Last Updated on May 10, 2023
Yield farming is a method of generating extra cryptocurrency with your existing cryptocurrency. It entails you lending your money to others through smart contracts, which are computer programmes. You receive fees in the form of cryptocurrency in exchange for your services.
Farmers that want to increase their yield will employ more complex tactics. To maximise their gains, they constantly shift their cryptos between multiple lending marketplaces. They’ll also keep the best yield farming tactics a well-guarded secret because the more individuals who know about an approach, the less effective it becomes. Yield farming is the wild west of Decentralized Finance (DeFi), with farmers competing for the greatest crops to farm.
In the blockchain arena, the Decentralized Finance (DeFi) movement has been at the forefront of innovation. What distinguishes DeFi applications from others? They are permissionless, which means that they can be interacted with by anybody (or anything, like a smart contract) with an Internet connection and a compatible wallet. Furthermore, they usually do not necessitate faith in any custodians or middlemen. To put it another way, they are untrustworthy. So, what new applications are made possible by these properties?
Yield farming is one of the new concepts that has arisen. It’s a novel approach to earning incentives using permissionless liquidity protocols and bitcoin holdings. It enables anyone to make passive income by utilising the Ethereum-based decentralised ecosystem of “money legos.” As a result, yield farming may influence how investors hold their investments in the future. Why sit on your assets when you can put them to good use?
So, how does a yield farmer care for their crops? What kind of returns can they anticipate? And where should you begin if you want to work as a yield farmer? In this blog post, we’ll go through all of them.
What is yield farming?
Yield farming, also known as liquidity mining, is a method of earning money from bitcoin assets. In simple terms, it entails securing cryptocurrency and reaping the benefits. In some ways, yield farming and staking are similar. However, there is a great deal of complexity behind the scenes. It frequently collaborates with liquidity providers (LPs), who contribute funds to liquidity pools.
What is the definition of a liquidity pool? It’s essentially a smart contract with funds. LPs are compensated for supplying liquidity to the pool. This incentive could come from the underlying DeFi platform’s fees or from another source. Some liquidity pools pay out in a variety of coins. These reward tokens can then be put into other liquidity pools to receive additional prizes, and so on. You can see how extremely complicated methods might evolve very fast. However, the essential concept is that a liquidity provider puts funds into a liquidity pool in exchange for rewards.
Yield farming is usually done on Ethereum with ERC-20 tokens, and the rewards are usually likewise ERC-20 tokens. However, this could change in the future. Why? Much of this activity is currently taking place in the Ethereum ecosystem.
Cross-chain bridges and other such improvements, on the other hand, may one day allow DeFi apps to be blockchain agnostic. As a result, they might run on other blockchains that enable smart contract functionality.
In order to achieve high yields, yield farmers will often shift their finances around a lot between different techniques. As a result, DeFi platforms may offer additional financial incentives in order to entice more capital to their platform. Liquidity tends to attract more liquidity, just as it does on centralised exchanges.
Types of yield farming
Liquidity provider: To provide trading liquidity, users deposit two coins to a DEX. To switch the two tokens, exchanges charge a nominal fee, which is paid to liquidity providers. This charge might be paid in fresh liquidity pool (LP) tokens on occasion.
Staking: In the universe of DeFi, there are two types of stakes. On proof-of-stake blockchains, a user gets paid interest in exchange for pledging their tokens to the network as security. The second option is to stake LP tokens obtained by providing liquidity to a DEX. Users can earn interest twice since they are compensated in LP tokens for supplying liquidity, which they can then invest to gain more yield.
Lending: Coin or token holders can use a smart contract to lend crypto to borrowers and receive interest on the loan.
Borrowing: Farmers can use one token as collateral for another token loan. The borrowed monies can then be used to farm yield. This allows the farmer to maintain their initial investment, which may appreciate in value over time, while also receiving interest on the borrowed coins.
How does yield farming work?
Liquidity providers are users who contribute their bitcoins to the DeFi platform’s operation (LPs). These LPs contribute coins or tokens to a liquidity pool, which is a decentralised application (dApp) built on smart contracts that hold all of the funds. When LPs place tokens in a liquidity fund, they are paid a fee or interest based on the underlying DeFi platform that the liquidity pool is running on.
Simply said, it’s a way for you to earn money by lending your tokens through a decentralised application (dApp). There is no middleman or intermediary in the financing process because smart contracts are used.
A marketplace where anyone can lend or borrow tokens is powered by the liquidity pool. Users must pay fees to access these marketplaces, which are used to compensate liquidity providers for staking their own tokens in the pool.
The Ethereum platform is where the majority of yield farming takes happening. As a result, the payouts are an ERC-20 token. While lenders can spend the tokens however they choose, the majority of them are currently speculators looking for arbitrage possibilities by profiting from the token’s market swings.
What are the risks of yield farming?
Beyond the regulatory dangers that most digital assets face due to the lack of defined policies addressing cryptocurrencies around the world, cyber theft and fraud are important worries. All of the transactions include digital assets that are stored via software. Hackers are skilled in finding weaknesses and exploits in software programmes in order to steal money.
Then there’s the issue of token volatility. Historically, cryptocurrency prices have been known to be erratic. Short bursts of volatility can occur, causing the price of a token to rise or fall while it is locked in the liquidity pool. This may result in unrealized gains or losses, and you may be better off if you kept your coins available for trading.
Smart contracts on DeFi platforms aren’t always as reliable as they appear to be. Many of these developing DeFi protocols are developed by small teams with minimal resources. This raises the possibility of platform-wide smart contract bugs.
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