DeFi yield farming is one of the popular ways to earn passive income in the crypto space. This article thoroughly explains what defi yield farming is and how it works.
When the Ethereum blockchain was published in 2015, it pioneered an ecosystem based on smart contracts, allowing users to create and interact with decentralized applications.
Decentralized finance (DeFi) surged in popularity, allowing users to participate in various peer-to-peer financial activities such as trading, borrowing, lending, and novel blockchain-specific methods.
One of these new tactics began with Compound, an Ethereum-based borrowing and lending platform.
Compound distributes COMP tokens to its users, allowing them governance abilities to influence protocol activity and increase user involvement.
Compound became the leading DeFi protocol in one trade day, with approximately $500 million in staked value.
Activity as a result of Compound’s token distribution continued quite strong, with periodic spikes until the end of 2021.
This historic milestone in DeFi and the ease with which Compound dispersed tokens spurred DeFi yield farming, which has been a key driver of DeFi growth.
DeFi yield farming is one of the many ways to invest in the DeFi space. We will walk you through this concept and all that has to do with it to ensure you are well-grounded to minimize losses while farming.
Let’s dive in!
What is DeFi Yield Farming?
DeFi yield farming is simply a method of earning incentives for deposited crypto assets.
A more thorough answer is that yield farming allows innovative individuals to maximize their profits on their investments rather than merely holding crypto assets.
Projects provide these advantages to people in exchange for temporarily using their assets. Projects typically use deposits to boost liquidity, although they can also be used for staking.
Deep liquidity is one of the most significant characteristics of any financial market since it facilitates quick and efficient financial transactions.
This article provides a thorough introduction to liquidity. DeFi yield farming is a practical approach for increasing liquidity.
New initiatives can boost their liquidity, while established projects with diminishing liquidity can reverse the trend by providing significant incentives.
Let’s see exactly how this Defi yield farming works.
How DeFi Yield Farming Works
DeFi yield farming initiatives allow users to earn incentives by locking their cryptocurrency tokens for a predetermined time.
Yield farms employ smart contracts to lock tokens and pay interest rates ranging from a few percentage points to triple digits. In many circumstances, the locked tokens are distributed to other users.
Users borrowing tokens pay interest on their crypto loans, with a portion of the proceeds going to liquidity providers.
In other circumstances, locked tokens offer the liquidity the decentralized exchange requires to support trading.
This decentralized exchange frequently employs an automated market maker, which requires locked tokens to complete buy and sell orders. In this situation, yield farmers gain passive money from transaction fees.
In addition to trading fees, users frequently receive extra liquidity incentives, such as governance and newly generated tokens.
DeFi platforms, such as Curve Finance, enable users to yield farm a variety of tokens on blockchains such as Ethereum, Bitcoin, and others.
Curve employs a unique algorithm that only moves the price when the loss is less than the profit. This allows it to generate more liquidity than a typical platform.
Moving ahead, we will see the common types of DeFi yield farming available in the DeFi ecosystem.
Types of DeFi Yield Farming
Some common types of Defi yield farming include;
- Staking
- Liquidity providing
- Lending
Staking
There are various types of staking in cryptocurrency. The first kind occurs at the protocol level of a Proof-of-Stake blockchain.
To protect a blockchain network, users lend a portion of its native cryptoasset (e.g., ETH on Ethereum, AVAX on Avalanche, etc.).
In exchange for this critical service, they receive a portion of the blockchain’s fresh token issuance.
The second type of staking is typically a limited-time opportunity to earn additional income as a liquidity provider (LP).
When you supply liquidity on a DEX, you receive an LP token, a type of receipt used to collect earned fees and redeem crypto assets in a pool.
Some platforms enable users to “stake” LP tokens by putting them in a staking smart contract.
This allows LPs to earn yield twice: once for liquidity in a pool and again for staking LP tokens on the DEX. DEXs use this type of staking to attract liquidity.
Verse Farms, for example, provides high-yield farming without custody—deposit liquidity pool tokens into Verse Farms to get additional incentives and trading fees for liquidity.
Liquidity Providing
Liquidity providers (LPs) donate crypto assets to a decentralized exchange (DEX) and gain a share of trade fees.
LPs must deposit equal quantities of two crypto assets in a trading pair, such as VERSE-WETH. All LPs with the same asset composition are pooled together; hence, they are known as pools or liquidity pools.
When someone trades between two cryptoassets, such as VERSE and WETH, the appropriate LPs receive a share of the exchange fees.
Lending
Finally, another type of DeFi yield farming is lending. DeFi enables users to borrow crypto assets from a network of lenders. The lenders profit from the interest the borrowers pay.
Let us see the benefits of DeFi yield farming.
Benefits of DeFi Yield Farming
The benefits of DeFi yield farming are numerous; some of them include the following;
- High yields
- Passive income
- Liquidity provision
High Yields
Some DeFi ventures offer higher yields than traditional financial products. Depending on market conditions, customers can earn significant returns on their investments.
Passive Income
Instead of simply holding, users can put their holdings to work and earn incentives in the form of extra tokens and fee money without actively trading.
Liquidity Provision
DeFi Yield farming facilitates more efficient trading and decreases slippage on DEXs. Users are vital to the DeFi ecosystem‘s operation because they provide liquidity.
Although Defi yield farming has all these unique benefits, some risks remain to consider before investing.
Risks of DeFi Yield Farming
On the surface, DeFi yield farming appears to be a simple way to profit from cryptocurrency markets using your tokens. However, DeFi yield farming is not without risk.
There are various ways to lose money with yield farming. Understanding the risks in this relatively new decentralized money is the first step toward self-protection.
Some risks of DeFi yield farming are;
- Impermanent loss
- Volatility
- Liquidity pools drying up
- Rug pulls
- Market fluctuations
Impermanent Loss
Impermanent loss is best understood in liquidity pools when users deposit two sorts of tokens. For example, if a user wants to support a liquidity pool in which other users can trade ETH for HBAR, they must deposit both tokens.
When someone buys HBAR from this liquidity pool, they effectively deposit ETH into it and withdraw an amount of HBAR equal to the deposited ETH.
When this occurs, the HBAR/ETH ratio alters, resulting in more ETH and less HBAR in the pool. This enhances the value of HBAR while lowering the value of ETH.
Because the pool contains monies placed by various liquidity providers, it also changes the percentage of tokens they have locked, leaving them with fewer tokens that have gained value.
In many situations, this results in a situation in which the overall worth of their tokens would be higher if they had kept them.
Volatility
Newer digital assets with minimal liquidity frequently experience severe price volatility. Although volatility can be beneficial, it can also lead to financial losses.
Because yield farm systems often force users to lock their cryptocurrency tokens for a set time, the price may fall dramatically before customers sell them.
Liquidity Pools Drying Up
Because a global pool of users supplies liquidity, the amount of liquidity might fluctuate as people withdraw their tokens.
Low liquidity causes more slippage, which means people will receive less money than expected when they sell tokens into the pool. Many exchanges allow customers to establish slippage tolerances to reduce low-liquidity risk.
However, there may be cases where liquidity is so low that users lose money when attempting to swap their tokens.
DeFi Yield farming may increase the danger of low liquidity because the tokens must be locked for a defined period and cannot be sold.
Rug Pulls
Rug pulls are scams in which someone creates a new cryptocurrency token, promotes it to get purchasers, and then departs the project without repaying the buyers’ funds.
In many situations, these schemes include somebody owning a significant amount of the token and selling it into liquidity pools, draining the available liquidity, and rendering the token worthless.
Market Fluctuations
DeFi yield farming payouts can vary significantly from day to day. In rare circumstances, users may lock their tokens in a pool with a high payout, only to discover that the pool removed the incentives later in the week.
During the time it takes for customers to unstake their tokens, other pools may boost their rewards, resulting in circumstances where the liquidity provider could have earned more if they had waited and deposited their assets in the new pool.
Keeping up with the various pools’ payouts and devising a yield farming plan might take much work.
We will briefly look at some platforms and protocols for DeFi yield farming.
Popular Platforms and Protocols For DeFi Yield Farming
Some platforms for DeFi yield farming include;
- Curve finance
- UniSwap
- Aave
- Yearn Finance
- Coinbase
Curve Finance
It allows investors to farm tokens across several blockchains, including Ethereum, Bitcoin, and Polygon. Curve is noted for its algorithm, which only moves the price when the loss is less than the profit.
UniSwap
This is a decentralized, permissionless, and automated liquidity mechanism based on Ethereum.
Aave
Aave creates liquidity pools that generate rewards for lending assets and staking.
Yearn Finance
This helps users to optimize their earnings from cryptocurrency assets by lending and trading.
Coinbase
Coinbase allows yield farmers to earn cryptocurrency rewards.
Final Thoughts
While DeFi yield farming might be a profitable way to generate yields in the cryptocurrency market, it is also one of the most dangerous activities you can engage in.
Even if you use recognized DeFi methods for yield farming, smart contract risk, and hacking could result in a total loss of cash.
Also, the value of the protocol token you receive as a DeFi yield farming reward significantly impacts your prospective profits. If the value of the protocol token falls, your DeFi yield farming profits could suffer.
Finally, the yield you receive today may differ from the yield you receive tomorrow. High yields tend to compress when more farmers invest in high-yielding farms, affecting your returns.
If you can take the risk, yield farming might be an exciting way to make a return on your cryptocurrency. However, it would help if you always did your homework and never spend more than you can afford to lose.