Yield Farming in Decentralized Finance (DeFi)
The word “Decentralized Finance” and Yield Farming has become a hot topic in the crypto space. Every day, interest in the technology keeps rising as it’s numerous benefits unfold. DeFi, as we call it, is one of the innovations that is changing the whole blockchain space. The reason for the increasing popularity is that Defi applications are permissionless and trustless. All you need to interact with DeFi applications such as smart contracts is to have a wallet and connect to the internet. You don’t even need to trust a middleman or custodian before interacting with decentralized applications.
In this article, we will discuss one of the DeFi concepts that have emerged in the space: Yield Farming. We will explain what it is in simple terms, how it works, what to do, the dangers, benefits, and general information about it. So, read on and understand more about DeFi yield farming.
What Is Yield Farming?
Yield farming is simply a way to use your crypto to earn more. It involves a simple process of staking your cryptocurrencies for rewards. If you also hear the words “liquidity mining” from community members, they’re also referring to yield farming. For yield farming to work, there must be liquidity providers who will push in funds to liquidity pools.
A liquidity pool is simply a smart contract with funds. The liquidity providers who provide these funds earn a reward by doing it. Their rewards usually come from the fees which the DeFi platform associated with the pool generates. Sometimes, LPs can get their rewards from other sources too. In some instances, liquidity providers may get their rewards in lots of different tokens and reinvest it into other pools to make more rewards. That’s why Yield farming sometimes seems complicated when you consider the strategies that liquidity providers adopt to earn rewards.
The tokens that facilitate the yield farming concept are ERC-20 tokens based on Ethereum. Also, yield farmers get their rewards in ERC-20 token. The reason for this is because DeFi was built on Ethereum, and most of the activities are happening in its ecosystem. However, some experts predict that the future may be different. , but for now, yield farming is using Ethereum ERC20 tokens.
What Triggered The Growth Of Yield Farming?
We can attribute the boom in yield farming to what we see in supply and demand. When a new DeFi project emerges, it will offer new tokens or present multiple ways through which users can earn rewards. When this happens, every user will rush towards the new project aiming to earn some rewards, creating a high demand for the project. With such high demand, the value which devs invested in the project and token will rise.
Also, the launch of COMP Token facilitated the rise of yield farming popularity. Compound Finance launched its governance token, which gives every holder the right to participate in decision making on the ecosystem. So, to distribute it in a decentralized way, they used the liquidity incentives method to attract LPs. These liquidity providers now provided liquidity to the pool by farming the new token to earn rewards.
The launching of COMP did not start the Yield farming concept. But it played a vital role in making the practice popular. Now, other decentralized finance projects leaned on the Compound Finance strategy to develop their schemes of attracting liquidity.
How Do Projects Measure Their Yield Farming efforts?
The simplest measure of yield farming success is what we call Total Value Locked (TVL). TVL is a measure of the total dollar value of tokens locked in decentralized finance, both in its lending plus other money marketplaces. You can say that Total Value Locked represents the value of liquidity in all the liquidity pools.
The importance of TVL in yield farming is that projects use it to know the progress or performance of yield farming and DeFi. It also helps participants to compare different DeFi protocols in terms of market share. With a platform like Defi Pulse, it’s easy for players in the ecosystem to identify the platforms with more crypto assets such as ETH and others.
With this, you can now see that one way to know if a project has lots of yield farming is to check the total value locked. If the TVL is high, that means YF is on the rise. TVL is measurable in BTC, ETH, and USD. So, it’s not just the United States dollars alone that can show the state of Decentralized money markets.
How Does Yield Farming Work?
Each DeFi application differs in its features and terms of operation. So, the uniqueness of the application determines how Yield farming will work on its platform. But the general practice of yield farming relies on the activities of the liquid providers, liquidity pool, and rewards. You can even liken the yield farming process to AMM (automated market maker).
The whole process starts through liquidity providers who deposit their funds into a DeFi application or liquidity pool. With the funds which they deposit on the platform, users can borrow, exchange their tokens and even lend to other holders. But these individuals who use the platform must pay a fee, and that’s what the LPs will earn according to the value of their funds in the pool. This is in a case where the LPs invest money into a pool of different tokens.
However, there’s another way through which liquidity providers earn rewards for their investment apart from the fees. It may be in the form of receiving a vast number of newly launched tokens. LPs can provide liquidity to a new DeFi application and accumulate a vast number of tokens, especially if there’s no other way to acquire the value they want in the open market. So, they can rely on yield farming to get the token they want.
In yield farming, the farmers mostly stake stablecoins like USD Coin (USDC), Tether (USDT), or Dai because tracking their profits & losses in these coins is easier. But it doesn’t mean that you can’t deposit funds with other cryptos like Ether (ETH). Sometimes, many Defi protocols prefer mint tokens, which represent the coins you add to the protocol. What do we mean by that? Many protocols can mint Compound DAI or cDAI for a farmer who deposited DAI into the Compound Protocol. Also, they can offer cETH to another farmer who deposited ETH into the protocol.
How Are Returns Calculated In Yield Farming?
Yield farming returns are calculated annually. So, as a farmer, you can get an estimate of the returns to expect in a whole year. The common computing metrics for calculating the returns are APR and APY (Annual Percentage Rate and Annual Percentage Yield).
APR: this is the annual rate of return charged on borrowers to pay capital investors. These rates are imposed on borrowers, but the developers use it to pay the capital investors.
APY: This is the yearly rate of return imposed on the capital borrowers but paid to the capital providers.
These two computing metrics are almost the same except that APR doesn’t apply a compounding effect to yield farming returns while Annual Percentage Yield applies it. So, it means that APR doesn’t allow the reinvestment of interest in the scheme for more profits. But APY allows compound interest accruals for the investors.
One thing to note about calculating yield farming returns with APY and APR is that the results are just projections and estimates. It is not easy to get an accurate estimate of the returns, even on a short-term basis. The reason for this is that yield farming rewards are never the same. Sometimes it may be high, and other times, it may be lower given the fast-paced nature and competition in the market. Also, the farmers contribute a lot to the fluctuations in yield farming rewards. Sometimes when they see that the strategy is working out for a long period, they all jump in to harness the opportunity, thereby driving the returns very low.
So, it is likely that decentralized finance may need to find other metrics that’ll make the calculations more solid.
Benefits In Yield Farming
The number one benefit of Yield Farming is profit. The farmers who are very fast to farm in a new DeFi project will accumulate a large number of token rewards. Once the value of the tokens appreciates, they can sell it and make high returns. After making the profits, they can also decide to reinvest their returns into another project for more yield. However, for yield farmers to make good profits in DeFi projects, they usually invest very high in their initial capital. Sometimes, a farmer may invest hundreds of thousands to make any notable profit. Therein lies the risk of yield farming.
The cryptocurrency market is highly volatile, and DeFi tokens are no better when it comes to volatility. The tokens can record high values today, and tomorrow, they’ll drop at an alarming speed. So, in such a situation where a yield farmer has invested hugely in the DeFi project thinking it will rise, but it drops, he/she will face compulsory liquidation.
But all hope is not lost because there are yield farming strategies that work if you know them well. Unfortunately, they are very complex for ordinary farmers unless you’re someone who understands how the protocols work. That’s why experts believe that yield farming is more suitable for Whales to explore because they have lots of capital to invest.
Another risk which yields farmers face is in smart contract code. Many entrepreneurs and developers with a limited budget are trying to cash in to the benefits of decentralized finance. Due to their zeal, they sometimes use unaudited smart contract codes that are easy prey to bugs. Sometimes, too even protocols with higher budgets often discover vulnerabilities after passing through auditing from reputable firms. These vulnerabilities usually expose the protocols to hackers who exploit the loopholes and steal millions of dollars.
There have been some cases where code vulnerability has led to the loss of farmers’ funds in yield farming. For example, bZx has recorded many attacks this year. The protocol even lost $8 million recently due to an error in code. Fortunately, the hacker returned the funds to the project. Also, YAM Finance, which was doing very well after it launched, suddenly crashed due to code flaws and other issues in performance and security. So, you have to be mindful of this risk when staking your money in DeFi smart contracts.
Another risk which yield farming face is in the nature of DeFi protocols. These protocols usually integrate easily. What this means is that the DeFi ecosystem relies on each application that makes it up. As such, the application works together all the time. So, if one malfunctions, the entire ecosystem may crash. Imagine what that will mean to yield farmers.
Are There Challenges In Yield Farming?
Many decentralized finance applications are based on Ethereum, resulting in many of the challenges that farmers faced in recent times. The popularity of yield farming has attracted a larger number of farmers into the Ethereum network. As a result, there have been a larger number of transactions on the network. But due to its scalability issues, the network is not able to complete these transactions as it should.
On the network now, farmers are experiencing delays in confirmation, and the transaction fees on the network are becoming outrageous. As a result, many speculators are saying that decentralized finance may soon self-cannibalize. Although, the upcoming Ethereum 2.0 upgrade will make it more scalable and secure to cater to the need of the crypto community. For now, DeFi operators on Ethereum are trying to reduce the scalability issues by developing second-layer solutions for the platform.
But it seems that other platforms may soon benefit from the inadequacies of the Ethereum network. For example, the emergence of Binance Smart Chain is providing a way out for yield farmers to utilize new DeFi applications like BurgerSwap.
Yield Farming Protocols and Platforms
There are many platforms to farm, but here are the most popular ones
This protocol is part of the DeFi exchanges that allow users to swap tokens. These easy token swaps help yield farmers to execute their strategies. On Uniswap, LPs creates a market by depositing two tokens that have equivalent values. By doing so, they provide a liquidity pool for traders to trade. Meanwhile, the liquidity providers will earn their rewards from the fees on trades in the pool.
This is one of the popular Defi protocols where you can earn rewards for yield farming. It facilitates the lending and borrowing transactions amongst users. On the Compound Finance platform, all you need to qualify for reward farming is your Ethereum wallet. Once you supply assets to the liquidity pool, you’ll earn rewards that automatically begin compounding.
Here is a credit platform that helps farmers to earn rewards in yield farming. Maker allows yield farmers to mint DAI and use it in their strategies. Generally, on MakerDAO protocol, an individual can lock collateral assets such as USDC, ETH, WBTC, or BAT in a Maker Vault then generate DAI against the collateral they have locked in the vault. However, this debt over time will incur interest known as the “stability fee,” and it is the holders of MKR token that usually set the interest rate.
Other popular DeFi protocols and exchanges include Aave, Curve Finance, Synthetix Yearn.finance, Balancer, etc.
We have tried to simplify the Yield Farming concept to equip you with how the processes all work. We have also discussed the benefits and the risks involved in it. One thing to bear in mind is that the crypto market is very volatile. You can make high returns today and make the lowest returns the next day. That’s why it’s difficult to offer an accurate projection of yield farming return even with the available metrics.
Nevertheless, yield farming is a simple way to earn more cryptocurrency with the one you have. But due to the market volatility, it’s best suited for people with a strong capital base.
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