What is yield farming in DeFi?

What is yield farming?

Yield farming is a method of allowing crypto investors to lock up their assets in exchange for rewards.

At its most basic level, yield farming allows crypto investors to profit from their investments. Yield farming is a method of earning interest from trading fees by depositing cryptocurrency units into a lending mechanism. The protocol's governance token also rewards some users with additional payouts.

Yield farming is analogous to taking out a bank loan. When a bank lends you money, you must repay it with interest. Yield farming works similarly, but this time the banks are crypto investors like you. Yield farming is a method of providing liquidity in decentralized finance (DeFi) protocols like Uniswap in exchange for returns using "idle cryptos" that would otherwise be wasted away in an exchange or hot wallet.

What are liquidity providers, liquidity pools and automated market makers (AMMs)?

Liquidity providers, liquidity pool, and AMMs are the key components of yield farming.

Yield farming is used to power a DeFi market with the help of a liquidity provider (LP) and a liquidity pool. An investor that deposits funds into a smart contract is known as a liquidity provider. The liquidity pool is a cash-filled smart contract. The automated market maker (AMM) model is used to perform yield farming.

On decentralized exchanges, the AMM technique is prevalent. The traditional order book, which stores all "buy" and "sell" orders on a cryptocurrency exchange, is replaced by AMM. An AMM generates liquidity pools using smart contracts instead of announcing the price at which an item is set to trade. These pools carry out trades using pre-programmed algorithms.

Liquidity is required for AMMs to work successfully. Slippages can occur in pools that are not appropriately supported. AMMs encourage users to deposit digital assets in liquidity pools so that other users can trade against them. This reduces slippages. 

The protocol pays liquidity providers (LPs) a portion of the fees paid on transactions completed on the pool as an incentive. In other words, if your deposit is equal to 1% of the liquidity locked in a pool, you will be given an LP token equal to 1% of the pool's collected transaction fees. When a liquidity provider wants to leave a pool, they can redeem their LP token for a portion of the transaction costs.

Furthermore, AMMs issue governance tokens to both LPs and traders. As the name suggests, a governance token grants the bearer voting rights on topics concerning the governance and growth of the AMM system.

What is a yield farming strategy?

Staking cryptocurrencies, providing liquidity to a pool in a decentralized exchange, staking the LP tokens, and supplying liquidity to lending protocols are all examples of yield farming strategies.

The goal of a yield farming crypto is to provide a high return on investment. Lending, borrowing, supplying cash to liquidity pools, and staking LP tokens will be among the procedures.

Lending and borrowing are two simple ways to earn annual percentage yield (APY) on your money. For example, a farmer could use a loan platform to offer a stable coin like DAI and start earning interest on their investment. They may then take it to the next level with liquidity and leverage.

A yield farmer can be paid with the fees charged for swapping different tokens by sending coins to one of the liquidity pools. They can increase that yield by using liquidity mining to earn more tokens. They can earn more BAL tokens with Balancer, for example, increasing the APY.

Some DeFi protocols will further motivate farmers by allowing them to stake their liquidity providers or LP tokens, which represent their involvement in a liquidity pool. 

Each of the tactics can be combined to give the farmer even better results. A strategy, like most financial markets, can quickly become obsolete if protocols or incentives change; therefore, it's critical to stay on top of it every day and adjust your methods as needed.

How does yield farming work?

Yield farming involves lending cryptocurrency to earn interest and sometimes fees.

An investor will go to a DeFi platform like Compound and gather crypto assets before lending them to borrowers and collecting interest on the loan. Interest rates might be fixed or variable, depending on the unique platform. Users are rewarded with Compound's native token COMP as well as interest payments.

To borrow money via the platform, a borrower must first deposit double the amount borrowed as collateral before proceeding with the transaction. The value of the collateral can be examined at any moment using smart contracts. 

If it is less than the amount borrowed, the contract may be triggered, causing the borrower's account to be liquidated and interest to be paid to the lender. This means that even if the borrower defaults on the loan, the lender will never lose money.

How to calculate yield farming returns?

Two metrics used to calculate yield farming returns are the annual percentage yield and the annual percentage rate.

Various DeFi platforms have their yield farming calculators to estimate returns. Usually, an annualized model is used to compute estimated yield returns. This metric depicts the potential earnings from storing your cryptos for a year. 

APY and the annual percentage rate (APR) are two of the most frequently used metrics for estimating yield returns. The main distinction is that APR does not account for interest compounding over a year. APY, unlike APR, considers the frequency with which interest is applied—the impacts of intra-year compounding.

Even still, the majority of computation models can only provide guesstimates. Because yield farming is a dynamic business, it is challenging to evaluate returns accurately. A yield farming approach may produce great returns quickly, but farmers may adopt it in large numbers, resulting in a reduction in profitability. For both borrowers and lenders, the market is very volatile and risky.

What is the difference between yield farming and staking?

The primary distinction between yield farming and staking is that the former necessitates consumers depositing their cryptocurrency cash on DeFi platforms whereas the latter mandates investors put their money into the blockchain to help validate transactions and blocks.

Yield farming necessitates a well-considered investment strategy. It's not as simple as staking, but it can result in significantly higher payouts of up to 100%. Staking has a predetermined reward, which is stated as an annual percentage yield. Usually, it is approximately 5%; however, it might be more significant depending on the staking token and technique.

The liquidity pool determines the yield farming rates or rewards, which might alter as the token's price changes. Validators who assist the blockchain establish consensus and generate new blocks are rewarded with staking incentives.

Yield farming is based on DeFi protocols and smart contracts, which hackers can exploit if the programming is done incorrectly. However, staking tokens have a tight policy that is directly linked to the consensus of the blockchain. Bad actors who try to deceive the system risk losing their money.

Because of the unpredictable pricing of digital assets, yield farmers are susceptible to some risks. When your funds are trapped in a liquidity pool, you will experience an impermanent loss if the token ratio is unequal. In other words, you will suffer an impermanent loss if the price of your token changes when it is in the liquidity pool. When you stake crypto, there is no impermanent loss.

Users are not required to lock up their funds for a set time when using yield farming. However, in staking, users are required to stake their funds for a set period on various blockchain networks. A minimum sum is also required in some cases.

What are the risks of yield farming?

Every crypto investor should be aware of the risks, including liquidation risk, control risk, and price risk related to yield farming.

Liquidation risk occurs when the value of your collateral falls below the value of your loan, resulting in a liquidation penalty on your collateral. When the value of your collateral diminishes, or the cost of your loan rises, you may face liquidation.

The difficulty with yield farming is that small-fund participants may be at risk because large-fund founders and investors have greater control over the protocol than small-fund investors.

In terms of yield farming, price risk, such as loans, is a significant barrier. Assume the collateral's price falls below a certain level. Before the borrower has an opportunity to repay the debt, the platform will liquidate him.

Is yield farming worth it, then?

Yield farming, like any other sort of investment, comes with its own set of risks. That isn't to suggest that the risks aren't outweighed by the benefits. Yield farming is still one of the most risk-free ways to earn free cash. 

All you have to do now is keep the risks mentioned above in mind and design a strategy to address them. You will be able to better manage your funds if you take a practical approach rather than a wholly optimistic one, making the project worthwhile. If you have a pessimistic view to yield farming, on the other hand, you'll almost certainly miss out on a highly rich earning opportunity.