DeFi is at the forefront of innovation, and learning How Yield Farming Works is essential and a necessary evil to obtaining a huge return on investment (ROI) in DeFi. I mean, why keep your assets idle when you can put them to work?
Read on to find out more!
Yield Farming for Beginners
The Decentralized Finance (DeFi) movement has been at the forefront of blockchain innovation. With these newly emerging solutions, businesses and individuals alike want to capitalize on the benefits of decentralized finance.
Decentralized finance has not only increased the potential for global financial inclusion, but it has also increased the potential for using and managing digital assets.
Following the DeFi innovations is a new emerging trend known as Yield Farming. This concept gained popularity in 2020 and is still popular today. It’s a novel way to profit from cryptocurrency holdings. Yield Farming, in essence, provides a flexible approach to earning passive income by depositing crypto assets in a liquidity pool.
To know more about liquidity pools, you can check out this great article on Liquidity Pools in DeFi.
Yield farming is an important part of the DeFi ecosystem because it supports the DeFi protocols that enable exchange and lending services. It is also necessary for the liquidity of crypto assets on various decentralized exchanges, or DEXs. Farmers may also be rewarded in the form of an annual percentage yield (APY).
What’s Yield Farming?
Yield farming is the process of incentivizing liquidity providers (LPs) to lock up their crypto assets in a smart contract-based liquidity pool by using decentralized finance (DeFi) protocols. This contributes to the growth of your cryptocurrency holdings.
These incentives can take the form of a percentage of transaction fees, lender interest, or a governance token. These returns are expressed as a percentage yield on an annual basis (APY).
In order to achieve high yields, yield farmers will typically move their funds around a lot between different protocols. As a result, DeFi platforms may offer additional economic incentives in order to attract more capital to their platform.
Its market cap has grown from $500 million to $40.03 billion by 2022, according to coinmarketcap, thanks to its innovative but risky and volatile application of decentralized finance (DeFi).
How Yield Farming works
Creating a liquidity pool is the first step in yield farming. This is based on a smart contract that facilitates all Yield Farm investing and borrowing. The funds are then deposited into the liquidity pool by liquidity providers. This pool is responsible for powering a marketplace where users can lend, borrow, or swap tokens.
These platforms charge fees, which are then distributed to liquidity providers in proportion to their share of the liquidity pool. The liquidity providers are compensated based on the amount of liquidity they provide to the pool, which is the basis for how an AMM works.
You can check out this great article on Automated Market Makers in DeFi.
Yield generation is a complex concept, and farmers must have sufficient knowledge and experience when dealing with Yield Farming. Yield Farmers could then transfer their funds across different DeFi protocols to maximize their returns.
What are the risks of Yield Farming
Yield farming is an intriguing way for cryptocurrency enthusiasts to earn a return on their investment that is not solely based on the currency’s value increasing. However, due to the risks involved, yield farming may not be worthwhile for many investors, particularly newer investors.
It is important to note that Yield Farming offers high-risk and high-reward ventures for investment. The notable risks with yield farming include the following:
Risk of Impermanent loss
Yield Farming involves providing liquidity by lending out your tokens to a liquidity pool. Liquidity providers are subject to impermanent loss because if there’s a change in price from when you deposited the token, it becomes subject to impermanent loss.
Although the loss is not permanent until you withdraw your funds from the liquidity pool. So to avoid this you can stick with providing liquidity for stable pairs, which might be less rewarding but more risk efficient.
You can check out this great article on Impermanent loss in DeFi.
Smart contract risk
Due to the nature of DeFi, many protocols are built and developed by small teams with limited budgets. This can increase the risk of smart contract bugs.
Even in the case of larger protocols that are audited by reputable auditing firms, vulnerabilities and bugs are discovered all the time. Due to the immutable nature of blockchain, this can lead to the loss of user funds. You need to take this into account when locking your funds in a smart contract.
Composability risk
One of DeFi’s most significant advantages is also one of its most significant risks. DeFi protocols communicate with one another invisibly. This means that the entire DeFi ecosystem is heavily dependent on each of its constituent parts. When we say that these applications are composable, we mean that they can easily work together.
As a result, Yield Farmers and Liquidity Pools face a risk if just one of the building blocks fails to function properly, causing the entire ecosystem to suffer. You must not only trust the protocol to which you are depositing your funds but also all others on which it may be reliant.
Yield Farming Vs Staking
Yield Farming and Staking are often used interchangeably since both are effective ways of earning rewards on cryptocurrency deposited in a pool.
Yield Farming
Yield generation is a popular method of generating returns on crypto assets. Essentially, it provides a flexible method for earning passive income by depositing crypto assets in a liquidity pool.
In the case of yield farming, the liquidity pools could be traditional bank accounts. Yield generation refers to the practice of investors depositing their crypto assets in liquidity pools based on smart contracts. The assets locked in the liquidity pools are now available for borrowing by other users using the same protocol.
Staking
Staking entails storing your crypto assets in the protocol in exchange for the ability to validate transactions on the protocol. This is done in order to keep a blockchain network secure.
Staking algorithms also open up new avenues for earning rewards measured in APY. Investors with higher stakes in the protocol may receive better rewards from the network, ensuring improved energy efficiency.
Here are some basic differences between Staking and Yield Farming:
| Comparison | Staking | Yield Farming |
|---|---|---|
| Rewards | Staking rewards are typically new coins created as a result of validation. | APY is a common form of yield farming compensation. |
| Underlying Technology | Staking uses the Proof of stake concensus algorithm which requires 51% of nodes on the network to agree before carrying out a trade. | Yield farming uses automated market makers to facilitate trades i.e., users here directly interact with smart contracts eliminating the counterparty. |
| Pools Interaction | Staking pools usually compete with one another because the more stake a pool has, the more likely it is to win the next block. | Yield farmers can generate returns through yield aggregators by utilizing multiple interconnect pools. |
Is Yield Farming safe?
The need to maintain safety in DeFi protocols cannot be overemphasized, as they have become a prime target for hackers due to the rewards associated with carrying out a successful attack.
Yield Farming poses certain risks, which have been discussed above, of which one of the greatest is Impermanent loss. Yield Farming without impermanent loss can only happen when the funds deposited in the liquidity pool are withdrawn before drastic price fluctuations.
But it goes without saying that Yield Farming safety is solely dependent on the protocol you’re interacting with and the measures taken to maintain the safety of Yield Farmers.
Conclusion
The growing interest in crypto assets is undoubtedly creating numerous new opportunities for investors. However, investors must understand the strategies they must employ in order to achieve the expected returns.
One thing to keep in mind, in this case, is the excitement and hype surrounding how Yield Farming works. The prospect of earning 100%, 200%, or more in annual interest is appealing.
Thus, the high risks and high rewards of Yield Farming present a balanced picture of its future. You should not participate, however, unless you completely understand how yield farming works and the risks involved.
Disclaimer: Please note that this article does not provide investment advice or recommendations. It’s essential to understand that every investment carries inherent risks. Readers are encouraged to conduct their own thorough research before making any financial decisions.
