In Brief:
You must be wondering what yield farming is.
Simply put, yield farming includes the process that enables crypto holders to lock up their holdings, thereby providing them with great rewards. Therefore, yield farming allows you to lock up your funds, resulting in greater rewards and returns.
This includes lending out cryptocurrencies through DeFi protocols to earn fixed and variable interest. The rewards can be far greater in amount than the traditional investments. But there is one thing to understand here!
Big reward brings big risks, particularly in such a volatile market.
How is Yield Farming carried out?
Yield farming is carried out using ERC-20 tokens, with the rewards being a form of an ERC-20 token on Ethereum. However, this can be changed in the future, as almost all the currently working yield farming transactions can occur in the Ethereum ecosystem.
Is Yield Farming the same as Staking?
No!
You must be wondering, isn’t storing my funds and then getting the rewards similar to staking? Well, it’s true; in Staking, you don’t lock up your funds and earn great rewards. But there is a fundamental difference but these two terms.
In Staking, you are utilizing your resources to support a specific blockchain. In yield farming, you are more focused on creating the maximum returns possible for the cryptocurrency you lock up.
| Staking | Yield farming | |
| Profit | Staking has a set reward, expressed by an APY. It is around 5% but could be higher based on the staking token and method. | Yield farming needs a well-thought and well-established investing strategy. It is not as simple as Staking but can yield much greater rewards or 100%. |
| Rewards | These rewards are the network incentives given to validators helping the blockchain reach consensus and produce new blocks. | Here liquidity pool determines the rewards, which can fluctuate according to the token’s price changes. |
| Security | Staking has strict policies and rules directly tied to the blockchain’s consensus. If bad actors trick the system, they risk losing their funds. | It depends on DeFi protocols and smart contracts. In this case, you’re prone to hackers if the programming has not been done appropriately. |
| Impermanent Loss Risk | No impermanent loss if you stake cryptocurrency | In yield farming, you are exposed to some risks due to the volatility of digital assets. So, there are chances of impermanent loss if your funds get locked in a liquidity pool, also if the ratio of the tokens in the pool is inappropriate and uneven. |
| Time | Blockchain networks need users to stake their investments or funds for a fixed duration. Some also need to have a minimum requirement. | In this case, you don’t need to lock up funds for a fixed duration. |
Liquidity Pools
It is perhaps one of the important characteristics to consider in yield farming. A liquidity pool is a collection of assets where liquidity providers can deposit their assets to be used by the platform. So, large amounts of cryptos are pooled together by those willing to do so.
It is commonly seen in Uniswap and other DeFi exchanges. These cryptocurrencies enable DeFi exchanges to have token pairs that can be exchanged, like ETH/LINK (chainlink). You can get a return on your investment by doing this via interest from the funds borrowed.
There is about a 0.3% fee for the users when swapping tokens. This 0.3% fee is divided among investors in proportion to what they invested. This is the case of UniSwap and differs from pool to pool.
Compound
The process of yield farming and liquidity pools can be well understood by considering the example of a compound. It is one of the protocols where yield farming actually exploded.
The compound is an Ethereum-based protocol that enables the lending and borrowing of crypto assets. The lender offers a loan by participating in the liquidity pool to the Compound platform and then gets interest in that loan. Then the lender’s interest is calculated based on the supply and demand ratio for the crypto assets they give, which obviously differs from time to time.
When contributing funds, you can get compound tokens easily. You can contribute to tokens for high Yield like 8.58% for USDC and 6.96% APY by using the compound.
Stablecoins such as collateral like DAI in Compound and other DeFi applications can be used to provide high yields. You can then get a bank loan using what you’ve put as collateral for switching to tokens on other platforms and reinvest them.
Various applications like Synthetic, MakerDao, Balancer, Aave, and others allow a great range of complicated strategies. DeFi can be as deep a rabbit hole as the traditional financial world.
Risks in Yield Farming
Smart contract bugs
Automated market maker runs on code. But there is still a chance of it being exploited.
Gas fees
This is an important factor to consider before investing. You need not invest when the gas fees are high. A new protocol might soon change this. However, for now, gas fees could be as much as your whole profit. So, you need to invest where gas fees are lower, or you can wait until Ethereum is manageable.
Liquidation
If collateral has been dropped below what you loan, there will be a penalty on that collateral. This could also happen if the value of your crypto declines.
Wrapping Up
Yield Farming is considered extremely lucrative, but that carries a fair amount of risk. During this process, you lock up your funds, risk your money, and receive great rewards.
There are great risks, as cryptocurrencies like Ethereum are very volatile. This is something you need to consider before diving into yield farming. Also, be aware of the gas fees of the blockchain you’re using. But of course, the riskier it is, there are more chances of higher profit.
Compound’s strategy can be used for yield farming. It just started in June 2020. And there are already running complex strategies and technological innovations that are taking place. It only needs time until the whole ecosystem becomes as lively as traditional centralized financial markets.
