Crypto Basics: What Is Yield Farming & Why You Should Care?

Crypto Basics: What Is Yield Farming & Why You Should Care?

By CryptoWise | CryptoWise | 10 Jun 2021


   

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I Feel:

“When you have a digital asset like crypto which is not only the source of main income but also the passive income, you know that you have a powerful tool to help you grow financially while you are sleeping. “

If you are among 1–2 % of the crypto population, who have chosen crypto as one of their core investment option, congrats you are already on the track to be financially free if you are in this market with a long-term HODLing strategy. If you are a crypto trader you already know that there are multiple ways to put your owned crypto to work and generate more cryptos for you.

If you are one who is still very new to this cryptocurrency arena and are looking to understand how you can earn from your owned cryptos to give some more passive income apart from crypto trading returns, you have come to the right place

Today we will discuss this highly promising, highly risky Defi innovation named “Yield Farming ” and see how this mechanism of digital farming helps you earn some extra bucks by simply lending it to the seekers.

What Is Yield Farming?

Fundamentally :

Yield farming is a process that allows cryptocurrency holders to lock up their holdings for a certain period and generate interest in the form of crypto. Yield farming also referred to as liquidity mining

Yield Farming In Brief:

  • You stake or lend your crypto assets existing in your wallet for a certain lock-in period and get rewarded back in the form of the crypto
  • In Yield Farming lending happens by using Defi protocols which have an underlying smart contract to earn fixed or variable interest.
  • Yield farming does generate higher returns as compared to some traditional fixed income options, but it comes with its own risk and volatility
  • The yield from your crypto depends upon the kind of crypto token you are holding. Stablecoin like USDT/USDC etc gives higher returns, as compared to volatile crypto-like Eth or BTC.
  • Few services provider do offer higher returns as compared to others on the same crypto assets you hold, so you need to do your own research for the same

Fiat Currency Analogy:

In the traditional banking domain, yield farming can be compared to be more like a bank loan, where the bank lends its fiat currency to the loan seeker and in return gets back the reward in the form of the interest, based upon agreed interest rate and tenure. Similarly, you are the bank, the custodian of your own digital currency, where you lend it and get backs the interest on the same based on the locking period and rate of interest, and you are not required to sell the currency.

In nutshell:

Crypto tokens that would otherwise be sitting in an exchange or in a wallet idle, are put to works via Defi protocols (or locked into smart contracts, in Ethereum terms) in order to generate a decent return.

How Does This Magic Of Yield Farming Works? source

The main functionality of yield farming involves augmenting the liquidity pool of any Defi platform/Project, these projects are essentially a smart contract that holds the added funds.

Due to the locking of your digital asset in the liquidity pool, many traders or whoever wants to leverage this pool engages in the activity of borrowing, lending, or exchanging their tokens. So eventually as a Liquidity provider, you get rewarded with fees generated from the concerned Defi platform. The overall process we discussed above is what drives the core foundation of how an AMM (Automated Market makers )works.

Remember the reward tokens themselves can also be added back in liquidity pools, and most of the smart traders use this strategy to hunt down the best Defi Protocol to maximize their yield.

Yield Farming Calculation:

In general, the return from the Yield Farming is calculated on an annual basis which estimates the returns that one could earn over the course of a given year.

Some commonly used metrics are

  • Annual Percentage Rate (APR)
  • Annual Percentage Yield (APY).

The difference between the two is that :

APR doesn’t take into account the effect of compounding, while APY does take it into consideration. Compounding, here, means that your returns are again reinvested to yeild more returns.

It is imperative to understand that, many Defi protocols have become highly competitive so your yield farming rewards can vary a lot and is not predictable, as more and more farmers start participating as Liquidity provider the rewards also may drop down over the period of time.

What Kind Of Tokens Are generally Used for Yield Farming?

Majorly stablecoins are used & are able to generate maximum yields

Example:

  • USDT
  • USDC
  • DAI
  • BUSD

Now ETH and BITCOIN are also supported on many Defi platforms

There are many protocols in which if you lock in your token, they will mint and reward you back with the same locked-in tokens, for example, if you have added ETH to the Compound Defi pool, you’ll get back cETH.

How It All Started & Become popular terms?

In the summer of 2020 Compound project kickstarted this new wave of yield farming by announcing that they would start issuing its COMP governance token to lenders and borrowers who will use their Compound Defi application. It paid off well for the compound and made it the leader in this space.

  • The biggest Defi protocol right now in Yield Farming in terms of value locked into smart contracts is Aave, a project that allows users to lend and borrow a number of cryptocurrencies.
  • Next is yearn.Finance, which works to move users’ funds between different lending and liquidity protocols (Compound, Aave, and dYdX) to get the best interest rates

Apart from this, there are some more projects which are catching up fast

  • MarketDAO: Is a decentralized credit platform that supports the creation of DAI, a stablecoin algorithmically pegged to the value of USD
  • UniSwap: This is a decentralized exchange (DEX) protocol that allows for trustless token swaps. Liquidity providers deposit an equivalent value of two tokens to create a market
  • PancakeSwap: It is the leading automated market maker and the first billion-dollar project on Binance Smart Chain.
  • Venus: Is an algorithmic money market for decentralized lending and borrowing. Users can deposit crypto assets like BNB, ETH, and stablecoins to earn interest.
  • Autofarm: is on a mission to aggregate yields and facilitates decentralized exchange in the most seamless way possible on Binance Smart Chain.

Pros & Cons Of Yield Farming?

One of the major reasons of these platforms getting so much popularity is the quick and lucrative returns it has been generating for the yield farmers as compared to the paltry returns of the traditional banking system.

If you are lucky enough to be a part of the gems project quite early, which ends up yielding you tokens whose valuations shoots up over time you may end up making some handsome returns, but having said the risk associated with such platforms are also enormous

Risk & Challenges :

  • Currently, most of the top Defi projects are currently hosted on the Ethereum blockchain, creating some critical challenges for yield farmers. Ahead of the most awaited Ethereum 2.0 upgrade, the Ethrereum blockchain network is experiencing scaling & congestion issues. So as yield farming is catching up like a fire today, the increased transactions are clogging up the Ethereum network, leading to slow confirmation times and shooting up GAS fees.
  • One risk of yield farming is smart contracts. Due to the nature of DeFi, many protocols are built and maintained by small teams with limited budgets. This can increase the risk of smart contract bugs.
  • Due to the immutable nature of blockchain, if any bugs pop up it can lead to the loss of your locked funds.
  • Many new Defi Projects are experimental their code remains unaudited, which has led to unintended consequences. so the user needs to be cautious in choosing the right platform to lock up their digital asset, co considering the risk factors involved.
  • Many DeFi projects are likely to pop up due to large fundings and fade away fast, so this high risk, high reward game has to be sensibly played by the user
  • Yield farming isn’t straightforward and is not for the newbies to be true. The most profitable yield farming strategies are highly complex and only recommended for advanced users. In addition, yield farming is generally more suited to those that have a lot of capital to deploy (called whales).

The Future Ahead?

Yield Farming, Staking, all these new technologies have all the potential to open a new kind of fintech revolution in the blockchain economy, but the bigger question is about the sustainability and scalability of such protocols. Can the increased traffic be handled by such platforms without failing the transactions is what are some of the bigger questions which loom large currently?

The kind of risk which is associated with this permissionless Defi platforms is still far away from earning the trust among the masses, having said that

 

I also feel that :

With great risk comes greater reward, so if you are among those who have some fat cash which if lost will not make much of a difference, you should be fine with this experiments, else you should be cautious enough until there is some kind of safety net involved in these systems. DYOR is what is recommended before participating in this promising wave of Yeild Farming.

 

Disclaimer!

Opinions expressed here at CryptoWise are not investment advice and are only for educational purposes. Investors should do their due diligence before making any high-risk investments in Bitcoin, cryptocurrency, or digital assets. Please be advised that your transfers and trades are at your own risk, and any losses you may incur are your responsibility

 

Note!

This article was first published on Medium, here is the link:

https://medium.com/crypto-wisdom/crypto-basics-what-is-yield-farming-7b3fc9c17c4

 

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