Mary Amakihi 
Yield Farming and Liquidity Mining: Financial Benefits of DeFi
Over the last five years, cryptocurrencies have exploded at an unprecedented rate, but so have the different methods of generating income in the DeFi space. This article discusses Yield farming and liquidity mining.
Yield Farming and Liquidity Mining are growing as key concepts in the DeFi (Decentralized Finance) space, enticing investors and developers with the creative potential of generating returns on crypto assets.
Understanding these ideas is vital for software developers who want to construct DeFi applications or those interested in the financial benefits of DeFi.
What is the purpose of yield farming in DeFi?
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 into 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 DeFi protocol in exchange for yield, staking can be defined 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 DeFi protocols that offer trade and loan services.
They also help to keep cryptocurrency assets liquid on decentralized exchanges (DEX). Yield farmers receive payment as an annual percentage yield (APY).
How Yield Farming Works
Yield farming is done via automated market makers (AMM), protocols used in liquidity pools to price assets automatically.
Liquidity providers deposit funds into a liquidity pool. Other users can borrow, lend, or trade the deposited tokens on a decentralized exchange powered by a specific pool.
These platforms impose additional fees, which liquidity providers pay based on their percentage ownership of the liquidity pool.
Because this technology constantly changes, new techniques are expected to emerge and replace old strategies.
Aside from fees, issuing a new coin may encourage people to donate money to a liquidity pool.
For example, a token may only be accessible in limited numbers on the open market. On the other hand, it can be generated by increasing the liquidity of a specific pool.
Each protocol implementation will follow its own distribution rules. The basic thing is that liquidity providers are compensated based on the quantity of liquidity they contribute to the pool.
Although not essential, stablecoins linked to the USD are commonly used as deposit mechanisms. USDT, USDC, BUSD, and other stablecoins are often utilized in DeFi.
What are the advantages of yield farming?
Here are some advantages of yield farming.
- Diversification
- High returns
- Decentralization
- Flexible terms
Diversification
One advantage of yield farming is the ability to diversify your cryptocurrency portfolio.
By supplying liquidity to many 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 DeFi protocols can provide annual percentage yields (APYs) as high as 400%. Of course, not all protocols provide such large returns and are subject to change based on market conditions.
However, the prospect of large earnings is appealing to yield growers.
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 DeFi protocols.
This democratizes finance and minimizes the need for centralized intermediaries like banks.
Flexible Terms
You are not obligated to commit to a specific lock-up period in yield farming pools. This suggests that you can adjust the level of liquidity as needed.
If you feel vulnerable or exposed to a particular pool, it is easy to withdraw quickly. You can, however, choose to invest additional tokens if you discover that a specific yield farming pool is giving you better farming conditions.
With that, let us see what liquidity mining is about.
What is liquidity mining in DeFi?
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 important part of the DeFi (decentralized finance) 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 Liquidity Mining Works
Let us look at an example to understand better how liquidity mining works. Assume there is a 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.
Let’s imagine 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 systems 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.
What are the Advantages of Liquidity Mining
Some advantages of liquidity mining are:
- Passive income earning
- Improved market liquidity
- Portfolio diversification
- Appreciation of token price
Passive Income Earning
Liquidity mining also allows traders to get passive money without actively trading.
Once traders have 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 earn money even when the market isn’t doing well or can’t actively trade.
Improved Market Liquidity
Liquidity mining also improves the overall Crypto 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.
Portfolio Diversification
Another advantage of liquidity mining is that it diversifies traders’ portfolios. Because liquidity mining can be done on multiple decentralized exchanges and currencies, traders can diversify their assets to lessen risk.
By participating in liquidity mining, traders can invest in various cryptocurrencies and get incentives for each, lowering their overall risk exposure.
Appreciation of Token Price
Providing liquidity to a token allows traders to boost its liquidity, leading to increased demand and, eventually, higher prices. This and the benefits obtained from providing liquidity can result in enormous gains for traders.
We have seen yield farming and liquidity mining. Now, let us see the differences between DeFi’s two financial benefits.
What is the difference between yield farming and liquidity mining?
Some key differences between yield farming and liquidity mining that we have picked out for you are:
Risk Profile
Yield farming has quite a risky profile. Yield farming entails transferring assets between liquidity pools or supplying liquidity to them.
Liquidity mining is riskier than yield farming because it provides liquidity for a particular cryptocurrency to make it more liquid.
Complexity
Yield farming involves moving digital assets between liquidity pools and providing liquidity to them.
Liquidity mining is more sophisticated because it includes supplying liquidity to a DEX.
Reward Profile
Yield farming Offers higher returns by moving cryptocurrencies between liquidity pools.
Liquidity mining offers higher returns by providing liquidity to a particular cryptocurrency.
Liquidity
Yield farming tokens are used to give liquidity to decentralized exchanges, affecting the market’s liquidity.
Liquidity mining tokens are also utilized to give liquidity to decentralized exchanges, affecting the market’s liquidity.
Requirements
In Yield farming, to lend or borrow, you must have some cryptocurrency and a compatible DeFi platform.
Liquidity mining requires providing liquidity to a DEX and having compatible tokens.
Conclusion
Making the ideal investment in a rapidly changing market like cryptocurrencies might be daunting. Ensuring you receive the finest rewards at the lowest rate can result in so many possibilities that investors choose none.
Most importantly, investors should examine their risk tolerance as the primary factor influencing their investment decisions.
In the world of Crypto yield farming and liquidity mining, particularly on DeFi, the greater the potential rewards, the less likely that option will be feasible in the long run.
