May 30, 2022
What is Yield Farming?
Cryptocurrency has proven to have the ability to provide maximum benefit to everybody. In fact, contrary to popular belief, you don’t have to trade to profit from this revolutionary financial industry. More people will be able to explore the limitless potential of decentralized technology due to the advancement of blockchain technology and smart contract innovation.
Surprisingly, becoming a farmer is one part of DeFi that might be profitable. Shocked? I’m sure you are! You may be wondering how farming and decentralized finance can coexist. Moreover, farming is a time-consuming occupation that you are familiar with. So, how does it relate to DeFi?
Farming in cryptocurrency includes lending your assets to others through computer programs built on the DeFi protocol known as smart contracts. As a result, you earn more cryptocurrency in exchange for your services.
What is Yield Farming?
Yield farming is the technique of maximizing returns through decentralized finance (DeFi). On a DeFi network, users lend or borrow cryptocurrency and receive cryptocurrency in exchange for their services. Put simply, it means you put your asset away(locked) for some period and get rewarded for the act.
Yield farming is similar to regular banking in that you receive interest on funds deposited into your bank account. However, unlike the risk-free assurance provided by a bank due to its centralized form, yield farming is much riskier and more complex.
In essence, yield farming is how you seek ways to make returns on your asset investments. As a result, returns may take several forms depending on how the assets are used.
However, to maximize profit, yield farming entails moving cryptocurrency via various marketplaces without the need for any middleman or intermediary. It is a way to earn money by lending your tokens and moving them across different protocols using a decentralized application (dApp).
How does Yield Farming Work?
To be a successful yield farmer, you must first comprehend the protocol’s complexity. Unlike traditional lending, where you leave your money alone, yield farming requires constantly moving your crypto asset around to get the most out of the protocol.
Yield farmers commonly use decentralized exchanges (DEXs) to lend, borrow, or stake coins to earn interest and speculate on price volatility. On the other hand, yield farming is strongly linked to the Automated Market Maker(AMM) concept. As a result, a liquidity pool and a liquidity provider(LP) are frequently required, and smart contracts facilitate this.
Using smart contracts, an AMM builds liquidity pools. These pools carry out trades using predefined algorithms. These liquidity pools provide the foundation for a marketplace where you can trade, borrow, and lend tokens. You’ve officially become a liquidity provider once you’ve added your asset to a pool. This means that as a liquidity provider (LP) in a DeFi protocol, you stake or lock up your crypto assets in a smart contract-based liquidity pool for a percentage return from your service to the protocol. These percentage returns are calculated and expressed in the protocol as Annual Percentage Yield (APY).
Furthermore, the pool’s reward can be placed into other liquidity pools to earn further profit. Moving your asset between multiple protocols for higher returns is a popular and accepted practice.
To demonstrate this, assume a yield farmer puts 5,000 USDT into a DeFi protocol, thereby providing liquidity to the platform; the protocol will compensate the yield farmer for the deposit. The yield farmer then deposits the awarded USDT into a DeFi liquidity pool, which accepts the USDT and rewards it with yield. The procedure is repeated endlessly across multiple platforms and liquidity pools to maximize results.
Yield farming is usually carried out on Ethereum with ERC-20 tokens, and the incentives are also ERC-20 tokens. Because the Ethereum ecosystem currently houses practically all yield farming transactions. However, as the DeFi ecosystem adopts more cross-chain compatibility, this may change in the future.
How Are Rewards Calculated in Yield Farming?
The projected return is calculated in the yield farming technique as annual percentage yield (APY). It is a percentage that shows the rate of return on an investment over a year, which accounts for compound interest.
Without a doubt, an APY of 100% is quite possible in yield farming. However, attaining this kind of return usually entails changing techniques frequently to maximize the possibility of the outcomes.
Risks Involved in Yield Farming
Yield farming is a complex operation that puts you at risk. For example, you can incur a higher risk of price slippage during volatile markets. Some risks associated with yield farming are:
Volatility
The incessant rise and fall of the asset price are called volatility. A volatile investment has a significant price swing in a short period. However, while your assets are locked in the pool, their value may fall or rise depending on the market trend.
Rug Pulls
The most common sort of yield farming fraud is rug pulls. This scam occurs when a cryptocurrency or smart contracts developer receives investor funds for a project and then abandons the project without paying any compensation. Rull pull scam is always an exit scam, and yield farmers are vulnerable. Rug pull is reported to account for approximately 99% of major fraud in 2020, according to CipherTrace.
Impermanent Loss
The AMMs do not adjust token prices in response to market fluctuations. For example, if the price of an asset falls by 40% on a price chart, the move will not be reflected instantly on a DEX. As a result, the price change –profit or loss– becomes permanent when you withdraw your coins. During periods of high volatility, impermanent loss happens.
Smart Contract Risk
Smart contracts are paperless digital codes that contain parties’ agreement on established rules that self-execute. As a result, yield farming smart contracts may include bugs or be vulnerable to hackers, putting your crypto asset at risk. However, smart contract security is improving thanks to better codes and security audits.
Regulatory Risk
Because cryptocurrency is still in its infancy, many regulatory questions surround the industry. For instance, the Securities and Exchange Commission (SEC) has determined that some digital assets are securities and thus fall under its jurisdiction, allowing it to regulate them. Nonetheless, DeFi is designed to be independent of any central authority, especially government rules.
Final Takeaway
With cryptocurrency becoming more widespread, there are countless and endless possible ways to explore the industry. For example, rather than hodling your assets, you can lock them in yield farming on DeFi Protocol and benefit handsomely.
However, while yield farming is highly profitable, it is also risky. As a result, you should conduct thorough research and avoid protocols that offer unrealistic APY.
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