YIELD FARMING EXPLAINED

At its most basic level, yield farming is a system that allows cryptocurrency holders to lock up their holdings in exchange for rewards. It’s a method of earning fixed or variable interest by investing in a DeFi market with cryptocurrency. Yield farming is mostly done on blockchains in which rewards are received. While this may change in the future, the Ethereum ecosystem currently handles almost all yield farming transactions.

HOW YIELD FARMING WORKS

The first process in yield farming is to invest in a liquidity pool, which is a collection of smart contracts that receive funds. These pools provide the foundation for a marketplace where users can trade, borrow, or lend tokens. You’ve officially become a liquidity provider after you’ve added your funds to a pool.

You’ll be rewarded with fees generated by the underlying DeFi platform in exchange for locking up your finds in the pool. It’s important to note that yield farming does not include things like investing in ETH.

It’s far from simple, and it’s certainly not cheap. Those who provide liquidity are rewarded in proportion to the amount of liquidity they provide, so those who reap large rewards have correspondingly large sums of capital.

APY IN YIELD FARMING

The majority of protocols and platforms, as well as yield farmers, calculate expected returns in annual percentage yields (APY). The annual percentage yield (APY) is the rate of return on a particular investment over the course of a year. The APY takes into account compounding interest, which is calculated on a regular basis and applied to the amount.

A list of ten most popular yield farming protocols include; AAVE, Compound, Curve Finance, Uniswap, Instadapp, SushiSwap, PancakeSwap, Venus Protocol, Balancer & Yearn.finance.

QUICK RUNDOWN OF YIELD FARMING

  • Liquidity suppliers deposit money in liquidity pools.
  • Deposited funds are typically USD-linked stable coins such as DAI, USDT, USDC, and others.
  • Another reason to contribute money to a pool is to accumulate a token that isn’t traded publicly or has a low volume by providing liquidity to a pool that rewards it.
  • Your profits are determined by the amount you invest and the protocol’s rules.
  • Reinvesting your reward tokens into other liquidity pools, which provide different reward tokens, allows you to create complex investment chains.

THE RISKS OF YIELD FARMING

Yield farming is a complicated process that exposes both borrowers and lenders to significant financial risk. When markets are volatile, users face an increased risk of temporary loss and price slippage. However, because of potential vulnerabilities in the protocols’ smart contracts, yield farming is vulnerable to hacking and fraud. Due to the intense competition among protocols, where time is of the essence and new contracts and features are frequently unaudited or even copied from predecessors or competitors, these coding bugs can occur.

References

[1]Hertig, A. (2020, December 17). What Is DeFi? Retrieved from https://www.coindesk.com/what-is-defi

[2] Deltec. (2021, February 12). What is DeFi and Yield Farming? Retrieved from https://www.deltecbank.com/2021/02/12/what-is-defi-and-yield-farming/

[3] Binance Academy. (2021, March 19). What Are Liquidity Pools in DeFi and How Do They Work? Retrieved from https://academy.binance.com/en/articles/what-are-liquidity-pools-in-defi

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