What is Yield Farming?
Decentralized Finance (DeFi) is the most trending term in the crypto industry at present. If you are not aware of DeFi, then let’s have a quick brief on it…
DeFi is a set of tools that are built on the Blockchain. As it is built on the blockchain, there is some sort of anonymity in each transaction. This blockchain has crypto wallet IDs which will help to identify the users of this platform.
According to DeFi Pulse, nearly $3.65 Billion in crypto assets is locked in DeFi right now. More and more value is added into the DeFi applications which are driven by the Compound’s COMP governance token. These governance tokens allow users to vote on the future of decentralized protocols.
On June 15, Compound started distribution of the governance tokens, COMP. The demand for these tokens increased rapidly and Compound was moved into the leading position in DeFi. Compound is the best example of lending and borrowing DeFi protocol.
Yield Farming is a new term in the crypto industry where you put some money into the crypto assets to generate some interest and rewards from the investment. Another term for Yield Farming is Liquidity Mining.
After a quick brief about these new terminologies in the crypto industry, let’s dive in deeper to understand more about Yield Farming.
What is Yield Farming?
For a real-life farmer, the yield is the amount of crop produced on a piece of land. While in the crypto industry, yield farming is any effort you put in crypto-assets to work and generate the most returns possible on those assets.
In other words, only investing in Ethereum is not considered as yield farming. When you lend your Ethereum to gain additional returns on the natural growth of ETH, Yield Farming occurs.
Now, let’s discuss how Yield Farming works.
How does Yield Farming Work?
To understand how Yield Farming works, let’s consider Compound which is the best example of a DeFi lending and borrowing protocol. Compound is the one that has created a lot of buzz in crypto yield farming. As Compound is a DeFi lending protocol, you can lend the capital on one of the money markets to earn good returns on DeFi.
If you deposit a stablecoin, then you can earn returns immediately. This DeFi protocol earned good popularity with the new governance token. A yield farmer can move assets around within Compound, chasing any pool that offers the best returns from week to week.
There are chances that the pools may be riskier. Although it is risky, most of the yield farmers have decided to accept the risk. Yield Farming essentially requires that its users should maintain appropriate collateral in their accounts. If the collateral is too little, then it may result in account liquidation.
There are various strategies in which you can earn yields in Yield Farming. Let’s have a look at various other strategies.
How & Where to Farm Yields?
There are various ways in which the yield farmer can farm yields. The ways are mentioned below:
Money Markets: Compound & Aave
Compound and Aave are the primary lending and borrowing DeFi protocols. If you choose to lend your capital on the money markets, then it is the easiest way to earn higher returns in DeFi. You can deposit a stablecoin on Compound or Aave and start earning returns immediately.
Aave offers better rates when compared to Compound. This is because Aave offers a stable rate of interest rather than a variable rate. The borrowers will have a stable rate higher than the variable rate. The margin returns to lenders will also be increased. While Compound has introduced incentives for users through the issuance of its governance token COMP. If you lend or borrow on Compound, you will earn a certain amount of COMP.
Liquidity Pools: Uniswap & Balancer
Uniswap and Balancer are the two liquidity pools available in DeFi. The DeFi liquidity providers will be offered with some fees as rewards for adding their crypto assets to the pool. In Uniswap, the liquidity pools are configured between two crypto assets in a 50-50 ratio. Balancer allows up to eight crypto assets in a liquidity pool.
Balancer pools will reduce some amount of impermanent losses, as pools do not require to be configured in a 50-50 ratio. The Balancer pools can be set up in an 80-20 or 90-10 ratio to reduce the impermanent losses. Users of the Balancer pools can earn the governance token BAL by providing liquidity on a Balancer pool.
Incentive Schemes
In the incentive scheme, Synthetix introduces an sETH-ETH pool that offers the liquidity providers with an added incentive of SNX rewards. sBTC and sUSD are the two substantial liquidity incentives that offer the liquidity providers with an added reward in Synthetix.
Similar to Synthetix, Ampleforth also launched Geyser, which offers the liquidity providers with rewards in Uniswap’s AMPL-WETH pool and an added reward in AMPL. Taking advantage of these rewards will be profitable provided the investors should be sure of the tokens they are earning, as it should not be a dud token.
Risks in Yield Farming
Other investment methods offer stable returns, whereas yield farming is a riskier method for investment. It is because in yield farming your investments are put up against liquidation risk and smart contract risks. If you invest in COMP, the interest rates are variable. While the earnings in COMP are quite good now.
In COMP, you do not earn the same returns forever. So, it has forced many of the investors to take riskier steps to earn more profit. As the interest rate is not stable, if the incentives begin to decline, then the yield farmers may leave the platform.
In yield farming, there are more risky and less risky options, it depends on you about how you will take the risks depending on your comfort zones and goals. Those who are reluctant to risks can go with the money markets way to earn lower-risk interest.
Those who can handle a little more risk can go with the liquidity pool to increase their earning potential. If you’re holding more number of crypto assets, then this strategy will work the best for you.
A perfect yield farm depends on the factors like the amount of funds that the individual owns, the time zone of the individual, and the amount of risk that the individual is willing to take. If you have less than $1000 worth of crypto, then yield farming may cost you more.
Conclusion
Yield farming is expected to bring a huge stream of assets into the crypto world. It’s just the beginning of yield farming, which is a good start. But, as it is a new platform, some of the yield farming opportunities may be risky and short-lived. So, for now, it is better to watch the space as it grows, and once it’s stable and reliable enough you can take advantage of it. If you invest in yield farming, there is no guarantee that you will earn good returns. So, as in the crypto industry, you should never invest money that you’re not willing to lose.
