Yield Farming is one of the main innovations brought by Decentralized Finance (DeFi) to the Cryptocurrency Market. And, without a doubt, it was one of the reasons for the explosion of these projects in the year 2020. So if you want to know more about what is Yield Farming, read further.
Yield Farming is one of the main innovations brought by Decentralized Finance (DeFi) to the cryptocurrency market and, without a doubt, it was one of the reasons for the explosion of these projects in the year 2020.
If in traditional finance the return on an application rarely exceeds 5% per year, with Yield Farming you can find annual returns of 100% or more!
As with most things related to blockchain and cryptocurrency, this concept can be daunting at first — but it’s simpler than it sounds.
Throughout this article, we will see what this concept refers to, as well as its components, its attraction to investors, and its possible risks.
Table of Contents
- What is Yield Farming?
- How to mine liquidity?
- Most Popular Yield Farming Projects
- Yield Farming Risks
What is Yield Farming?
At its core, liquidity mining is a process that allows holders of cryptocurrencies to earn rewards for their investments. There are several platforms for doing this type of trading, such as Compound and Aave, for example.
From the standpoint of decentralized platforms and applications ( Dapps ), the main objective of agricultural production is to attract liquidity by rewarding investors who are willing to lend their assets.
The mechanism takes place with an investor depositing units of a cryptocurrency to earn interest from trading fees. These returns are expressed as an annual percentage yield, as we will see later.
We can make an analogy with the traditional system: when loans are made through banks using fiat currency (US Dollar, Euro), the amount borrowed is repaid with interest. With Yield Farming, the concept is the same: the Crypto Asset borrowed in DeFi protocols (or locked in smart contracts) gives you returns.
It is also worth mentioning that as more investors add funds to any related liquidity pool, the value of issued returns increases. Some platforms also reward their users with additional revenue from the protocol governance token.
The governance tokens give holders the power to influence decisions regarding the protocol, or product development roadmap, as well as hiring and changes to the governance parameters.
How to mine liquidity?
The first step in yield farming involves adding funds to a liquidity pool, which are essentially smart contracts that contain funds. After adding your funds to a pool, you officially become a liquidity provider.
Your returns to users are based on the amount you invest and the rules on which the protocol is based.
Also, by getting more intimate with the system, some users can further maximize their profits. Some take a loan on one platform, for example, to lend this capital on another, to monetize the crypto received.
In traditional finance such “loan marriages” would never be possible, but in the world of digital assets, it is possible! Yes, you didn’t read that wrong: in this disruptive world, there is a way to borrow back profits from a protocol to further amplify your gains. This process is known as Yield Hacking.
Calculation of income
Estimated yield returns are calculated on an annualized model, which can be APR or APY.
By calculating the APY, compound interest is considered, which is nothing more than the direct reinvestment of profits to generate more profits. In the APR calculation, the reinvested amount is not considered, therefore, it is a simple interest calculation.
However, there is something to keep in mind: as the cryptocurrency market is extremely volatile, calculation models are simply estimates. It is difficult to accurately calculate returns at all dynamism.
Farming strategies can change in a day as new farms emerge bringing new requirements for deposits and amount of payouts.
Most Popular Yield Farming Projects
Users can use many apps for Yield Farming and each has its own rules for determining rewards.
There are several DeFi projects currently that offer such a system. Some of the best ones that move the most money are:
Aave means “ghost” in Finnish. Formerly known as ETHLend (LEND), the Aave protocol was founded by Stani Kulechov and released in November 2017.
It allows users to borrow and borrow several cryptocurrencies and is currently the project with the highest TLV ( Total Value Locked in the protocol) among the DeFi projects.
The platform supports various stablecoins and other assets such as DAI, USDT, BAT, and yearn.finance. In addition, it is also operated by the second layer of the Ethereum network, Polygon (MATIC).
Whenever you borrow from Aave, you will earn “aTokens” in a 1:1 ratio. These are basically Aave versions of the token you are borrowing being provided as an additional reward in addition to the interest you earn.
Compound is a non-custodial and open-source protocol – non-custodial means you have control of your private keys – for decentralized borrowing and lending. He is very similar to Aave.
COMP started the yield farming craze when it was launched about a year ago, and its interest rates for borrowing and lending are algorithmically based on supply and demand.
According to the DeFi Pulse website, it has nearly US$8.51 billion in Crypto Assets today.
It is a protocol that was founded by Hayden Adams in 2018. In May 2021 Uniswap V3 was released, bringing several changes, such as multiple fee levels and concentrated liquidity, allowing users to manage risk more efficiently.
Essentially, the normal borrowing of DEX (decentralized brokerages) puts trades in a price range from 0 to infinity. However, in concentrated liquidity, you are allowed to choose the specific price range you want to leave Yield Farming.
In addition, UNI, as it is popularly known, is also an automated market maker (AMM) that allows users to exchange almost any pair of ERC20 tokens (token patterns within the Ethereum blockchain) without intermediaries.
Despite growing competition from DeFi protocols and the stumbling block of only working over the Ethereum network (ERC-20), the volume at Uniswap continues to grow monthly.
Yield Farming Risks
Undoubtedly, the practice of Yield Farming allows you to obtain much higher returns than in any conventional financial institution.
However, as might be expected, with all these potential gains comes the risk of a big hole full of scams, theft, and the possibility of losing everything, not to mention that the users are also at additional risk of Impermanent Loss and such as falling prices when assets are locked in a protocol.
If you are new to the field, the term “Impermanent Loss” refers to the temporary loss of funds occasionally experienced by liquidity providers due to volatility in a trading pair.
Furthermore, another risk is the settlement risk. That is, if you have taken out a loan and the market turns, with your debt becoming unpayable, you could lose your money.
However, in my view, the main risk is the susceptibility to hacks and fraud because of possible vulnerabilities in smart contracts protocols.
The Smart-contracts are digital codes without paper containing the agreement between the parties on predefined rules that are automatically executed (think of this as a contract in your bank).
These hacks can occur due to fierce competition between protocols so if a project is not audited or a team member unwittingly creates an exploitable smart contract, anyone with sufficient technical knowledge can steal funds.
An example of a vulnerability that resulted in severe financial losses includes the Harvest.Finance protocol, which in October 2020 lost more than US$20 million in a liquidity hack.
Since the blockchain is immutable in nature, most of the time DeFi losses are permanent and cannot be undone.
Decentralized Finance and Yield Farming are available to anyone in the world with an internet connection.
When choosing a decentralized broker, it is important to analyze all aspects of the security and reliability of the platform’s open-source. Mining liquidity is part of what makes decentralized financing go round.
With Yield Farming, instead of your cryptocurrency sitting in a wallet and only appreciating or devaluing as the market comes and goes, it is instead invested to generate passive income. In addition, Yield Farm production is important because it can help projects obtain start-up liquidity, but it is also useful for lenders and borrowers.
Although Yield Farming generates passive income, users who farm should always think about whether it is better to sell the asset or store it for speculative purposes to remain profitable.
Finally, consider that this market is still poorly regulated and extremely new. Generally speaking, there is no guarantee that your funds will be protected.
In the coming years, we will certainly see this sector mature, with the consolidation of some of its agents and new innovative and disruptive financial services.
Big opportunities are accompanied by big risks. Don’t invest more than you can lose. Be a conscientious investor and don’t get carried away by emotion!