What Is Yield Farming: How Does Investment Strategy Work in Defi
Decentralized finance is an important part of the crypto market. The entire value locked of liquidity pools reaches new levels and helps participants to generate additional income. That is why yield farming is one of the main ways to make money in the crypto market segment. Follow the reading to understand what is yield farming and how to reward yield.
What Is Yield Farming & Liquidity Pool, and How Does It Work?
“What are the main risks of yield farming?”, “How to become a promising farmer?” and “What yield farming strategy to use?” are the questions we are ready to answer in this article.
The most powerful rise in the cryptocurrency market was in 2020–2021. The capitalization of the cryptocurrency market has grown dramatically. We can observe that the number of promising projects is amazing.
Public companies and states began to invest in crypto start-ups with governance tokens. Popular blockchains (Avalanche, Cardano, Ethereum, Solana) and the decentralized protocols running on them have grown. Yield farming has become widespread in the DeFi sector.
Yield farming is a financing strategy that generates income in the DeFi sector. Liquidity providers or yield farmers temporarily provide liquidity to the DeFi protocol, and in return, they get tokens. They deposit funds and provide liquidity.
Yield farming is an extremely profitable, albeit risky, investment. If you skillfully manage the compound finance ecosystem and your portfolio and be at least a little lucky, you can get a compound interest of 10% — 50% per annum. We associate high risks of yield farming primarily with the characteristics of the DeFi sector itself.
If you make a mistake in a smart contract, you can lose crypto assets. The essence of decentralized finance — you cannot hold anyone accountable. A smart contract is a kind of agreement between the platform and the user, who handles everything.
Yield Farming and Staking: Same or Not
How does yield farming work, and is it the same with staking? Would be yield farm profitable, or is it better to choose staking as a method of gaining staked funds?
Yield farming is a method of earning. The investor’s task is to generate digital assets. The investor lending cryptocurrency in the liquidity protocol of the DeFi segment and, in return, gets his reward.
To understand all the details concept and how to earn rewards, you need to understand what DeFi is and how does DeFi market cap work.
DeFi is an alternative to traditional banking, where there is no single control center, and we are seeing a complete decentralization of the financial market.
Liquidity mining on the platform of the DeFi segment is automated thanks to smart contracts and DeFi protocols. This is a digital analogue of conventional contracts that developers pre-program under certain conditions of transactions.
To work and “grow cryptocurrency”, decentralized finance need liquidity. The liquidity provider invests his money in the cryptocurrency market. Users block digital assets to get good interest using DeFi protocols and a liquidity pool.
The DeFi protocol could work thanks to this liquidity. Liquidity providers further will use them for borrowing, lending, or trading. All digital assets will store on a smart contract. Community participants get three forms of rewards. It could be an interest according to the share of investment, a governance token, or a percentage of the transaction fees.
The conditions, as well as the level of profit, can vary significantly depending on the DeFi project in which you will participate as an investor. The more investment capital that you provide to the liquidity pool, the higher will be your reward. But liquidity incentives scheme has the structure to encourage investors to maintain the cryptocurrency market, and yield farming work doesn’t stop.
Staking and yield farming are pretty much the same thing on the automated market maker. The second is a type of passive income in which you invest in one or more cryptocurrencies to ensure the performance of its network. The user chooses this investment strategy, lending crypto assets to receive a governance token or commission from transactions on the blockchain.
Staking is used on blockchains that use a PoS mining algorithm, such as Cardano, Binance, or Polkadot. PoS blockchains don’t require massive computing power to validate new blocks, so they are less energy-intensive.
Staking in the PoS blockchain has two schemes of work: independent staking and delegation. In the first working scheme, you need to create your own network node to handle network operations for which they can reward the user. In this case, you have to understand the technicalities of setting up a node.
The second scheme is easier. In the second case, the scheme involves the transfer of assets to a system participant who already has a network node. This means you have to share profits with the owner of the network node.
The average profitability of locking assets for staking is about 5% per annum, but yield farming brings about 10–15% per annum at an early stage. However, there are also risks involved in staking. To ensure security, you should choose proven pools. Also, when forming a node, mistakes can be made, which are also risks, and the stability of networks may fluctuate over time.
It is important to understand that neither yield farming nor staking guarantees earnings. Both depend on price movements in the cryptocurrency market. Therefore, any of these methods can lead to losses if the rate of the working cryptocurrency falls.
Yield Farming: How Does It Work & What Yield Farmers Need to Know
What is yield farming, and how are yield farmers get their reward? Liquidity providers (LPs) provide their assets for the functioning of the DeFi platform. Yield farmer provides tokens and coins to a liquidity pool. To clarify, the liquidity pool is a smart contract. It is based on a decentralized application that contains all the funds. Users will get their rewards when the LPs lock tokens into liquidity. The DeFi platform where the liquidity pool is will reward users with a fee or interest generated there.
You can reward tokens by lending your crypto through a dApp using smart contracts that work without mediators and middlemen. Anyone can borrow assets and power the liquidity pool on a cryptocurrency market. When they use such platforms, they incur fees from the users and use them to pay liquidity providers. This is the payment for staking their tokens in the liquidity pool. Yield farmers will typically farm on the Ethereum platform and move their funds around between different protocols in search of high yields.
Popular Yield Farming Protocols
There are many DeFi platforms where investors lock their assets, optimizing returns and providing liquidity. Now you know the main idea of DeFi platforms work and how they are yield. You deposited coins and borrowed your assets. You get high fees and reward in return for borrowing and lending from liquidity pools. But normally, users should have control over investments and understand how yield farming protocols work. We’re underlying DeFi platform and list the key protocols for yield farming:
Compound is the main borrowing protocol for yield farming. It is a special marketplace that offers yield farmer borrowing and lending protocols. Compound Finance is based on blockchain, where users can get compounding interest for their digital assets. Using the COMP token, this yield farming protocol gives the users privilege of dictating governance precedents. Every user with an Ethereum wallet can provide assets to the Compound liquidity pool and receive comp coins. The ecosystem adjusted rates algorithmically based on demand and supply. The liquidity mining enables investors to take the income that ranges from 0.20% to 4% annually.
Aave is a decentralized borrowing and lending protocol that is widely used by yield farmers. Interest rates are adjusted with the use of an algorithm based on the current market conditions. Crypto investors receive AAVE governance tokens in exchange for their funds. The TVL level is the highest here and has over $21 billion. Immediately after the deposit of tokens, interest accrues to the accounts of creditors.
Curve Finance is a decentralized exchange. It was designed for efficient stablecoins exchange with low transaction fees and used its unique market-making algorithm. The Curve is a key piece of infrastructure with over $9.7 billion locked. The yield farming returns are calculated easily. The level of annual rewards can go over 40%.
Uniswap is a decentralized exchange (DEX) for yield farming that allows the exchange of any ERC20 token pair. To create a market, liquidity providers deposit a 50/50 ratio of two tokens. After which, traders can trade against this liquidity pool. In exchange for liquidity, providers receive a commission. It comes from transactions with the UNI governance tokens taking place in their pool.
The platform’s basic idea was to leverage the DeFi potential. With Instadapp, users can create and manage a DeFi portfolio. Developers can build a decentralized finance infrastructure that is made easier by the platform’s SDK.
Yearn.finance is a decentralized ecosystem for landing services like Aave, Compound, and more. It is aimed at optimizing the landing of tokens by algorithmically searching for the most profitable landing services. Deposited funds are converted into yTokens, which are periodically rebalanced to maximize more capital.
PancakeSwap is an AMM exchange for yield farming built on the Binance Smart Chain and is the largest platform in this ecosystem. Users have BEP20 tokens to trade against the liquidity pool. PancakeSwap also provides access to team battles, lottery, and NFT collectibles and plans to launch a marketplace. Generated APYs could be over 400%.
Venus Protocol is a complete decentralized finance-based credit and lending system. It uses an algorithmic-based money market system on the Binance Smart Chain. Users get rewards from the digital assets they give to the network as lending. This payment is the interest for borrowing assets that the borrowers pay. Venus protocol also can be used to mint synthetic stablecoins that protect the protocol and are backed by a cryptocurrencies basket.
Maker is a decentralized lending platform. It initiates the creation of the DAI stablecoin, algorithmically pegged to the value of the US dollar. Farmers can use Maker to issue DAI and earn from receiving stablecoins. In the Maker vault, you can block digital assets like WBTC, ETH, USDC, BAT. Interest is charged on the number of borrowed tokens. This is a stability fee. The commission rate is set by holders of MKR tokens.
Is Crypto Yield Farming Profitable, and How Can Be Yield Farming Returns Calculated?
Earnings on yield farming are real. We provide them for placing the participant’s funds in other liquidity pools as collateral or deposit. The yield farmer registers in the DeFi project and transfers digital funds to another user on the condition of receiving interest from the use of his crypto assets.
The farmer’s income is two kinds of coins. The first is yielding LP tokens, which serve as confirmation that he has provided liquidity to the pool. The second is bonus DEX or DeFi protocol tokens that the farmer receives as a reward for the activity. The pool income commission is distributed in proportion to the funds deposited by the participants.
Bonus tokens are sold in exchange for basic liquidity, which is again supplied to a certain liquidity pool. After that, the algorithm awarded bonus tokens to participants again.
The algorithm for calculating annual interest is like the one used in the banking system. The most common metrics are the Annual Percentage Rate (APR) and Annual Percentage Yield (APY). The difference between them lies in the calculation of compound interest (direct reinvestment of income to get greater profits). The APR does not provide for the reinvestment of a cryptocurrency deposit.
Risks of Yield Farming
Yield farming can be difficult and risky for borrowers and lenders alike. Usually, these risks are financial and are associated with high gas fees on the Ethereum network. Also, among the main risks are errors, bugs, vulnerabilities in smart contracts, liquidation risk, the fall of the token against the background of inflated interest rates, fraud, or economic failure of the project.
Smart contract bugs. Small teams with limited budgets develop many protocols. This leads to the emergence of risks associated with the vulnerability of smart contract bugs. For example, the Yam protocol raised over $400 million, and a critical bug in the protocol was discovered a few days later.
High fees in the Ethereum network. Because of the high gas fees for financial transactions, some operations with comp tokens become unprofitable.
Fraud. Because of the vulnerability of smart contracts, there are many cases of fraud in the DeFi sector. Automated market makers providing liquidity and yield farming becomes risky.
Withdrawal of digital assets and token rewards from liquidity pools. Users of the decentralized exchanges can withdraw their liquidity at any time unless a third party blocks the assets. In most cases, developers have control over the underlying assets and can dump investor funds on the market.
Rug pull. This is the theft of investors’ money and yield farming rewards by the project team. Most often, it occurs if an anonymous team works on a DeFi project.
How to Reduce Risks, Make Yield Farming Safe & Get the Best Annual Percentage Yield
Although yield farming has been compared to keeping money in a bank account, others say that such earnings are not safe. The risk that investors can lose money is high, but there are several ways when farming work can bring new comp coins:
Use reputable protocols for liquidity mining. If you stick with reputable providers, you should be able to manage the risks accordingly.
Invest in stablecoin pools. The popular stablecoins DAI/USDC/USDT, USDap/USDN, or DAI/BUSD fluctuate in a narrow range. The risk of losses in these liquidity pools is much less. Although there are also disadvantages — this is a lower yield from 3 to 15% with low transaction fees.
Invest in pools of correlated assets. Such liquidity pools become cheaper and rise in price simultaneously, which means that the risk of loss is less.
Is Yield Farming What You Need to Get Extra Income?
With yield farming, you will get such pros:
- Conservative low-yield farms and aggressive high-yield farms offer investors a huge range of opportunities.
- Easily earn interest and passive income on crypto assets.
- Use the most popular DeFi protocols.
- Be a part of the DeFi projects. Vote and decide via governance tokens` rewards.
- Master future DeFi innovations and become a part of the whole ecosystem.
For long-term buy-and-hold token holders, yield farming is an opportunity to beneficially boost digital assets and crypto holdings. You may look into yield farming, weigh all the risks and enter the DeFi world. Take part in lending and liquidity pools and get additional income.