Mary Amakihi 
What Are Yield Farming and Liquidity Mining in Decentralized Finance (DeFi)?
Decentralized finance (DeFi) is no longer a new concept, with its sphere of influence growing even wider by the day. There are many ways to invest in decentralized finance (DeFi). We will discuss yield farming and liquidity mining in this article.
As we already know, DeFi is not just a buzzword; it stands for decentralized finance and refers to financial services that run on open-source blockchains.
Anyone in the globe can have complete ownership of their assets by bypassing centralized financial intermediaries and using a smart device with an internet connection.
Investing in decentralized finance (DeFi) is significantly more accessible with a non-custodial asset management platform.
All you have to do to get started is establish an Ethereum wallet and get it connected. Once that’s done, you can begin strategizing and expanding your decentralized finance (DeFi) crypto portfolio.
When it comes to DeFi investing, there are several crucial strategies to consider. Ultimately, your risk tolerance will determine which option you choose.
We will take you on a walk through two major investment strategies in decentralized finance (DeFi). First, let us begin with yield farming.
What is Decentralized Finance (DeFi)Yield Farming?
Yield Farming, or YF, is the most popular technique for benefiting from cryptocurrency holdings. Investors can get passive income by holding their cryptocurrency in a liquidity pool.
These liquidity pools are similar to centralized finance or the CeFi counterpart of your bank account. You deposit funds, which the bank uses to make loans to others, paying you a specified part of the interest earned.
At its core, yield farming collects interest on cryptocurrency assets by lending or staking them in decentralized finance (DeFi) protocols.
These protocols provide a variety of incentives, such as governance tokens, to encourage users to secure their assets and contribute liquidity to the platform.
Yield farming is more recent than staking, yet it shares many similarities.
While yield farming provides liquidity to a decentralized finance (DeFi) protocol in exchange for yield, staking can be seen as locking up 32 ETH to become a validator node on the Ethereum 2.0 network.
Farmers aggressively seek the highest yield on their investments, switching between pools to maximize their profits.
Yield farmers, or investors, deposit crypto assets in a smart contract-based liquidity pool such as ETH/USD. This technique is known as Yield Farming.
The locked assets are subsequently made available to other protocol participants. The lending platform allows users to borrow these tokens for margin trading.
Yield farmers form the foundation for decentralized finance (DeFi) protocols that offer trade and loan services.
They also help to keep cryptocurrency assets liquid on decentralized exchanges (DEX). Yield farmers receive paid in the form of annual percentage yield (APY).
How Does Yield Farming Work?
To begin yield farming, an investor must acquire a digital asset compatible with decentralized finance (DeFi) protocols, such as Ethereum or Binance Smart Chain.
Once they have bought the asset, they must deposit it in a decentralized finance (DeFi) protocol, such as a liquidity pool.
Liquidity pools are collections of cryptocurrency assets locked in smart contracts and used to facilitate transactions on decentralized finance (DeFi) networks.
When a user puts assets into a liquidity pool, they are given liquidity pool tokens in exchange. These tokens reflect the user’s part in the pool and can be used to redeem assets from the pool.
After depositing their assets into a liquidity pool, yield farmers can earn additional cryptocurrencies by lending liquidity to the pool.
This is accomplished using their liquidity pool tokens to engage in various decentralized finance (DeFi) transactions such as lending, borrowing, and trading.
For example, a yield farmer may lend their crypto assets to borrowers in exchange for interest payments, providing liquidity to a lending platform.
Alternatively, users could utilize their liquidity pool tokens to participate in a liquidity mining program, compensating them for providing liquidity to a specific decentralized finance (DeFi) protocol.
Yield farmers earn more cryptocurrency by earning a fraction of the fees collected by the decentralized finance (DeFi) system in which they participate. These fees are usually paid in the form of the digital asset that they are cultivating.
With that said, let us see the benefits of Yield farming.
Benefits of Yield Farming
Here are some of the benefits of yield farming.
- Diversification
- High returns
- Promoting diversification
- Access to new tokens
- Community involvement
Diversification
One of the benefits of yield farming is the ability to diversify your cryptocurrency portfolio.
By supplying liquidity to many decentralized finance (DeFi) protocols, yield farmers can spread their risk and avoid concentrating all their assets in one location.
Yield farming also allows users to receive incentives in various cryptocurrencies, further diversifying their portfolio.
It is important to note that diversification does not guarantee profits or safeguard against losses, but it can help decrease risks.
High Returns
Another significant advantage of yield farming is the possibility of high profits. Some decentralized finance (DeFi) protocols can provide annual percentage yields (APYs) as high as 400%.
Of course, not all protocols provide such significant returns and are subject to change based on market conditions. However, the prospect of big earnings is appealing to yield farmers.
Promoting Decentralization
One of the fundamental principles of cryptocurrency is decentralization. Yield farming encourages decentralization by allowing anyone with an internet connection to offer liquidity for decentralized finance (DeFi) protocols.
This democratizes finance and minimizes the need for centralized intermediaries like banks.
Access to New Tokens
Yield farming also grants access to new tokens not seen on regular cryptocurrency exchanges. Yield farmers that provide liquidity to a new decentralized finance (DeFi) network can earn incentives in the protocol’s native coin.
The token’s value may rise if the protocol is effective, creating extra upside potential. However, it is critical to undertake thorough research before investing in any new token or decentralized finance (DeFi) protocol.
Community Involvement
Yield farming also encourages community involvement. Many decentralized finance (DeFi) protocols have active communities of developers and users dedicated to the protocol’s aim.
By providing liquidity to these protocols, yield farmers become community members, allowing them to participate in governance and decision-making.
This can foster a sense of ownership and belonging while also promoting financial decentralization.
Now, we do know that only profitable business is with risks. Let’s look at the risks associated with yield farming.
Risks of Yield Farming Investing
Some risks associated with investing in yield farming are;
- Impermanent loss
- Liquidity risks
- Smart contract risks
- Transaction fees
Impermanent Loss
Impermanent loss occurs when you give liquidity to a decentralized exchange (DEX), and the token price fluctuates.
As a result, you may wind up with fewer tokens than when you started, even if their value has increased. This risk is incredibly high in volatile markets, where token prices change quickly.
Liquidity Risk
Liquidity risk is another issue with yield farming. When you supply liquidity to a DEX, you effectively lock up your cash for a set amount of time.
If you need to access your assets before the lock-up period expires, you may face a penalty or additional penalties.
Plus, there is always the possibility that the liquidity pool will dry up, rendering you unable to withdraw your funds.
Smart Contract Risk
Smart contract risk is one of the most significant concerns associated with yield farming.
Yield farming is investing your cryptocurrency in smart contracts, which are self-executing contracts that determine the terms of the transaction.
These smart contracts are susceptible to hacks, flaws, and other technological issues, which may result in the loss of your cash.
According to an Argent investigation, a smart contract vulnerability was exploited for $24 million in one yield farming business.
Transaction Fees
Yield farming also requires transaction fees, which can quickly pile up. These fees may include gas fees for communicating with the Ethereum blockchain and fees for trading tokens on a DEX.
In some situations, these costs can deplete your revenues, making yield farming less profitable than anticipated.
There you have it. You have been well-fed when it has to do with Yield farming. Now, we will proceed to liquidity mining.
What is Decentralized Finance (DeFi) Liquidity Mining?
Liquidity mining is commonly recognized as one of the most essential parts of DeFi’s success and an effective way to bootstrap liquidity. Liquidity mining, like YF, is a subset of staking.
The main distinction is that liquidity providers are compensated with the platform’s coin and fee revenue.
Liquidity mining is a technique that pays users who provide liquidity to a decentralized exchange (DEX) with tokens.
In other words, liquidity mining is a method for users to make passive revenue by contributing to the liquidity pool of a decentralized exchange.
Liquidity mining has become an essential part of the decentralized finance (DeFi) ecosystem because it offers liquidity to DEXs, allowing traders to trade assets without needing a centralized intermediary.
Decentralization improves platform security and lowers transaction costs associated with trading on centralized exchanges.
How Does Liquidity Mining Work?
Let us look at an example to understand better how liquidity mining works. Assume there is a decentralized finance (DeFi) protocol that allows users to exchange between two tokens: Token A and Token B.
The protocol requires liquidity in the form of both tokens to facilitate trade. LPs can supply liquidity by adding equal quantities of Token A and Token B to the liquidity pool.
Suppose a customer wishes to exchange 100 Token A for Token B. The protocol will execute the trade with the liquidity given by the LPs.
If there is insufficient liquidity for the trade, the protocol will automatically change the prices to entice other LPs to provide liquidity.
LPs receive incentives in the form of the protocol’s native tokens, which may include UNI, COMP, or SUSHI, depending on the protocol. Tokens are allocated by LPs’ contributions to the liquidity pool.
For example, if an LP contributes 10% of the total liquidity pool, they will share 10% of the rewards.
Liquidity mining is a method for DeFi protocols to reward users for offering liquidity and facilitate trading.
By providing liquidity, LPs accept the risk of temporary loss, which occurs when the prices of the tokens in the pool fluctuate relative to one another.
However, the incentives from liquidity mining can help offset the temporary loss and potentially produce profits.
Benefits of Liquidity Mining
Some benefits of investing in liquidity mining include;
- Higher returns on investment
- Passive income earning
- Improved market liquidity
Higher Returns On Investment
One of the primary benefits of liquidity mining is that it allows traders to make better returns on their investments.
Liquidity providers receive a share of the trading fees earned by the exchange, which can be much larger than typical savings accounts or even some investment vehicles.
This means that traders can generate passive income while increasing their return on investment.
Passive Income Earning
Liquidity mining also allows traders to get passive income without actively trading.
Once a trader has given liquidity to an exchange, they can earn incentives based on trade volume without having to monitor market conditions or execute trades actively.
This enables traders to make money even when the market isn’t doing well, or they can’t actively trade.
Improved Market Liquidity
Liquidity mining also improves the overall cryptocurrency market by increasing liquidity.
Liquidity providers’ enhanced liquidity stimulates more trading volume, which helps to narrow the spread between buy and sell orders, allowing traders to complete deals at better prices.
This additional liquidity also contributes to market stabilization, lowering volatility and creating a more stable trading environment.
Moving over to the risks of investing in liquidity mining, let’s see what we have under that section.
Risks of Investing in Liquidity Mining
Here are some risks associated with liquidity mining investing in decentralized finance.
- Cryptocurrency risks
- External risks
- Smart contract vulnerability
Cryptocurrency Risks
Liquidity mining may pose threats to the underlying coin. Cryptocurrencies are notoriously volatile, and unexpected price changes can result in significant losses for investors.
Also, liquidity providers may face risks related to the cryptocurrency utilized in the liquidity pool, including scalability concerns, network congestion, and security vulnerabilities.
External Risks
Liquidity mining may be vulnerable to external threats like regulation changes, market manipulation, and flash loan attacks.
Regulatory changes can impact the legality of liquidity mining, leading to the closure of liquidity pools. Market manipulation can cause sharp price fluctuations, resulting in losses for liquidity providers.
Flash loan assaults, in which hackers use temporary access to enormous amounts of funds to manipulate the market, can also cause significant losses for investors.
Smart Contract Vulnerabilities
Another danger linked with liquidity mining is the possibility of smart contract vulnerabilities.
Smart contracts are self-executing contracts in which the buyer and seller’s agreement is directly encoded into lines of code.
Smart contracts can automate complex financial operations but are also vulnerable to attacks and abuses. In a smart contract vulnerability, investors may lose their deposits.
Final Thoughts
Decentralized finance (DeFi), has emerged as a revolutionary force in the financial industry, challenging traditional assumptions about banking and investing in an ever-changing market.
DeFi, a blockchain-based alternative to conventional economic systems, provides consumers with a decentralized, open-source financial management solution.
DeFi’s capacity to generate passive income and allow users to accumulate wealth through cryptocurrency assets is one of its most appealing aspects.
We have discussed two of its principal investment methods in this article. Be sure to conduct an in-depth study before choosing the investment method that best suits you.
