Understanding Yield Farming

When it comes to innovation in the blockchain arena, the Decentralized Finance (Defi) sector has been at the head of the pack. Permissionless implies that anybody or anything may interact with them, including smart contracts which have a Connection to the internet and a wallet that is compatible with them. Furthermore, they often do not need the involvement of any custodians or middlemen, which has opened up several new sources of revenue for investors.

In Defi, one such investment technique is yield farming began in 2020. It entails lending / staking your crypto coins or tokens in exchange for incentive schemes of transaction fees plus interest on the money you lend or stake.

Jay Kurahashi-Sofue, vice president of marketing @ Ava Labs, explains that “yield farming is an incentives program for early adopters.”

It is interesting to look further to have a more complete grasp of yield farming methods.

What exactly is meant by Yield Farming?

Yield farming is just a method of earning extra crypto with your existing coin. It entails you lending your cash to others via the use of computer programs known as smart contracts, which work like magic. In exchange for your services, you get paid in the form of cryptocurrency.

Yield farming, also known as liquidity mining, is a method of generating rewards from crypto holding. In simpler words, it implies storing cryptocurrency and receiving incentives.

Yield farming became famous after the introduction of the COMP token, which serves as a governance token for the Compound Finance ecosystem. Holders of governance tokens can participate inside this governance of the Defi protocol.

How does Yield Farming work?

In many ways, yield farming is similar to a business concept termed automated market maker (AMM). Liquidity providers and liquidity pools are often involved in this process. Let’s see how well it works out for you.

Liquidity providers make deposits into a liquidity pool to make money available. This pool of tokens serves as the backbone of a marketplace whereby users could lend, borrow, and swap tokens. The use of these platforms results in the collection of fees, which are subsequently distributed to liquidity providers in proportion to their respective shares in the liquidity pool. This is the fundamental principle about how an AMM operates.

The distribution rules will be determined by the protocol’s implementation. In short, liquidity providers are paid depending on how much liquidity they give to the pool. Interest rates fluctuate in response to demand. Yield farming is often carried out on Ethereum using ERC-20 tokens, and the incentives are likewise frequently in the form of an ERC-20 token of some kind.

What causes it to become complicated?

Decentralized Finance (Defi) is the wild west of yield farmers. They use very complex ways to maximize their profits. Because they want to optimize their earnings and transfer their cryptos around constantly between different lending platforms.

They’ll also keep the greatest farming strategies for increasing yields a closely guarded secret which complicates things more to some extent. The greater the number of individuals who are aware of a technique, the less successful it may be. It collaborates with third-party users known as liquidity providers (LP), who provide money to liquidity pools.

In the cryptocurrency world, a liquidity provider is just a person who deposits crypto assets into a liquidity pool to assist trade on the platform and receive passive income on her investment. Liquidity pools are Basically, it is smart contract that holds money.

See our article “Understanding Liquidity Pools” for more information.

What is the method of calculating yield farming returns?

The expected return on investment in the yield farming method is the annualized rate of return that the user earns for a year.

APR (Annual Percentage Rate) & APY (Annual Percentage Yield) are two measures that are often employed to calculate the returns. In contrast to APR, which does not account for the impact of compounding, APY does account for compound interest into consideration when calculating the annual percentage yield. For the sake of this example, compounding involves actively reinvesting gains to produce even greater returns.

Categories of Yield Farming:

A more in-depth grasp of the many forms of yield production or farming practices also, new Defi companies have created new liquidity mining programs, using governance tokens as incentives. As it could aid in gaining a more thorough understanding of yield farming.

Stake Farming:

Stake farming is a method of generating income by investing crypto assets into such a smart contract that offers a staking pool. But a staking pool is not a decentralized trading pair. It’s more like a decentralized vault for a single asset kind.

Stake farming in yield farming doesn’t allow trading and is focused on securing deposits. Unlike liquidity pool farms, stake farms may provide a more simplified user experience. Unlike operating as a liquidity provider on a decentralized exchange, users of stake farms just need to deposit one asset to receive passive revenue.

Liquidity Pools (LP farms):

In a liquidity pool farm, customers deposit crypto assets into a smart contract that offers a liquidity pool. These pools work as a decentralized trading pair for two or more coins.

The LP farms only accept cryptocurrency from the liquidity providers. Decentralized finance applications reward liquidity providers using LP tokens in exchange for deposits. In addition to the liquidity pool deposits, the yield farming coin might assist recoup trading expenses.

Arbitrage Mining:

Arbitrage mining is a new scenario that is developing that demonstrates how to yield farming works from a different standpoint than the previous ones. The technique of arbitrage mining is centered on yield farms that offer incentives, notably to arbitrage traders, to maximize profits. Arbitrage traders take advantage of price disparities across the Defi ecosystem to their advantage.

Insurance mining:

It center’s solely on yielding farms for such purpose of rewarding users who are required to deposit assets in decentralized insurance funds to be eligible for rewards. The decentralized insurance funds are very hazardous since the proceeds from successful insurance claims are taken away from them. The yield farming margins on the money that depositors put online for protecting projects might be attractive to depositors in this sort of yield generating.

Platforms for Yield Farming:

A collection of the most common platforms used by yield farmers is shown in the following section.

Compound Finance:

It is a financial product that is compounded where Users may lend and borrow assets via the use of an algorithmic money market, which is known as the compound. Individuals who have access to an Ethereum wallet may contribute assets to Multiply’s liquidity pool and get incentives that instantly begin to compound. The rates are modified algorithmically depending on the supply and demand conditions in the market.

In the yield farming environment, compounding is considered to be one of the most important processes as earlier noted,

MakerDAO:

Maker is a decentralized credit platform that allows users to create DAI, a USD-pegged stable coin. Anyone could open the Maker Vault and lock ETH, BAT, or WBTC. They may produce DAI for debt against the secured collateral. This loan accrues interest, which is determined by MKR market participants.

Maker could be used by yield farmers to mint DAI.

Aave:

Aave is a decentralized lending protocol. Adjustment of interest rates is algorithmic. Lenders get “tokens” for their money. Upon deposit, these tokens begin generating interest. Aave also enables sophisticated features like flash loans.

Decentralized lending & borrowing procedures are utilized by yield farmers.

Curve Finance:

Curve Finance is just a decentralized trading mechanism for stable coin swaps. Unlike Uniswap, Curve lets users perform high-value stable coin trades with negligible slippage. Curve pools are essential inside the yield farming environment owing to the number of stablecoins.

Uniswap:

Trustless token swaps are possible with the Uniswap decentralized exchange system. To construct a market, liquidity providers deposit two tokens. Traders may then trade against such a pool. Liquidity providers get payments from transactions that occur in their pool in exchange for their services.

Token exchanges using Uniswap are quite popular because of their low friction. This is useful for farming yields.

Yearn.finance:

Yearn.finance is a decentralized network of aggregators for loan services like Aave and Compound. It seeks to maximize token lending by discovering the most lucrative lending services algorithmically. Upon deposit, funds get converted to yTokens that are rebalanced to optimize profit. The Yearn.finance protocol is important for farmers that want the finest methods chosen for them.

Synthetix:

Synthetix is a protocol. Anyone could stake Synthetix Network Tokens (SNX) / Ethereum and mint synthetic assets. Synthetix could enable future yield farming of all assets.

Benefits associated with yield farming:

Within the Defi sector, the notion of a yield farming coin is novel and pioneering in and of itself.

• Many individuals who are now exploring the Defi ecosystem use the terminology “yield generation” as a starting point for their discussions.
• One of the most significant advantages of yield farming is that it has the potential to generate significant profits, which is immediately apparent. If you are a first-mover in a new project, you may be able to get token awards, which may increase in value over time. You have the option of either selling all of your awards for a profit or reinvesting your rewards.
• When compared to conventional banks, yield farming may provide more appealing returns on investment.

Risks associated with yield farming:

Yield farming is fraught with difficulty. Some of these hazards include:

Volatility:

It refers to the extent to which the price of an investment swing. The term “volatile investment” refers to an investment that sees significant price volatility in a short period. When your tokens are locked up, the value of your tokens might collapse or surge.

Temporary loss:

While your cryptocurrency is being staked, the worth of your crypto could increase or decrease, resulting in temporary unrealized profits or losses. Once you withdraw your coins, these profits or losses become permanent.

Rug pull:

Escape scams like rug pull occur when a cryptocurrency developer collects investor cash for a project and abandons it without repaying them. According to a CipherTrace analysis, approximately 99 percent of serious fraud that happened during the second period of last year was caused by rug pulls as well as other exit scams, which yield farmers are especially vulnerable to.

Smart contract threats:

Smart contracts can be hacked, putting your crypto at risk. According to Kurahashi-Sofue, most yield farming hazards stem from smart contracts. Better code screening and third-party audits improve contract security.

Fraud:

Yield farmers might unknowingly invest their coins in fraudulent initiatives or scams.
According to CipherTrace, fraud & misappropriation contribute to the great bulk of the $1.9 billion of crypto crimes in 2020.

Conclusion:

Harvest farming is the practice of staking and locking up your bitcoin in return for interest or additional cryptocurrency. While yield farming has the potential to provide significant rewards, it also has a high risk of failure. A great deal may happen while your bitcoin is locked up, as proven by the many instances of fast price fluctuations that have been seen in the cryptocurrency markets.