assets on the Ethereum blockchain. It also supports various types of synthetic commodities such as gold, silver, synthetic cryptocurrencies, synthetic fiat currencies – in other words, anything that has a reliable price. Synthetix also allows anyone to deposit Synthetix Network Token (SNX) or ETH as collateral and mint synthetic assets against it.

Aave

Aave is an open source and non-pledged decentralized credit protocol widely used by revenue farmers. Depending on market conditions, interest rates can be adjusted algorithmically. Once lenders have contributed their funds, they receive tokens in return that can earn interest and compound interest when deposited.

Uniswap

Uniswap is a decentralized exchange protocol that allows users to perform trustless token exchanges. With this protocol, it is possible to perform automated transactions with cryptocurrency tokens on the Ethereum blockchain using smart contracts.

To establish a new market, Uniswap also allows liquidity providers to deposit an equivalent of two tokens. After that, traders can trade against this liquidity pool, and LPs can earn fees from trades that take place in their pool.

Curve Finance

Curve Finance is an Ethereum-based DEX protocol designed to allow users to efficiently perform high-value swaps with stablecoins. Curve also supports DAI, USDC, TUSD, and BTC pairs and allows users to trade quickly and efficiently between these pairs.

Balancer

Balancer is an automated market-making protocol for multiple tokens. It allows for custom token allocations within a liquidity pool and offers liquidity providers the ability to set up custom balancer pools and earn fees for trades made in their pools. Because of its flexibility, Balancer has been used by many yield providers to optimize their operations.

The prospects for revenue agriculture

At this point in time, it is almost impossible to accurately and reliably predict the outlook for revenue agriculture. It is undeniable that high profits remain the main motivating factor that drives investors and crypto enthusiasts to take advantage of the liquidity mining market. Certainly, the high gas fees on the Ethereum network, along with the numerous risks, can deter inexperienced players. Nevertheless, most DeFi participants – 70% to be exact – express a strong desire to continue earning returns, and their positive experience will surely attract many new players.

Today, yield farming is expected to become the new star of the DeFi universe, contributing enormously to the expansion of the industry and attracting financial capital and new participants.

The yield farming sector is gradually becoming more robust, and its architects are developing various approaches to improve liquidity incentives and ensure better security for all users. To date, however, we still need to conduct the necessary research and risk assessments to ensure the smooth operation, safety, and efficiency of yield farming and to create the desired level of confidence in the industry.

Conclusion

Yield farming is a new financial incentive within the DeFi infrastructure that both incentivizes liquidity and allows for fair token distribution. This activity has also provided significant benefits to DeFi stakeholders by reducing slippage for token swaps across multiple DeFi apps and fostering the growth of strong communities that wouldn’t otherwise exist. In addition, yield farming has enabled numerous projects to get off the ground that can now secure billions of dollars in user funds in the short term.

It is obvious that crop agriculture will evolve. Technological advances and breakthroughs in DeFi infrastructure are now commonplace, and yield agriculture will certainly remain with us, although it may undergo some change and transformation.

Brugu always keeps up to date with the latest developments and trends in the DeFi and cryptocurrency space. If you decide to get started with Yield Farming, contact our team of top specialists first.