Yield Farming Explained
Yield farming is the wild west of decentralized finance (DeFi). Here, farmers compete to get a chance to "farm" the best "crops". It's a way to essentially make more crypto with your crypto. It involves lending your assets to others via smart contracts and, in return, you earn fees in the form of crypto. Yield farming may change how investors hold their crypto assets in the future due to the ability to earn passive income at higher percentages.
Let's take a look into yield farming and find out what it's all about!
In simple terms, yield farming means that you lock up your crypto and earn rewards off of it. This can be paralleled with staking but, in many cases, it works with users called liquidity providers (LP) that add funding to liquidity pools. A liquidity pool is a smart contract that contains funds. For providing liquidity to the pool, LPs get a reward for doing so either by the DeFi platform itself or other sources.
Some liquidity pools pay out rewards in multiple tokens. This means that you will receive different tokens for locking a certain token in a pool. You can then turn around and use these rewarded tokens in other liquidity pools to earn additional rewards. This allows you to maximize your returns if you are strategically placing your assets in the correct pools.
So how do you know which pool to add liquidity to? Total Value Locked (TVL) is a good way to measure the overall health of the DeFi and yield farming market as a whole. This is also used to compare the market share of different DeFi protocols. The more value that is locked, the more yield farming should be occurring.
As of writing this article, yield farming is typically performing using ERC-20 tokens on the Ethereum network. This calls for rewards also usually being a type of ERC-20 token. The rewards system could change in the future if other blockchains begin to utilize yield farming and bridging between one another. They would be able to run on other blockchains that also support smart contract capabilities. Liquidity tends to attract more liquidity so, with that being said, DeFi platforms usually also provide other economic incentives to attract more capital to their platform. Due to this, yield farmers typically move their funds around quite a lot in search of the highest yields for their assets. You can track TVL here and see which platforms have the highest amount of Ethereum or other assets locked in DeFi.
Yield farming is closely related to the automated market marker (AMM). Here's how an AMM works:
- Liquidity providers deposit funds into a liquidity pool
- The pool powers a marketplace where users lend, borrow, and/or exchange tokens
- Using the platforms incurs fees each transaction
- Fees are paid out to liquidity providers according to their share of the liquidity pool
Although close in nature, yield farming can have implementations that make it different as well. Since it's still new technology, I wouldn't be surprised if we see new approached that improve current algorithms. As mentioned above, the farmer has the opportunity to be rewarded new tokens through locked assets within the liquidity pool. These rewarded tokens may not even be available on the open market yet!
Usually, the estimated yield returns are calculated annually. This is commonly referred to as Annual Percentage Yield (APY) and Annual Percentage Rate (APR). APR does not take compounding into account, but APY does. All calculations are only estimates and projections, as yield farming is highly competitive and fast-paced. Rewards can fluctuate rapidly, just like the crypto market as a whole, so farmers need to jump on the best opportunity as soon as it becomes available.
As with anything, there's always a risk involved with your crypto assets. Yield farming isn't as easy as experienced investors make it out to be and you need to tread the waters accordingly. Due to the nature of DeFi, most protocols are developed by small teams with low, limited budgets. This increases the risk of smart contracts not being completed bug-free. Vulnerabilities and bugs are discovered frequently throughout DeFi platforms through reputable auditing firms. Since DeFi protocols are permissionless and integrate seamlessly, the entire DeFi ecosystem is reliant on each individual building block. If one block does not work as intended, the entirety of the ecosystem may suffer and collapse. This is one of the greatest risks to the average yield farmer.
There are many popular platforms that yield farmers use on a daily basis. Below, you will find a list of protocols that provide yield farming strategies. Remember, it's always important to do your own research prior to locking away your valuable assets!
Overall, once you get the hang of it, yield farming can bring any investor some great rewards for simply doing nothing but locking away your assets for a period of time. The amount of time that assets need to be locked varies between pools, so it's important to make sure you will not be needing these assets in the near future. Trustless liquidity protocols and other DeFi products are definitely the cutting edge of finance, cryptoeconomics, and computer sciences. They can help create a more open and accessible financial system available to anyone around the world!
What yield farming platform do you prefer to use?
Let us know in the comments down below!
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