Yield Farming Explained

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Roland Guirdonan

Sep 13, 2022

Yield Farming Explained

Decentralized finance, an emerging financial technology that aims to remove intermediaries in financial transactions, has opened up multiple avenues of income for investors. One such investment strategy in DeFi is yield farming.

Lending or staking your cryptocurrency coins or tokens in exchange for rewards such as transaction fees or interest is what it entails. This is similar to earning interest in a bank account; technically, you are lending money to the bank. Only yield farming, as opposed to putting money in a bank, can be riskier, volatile, and more complicated.

 

What is Yield Farming?

Yield farming is the process of generating additional earnings on your crypto holdings by utilizing decentralized finance (DeFi) protocols. Users can lend or borrow cryptocurrencies and earn cryptos in exchange for their services through a DeFi platform.

Users who want to increase their yield outcome can use more elaborate strategies. Yield farmers, for example, can continuously shift their digital assets between multiple loan platforms to maximize their profits.

When people discuss yield farming, they do so in terms of annual percentage yield (APY). This frequently prompts a comparison to the interest rate on a savings account at a bank. And even though bank interest rates are extremely low, yield farming can generate APYs in the triple digits in some cases (although those returns come with considerable risks and are unlikely to last long).

This article will define yield farming, explain how it works, and discuss the advantages and disadvantages of using yield farming to increase your cryptocurrency returns.

 

How Does Yield Farming Work?

Yield farming allows investors to profit by investing in a decentralized application, also known as a dApp. Examples include cryptocurrency wallets, decentralized exchanges, decentralized social media, and other dApps.

Yield farmers frequently use decentralized exchanges (DEXs) to lend, borrow, or stake coins in order to earn interest and speculate on price swings. DeFi benefits from smart contracts, which automate financial agreements between two or more parties.

There are several ways to generate returns on your cryptocurrency holdings. Staking your tokens on a blockchain is one option. Solana (SOL), Cardano (ADA), and Polkadot (DOT) are examples of blockchains that use a proof-of-stake system to reward stakeholders for confirming transactions on the blockchain. Ethereum (ETH) is just a few days away from moving toward a proof-of-stake (PoS) system and will reward those who stake its Ether cryptocurrency.

The PoS system is an energy-efficient alternative to the proof-of-work system, which rewards cryptocurrency miners. The majority of yield farming happens on the Ethereum blockchain. Therefore, the profits are usually in the form of an ERC-20 token.

While lenders can use the tokens as they see fit, others are looking for arbitrage opportunities by capitalizing on the token's market fluctuations.

 

Types of Yield Farming

Liquidity provider

Another way to increase the value of your cryptocurrency assets is to become a liquidity provider for a decentralized exchange. When a user goes to Uniswap to exchange Ether (ETH) for DAI, for example, Uniswap will take some DAI from the liquidity pool and combine it with the Ether the user is exchanging. This enables Uniswap to provide exchanges for virtually any cryptocurrency pair imaginable without the need to hold any cryptocurrency itself.

Uniswap distributes the fees it receives from exchanges to liquidity providers. The amount received by each provider is proportional to their share of the protocol's total liquidity pool.

 

Lending

If you decide to put your crypto assets into a lending protocol, you have a good chance to earn even higher yields. Several lending protocols have emerged to allow cryptocurrency holders to access the value of their holdings without having to liquidate their assets and incur taxes. 

They accomplish this by providing over-collateralized loans. A borrower may be required to put down $200 in collateral to obtain a loan for $100 worth of cryptocurrency.

If you become a lender under one of these protocols, you will earn interest from the asset's borrowers. Interest rates are determined by supply and demand and can change from one minute to the next. Some platforms will work to stabilize interest rates for lenders seeking more constant returns.

As a lender, yield farming will necessitate the use of a DeFi protocol such as Compound or Aave. When you want to lend, you exchange your tokens for their equivalent tokens. The exchange rate for those tokens is constantly improving as borrowers pay interest on their loans. When you return your tokens to your original cryptocurrency, you will receive more than you originally exchanged.

 

Borrowing

Farmers can use one crypto as collateral for another token loan. The borrowed coins can then be used to increase the farm's yield. In this way, the farmer retains their initial holding, which may grow in value over time, while also earning yields on their borrowed digital assets.

 

Staking

If you believe in the long-term potential of a proof-of-stake blockchain project, you may be interested in purchasing the native token and staking it to earn additional rewards.

To participate in crypto staking, you pledge your tokens to a blockchain protocol like Pancakeswap, Solana, and more. The protocol will then select one user from those staking to confirm the next block in the blockchain platform. The higher your crypto stake, the more likely you are to be selected. The chosen user is rewarded for confirming the block.

In practice, staking through your exchange, such as Coinbase, is the simplest way to begin earning staking rewards. All technical details will be handled by the exchange, and any rewards you earn will be added.

Furthermore, you should know that there are two types of staking in the world of DeFi. The most common is on proof-of-stake blockchains, where a user is paid to pledge their tokens to the network in exchange for security.

The second option is to stake liquidity pool (LP) tokens earned by providing liquidity to a decentralized exchange. Users can then earn yield twice because they are paid in LP tokens for supplying liquidity, which they can then stake to earn more yield.

 

How Did Yield Farming Gain Popularity?

The launch of the COMP token, a governance token of the Compound Finance ecosystem, has contributed to the increase in the practice of yield farming. Holders of governance tokens can also participate in the governance of a DeFi protocol.

For instance, governance tokens are frequently algorithmically distributed with liquidity incentives to launch a decentralized blockchain. This incentivizes potential yield farmers to contribute liquidity to a pool.

Uniswap, Aave, Sushiswap, Compound, and Curve Finance are some of the most popular yield farming platforms.

 

What Are The Risks Associated With Yield Farming?

Beyond the regulatory risks that most digital assets face due to a global lack of concrete cryptocurrency policies, cyber theft and fraud are major concerns. 

All transactions involve digital assets that are stored using the software. Hackers are skilled at locating vulnerabilities and exploits in software code to steal funds.

Then there's the issue of token volatility. Historically, cryptocurrency prices have been known to be volatile. Volatility can also occur in short bursts, causing the price of a token or cash to rise when it is locked in the liquidity pool. This may result in unrealized profits or losses, and you may be better off if you kept your tokens available for trading.

Smart contracts on some DeFi platforms are not as reliable as they seem. Many of these emerging DeFi protocols are built by small teams with limited resources. This increases the possibility of smart contract bugs in the platform.

 

Disclaimer: The views and opinions expressed in this article are solely the author’s and do not necessarily reflect the views of MultiBank io. No information in this article should be interpreted as investment advice. MultiBank io encourages all users to do their own research before investing in cryptocurrencies.