Yield farming is one of the most popular aspects in the world of decentralized finance, allowing anyone to put their cryptocurrency asset to work and earn interest in return based on the estimated APY. In cryptocurrency, yield farming is basically the process where anyone can earn passive income by locking up a particular cryptocurrency asset based on the percentage yields or APY. In yield farming, anyone can earn either fixed returns or variable returns based on the specific cryptocurrency asset and the percentage yields.

In yield farming, cryptocurrency investors can earn more passive income or maximize their investment by taking advantage of different DeFi protocols or yield farming platforms. On DeFi protocols such as uniswap, investors can lock up their cryptocurrency assets in the liquidity pools and become liquidity providers. The liquidity providers earn a proportion of the transaction fees for adding assets to the liquidity pools based on the percentage yield. If done properly, yield farming is a great way for any investor to gain more value and profit from their investment.

How Does Yield Farming Work?

In cryptocurrency, when we talk of yield farming, it is pretty much the process anyone can put their cryptocurrency asset to work and earn interest in return based on the estimated APY. Investors can earn more passive income or maximize their investment by taking advantage of different DeFi protocols or yield farming platforms. If we think of the conventional banking system where banks provide loans to other users and collect interest in return, yield farming is very much similar. By yield farming in cryptocurrency, it means that cryptocurrency holders can put their cryptocurrency asset to work and earn interest in return based on the estimated APY by locking up their funds over a period of time.

A clear example of yield farming in cryptocurrency is providing liquidity on uniswap. Cryptocurrency holders can lock up their cryptocurrency assets in the liquidity pools and become liquidity providers. The liquidity providers earn a proportion of the transaction fees in return for adding assets to the liquidity pools based on the percentage yield. On Uniswap, the Liquidity pools are simply pairs of ETH and ERC-20 tokens that are swapped for each other on the uniswap DEX protocol. ETH and DAI is a very popular liquidity pool on uniswap. Yield farming operates on the concept of automated market maker also known as AMM.

When users add liquidity into the liquidity pool, they would start earning a portion from the transaction fees. Any amount can be used, however, it has to be at a ratio of 50/50. What this means is that the two tokens to be added into the liquidity pool will be 50% each. Once the liquidity is added, anytime a trader performs a swap transaction on uniswap protocol, that trader would have to pay a fee of 0.3% which ends up going into the pool and is shared proportionally to each liquidity provider based on amount of tokens deposited into the pool.

Advantages & Disadvantages Of DeFi Yield Farming

As always, anything that has an advantage would most likely have a disadvantage. Even though yield farming is very popular in the DeFi space and has a lot of benefit in terms of passive income, it also has some disadvantages as well. Here are some advantages and disadvantages of yield farming;

Advantages

• Anyone can grow and increase the value of their investment capital by earning passive income.

• It operates on DeFi which means that the users have full control of their decisions and there are no central authority that have the control.

• Users can earn even better annual returns APR/APY compared to a lot of the conventional financial system.

• Investors can put their cryptocurrency assets to work without doing anything and earn annual yields just by locking their asset up.

• Increased profit is another advantage of yield farming because anyone can make more profit from their annual yields, especially if the price of their locked investment increases in addition to the earned income.

• No restrictions is another advantage of yield farming platforms compared to the conventional financial system. In yield farming, any user can participate and earn annual yields and passive income from their investment.

Disadvantages

• High transaction fees can be a big problem when it comes to yield farming on some platforms. A lot of yield farming platforms operates on the ethereum blockchain which is known in recent times for its high gas fees. This can be a disadvantage especially for small investors who only want to lock up a small value in dollars.

• High price volatility can also be a major disadvantage of yield farming. We all know that the cryptocurrency market is very volatile, this means that, depending on the locked cryptocurrency asset, the value can depreciate after 1 year compared to the value before the yield farming. Sometimes it is much better to hold the asset and sell when the price increases, than locking it up for 1 year.

• Hack involving smart contracts is also a problem because hackers try to exploit and take advantage of loop holes in smart contracts to steal user funds and assets.

• Liquidation risk is also a big disadvantage because it happens when the value of the provided collateral decreases compared to the price of the loan.