The Concept of Yield Farming

by in Crypto 101, Cryptocurrency For Beginners

yield farming

What is Yield Farming?

Yield Farming allows the owners of crypto to make more crypto. It's done by lending the funds to other users via smart contracts. In return the lending part receives rewards. Anyway, the process isn't as simple as it seems from the first sight. Actually, yield farmers need to use different tactics. One of them is the moving of crypto assets between various lending markets continuously, to make as much profit as possible. Besides, generally, each yield farmer has his own secret tactics.

Note that yield farming and investing digital assets are two different things. For instance, investing in ETH is not yield farming; lending out ETH on Aave for a profit beyond the ETH rate valuation is yield farming. Yield farming is more preferable while dealing with large amounts. In the case of a small amount, the risk of loss is bigger.

As a rule, yield farming is arranged with ERC-20 tokens on Ethereum. The bonuses are also ERC-20 tokens. The reason is that most of the activities happen in Ethereum. Maybe, over time, when DeFi programs could operate on other blockchains supporting smart contract aptitudes, this will change.

Normally, it takes quite a long time to find a protocol with high yields. Therefore DeFi platforms find ways to engage more assets. The rule "liquidity is inclined to draw more liquidity" works everywhere.

Origin

Yield farming is widespread nowadays. The attraction can be connected with the appearance of the Compound token (COMP). It created a unique way of token circulation form. Other DeFi projects followed this, creating modern ways to pull more liquidity.

To compare yield farming to traditional finance, you can visualise people attempting to discover the best financial version with the APY (Annualized percentage yield). It's a common way of comparing rates of return on your money across different products. It's also a natural way of exposing the interests of various yield farming approaches.

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If we consider the whole history of DeFi, we will see that the first steps in yield farming were taken by Curve (liquidity aggregator) offering low-slip transactions between similar assets, such as stablecoins or tokenized Ethereum-based BTC. In June, Curve's volume broke its own records for several days in a row, mainly due to the large number of people looking to borrow USDT from MakerDAO to seed COMP. As a result, the lending rate increased by 100% per annum.

Now, after the appearance of funds in Curve in the sBTC pool, liquidity providers can receive both good profitabilities from Bitcoin and liquid funds in the form of SNX, REN, BAL and CRV tokens.

Ways of increasing capital

The most common ways of increasing capital are:

  1. Lending. The users put money on the platform providing credit and get a profit for that. There are also incentive shares - as a reward the users receive governance tokens or control tokens.
  2. Borrowing. In this case, the users borrow against another cryptocurrency. This way they can earn interest by arbitration or lending.
  3. Liquidity pools. Yield farming is frequently called liquidity mining. The users provide crypto to liquidity pools. As a rule, the pool includes several digital assets. In response, the provider gets a certain share in the pool and also tokens. In many cases, it operates with purchasers named liquidity providers (LP) that contribute capitals to liquidity pools. Liquidity pool is like a smart contract that includes stocks. In answer for contributing liquidity to the pool, LPs get a bonus. That bonus may appear from taxes caused by the fundamental DeFi system or in other forms. Some liquidity pools give the provider a lot of tokens as an award. These tokens can be transferred to other liquidity pools and bring rewards from there too. But the main concept is that a liquidity provider puts capital into a pool and gets bonuses for it.
  4. Staking Control tokens. It means that the users lock the tokens in the platform for some annual percents. However, as mentioned above, there are many individual ways and secrets to yield farming.
  5. Leverage. This is an investment technique of using borrowed money—particularly, the use of various financial instruments or borrowed capital—to increase the potential return of an investment. It is another component of yield farming which makes super high profits reasonable.

Yield farmers can deposit their digital assets as security for extending the loan (collateral) to one of the lending platforms and borrow other currency. Due to reoccurrence of the entire process farmers can leverage their original amount of crypto again and again making even higher profits on their initial capital. So, this unique method helps borrowers to earn a return on a loan from their lender.

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Risks

As mentioned above, to borrow assets the users need to provide some collateral at first. That is insurance for the loan. Each protocol has its own ways and rules, but no matter which one are You using, it's necessary to follow the collateralization ratio. If your collateral’s price drops under the borderline needed by the protocol, your collateral may be liquidated on the trading platform. To bypass this, You will necessitate providing additional collateral. The term over-collateralization is typical for DeFi structures. It suggests that borrowers need to deposit more than they are intended to take. It is done to minimize the risk of extreme market declines liquidating a great deal of collateral in the network. There are also other risks like errors, platform changes, admin keys and systemic risks, for example, Ether sharply losing its value. Besides, attacks meant to reduce certain liquidity pools in DeFi can happen.

Considering all the factors, we can definitely say that yield farming is a pretty exciting way of earning. The risks are high, but so are the rewards.

Sum Up

If you decided to try yourself in yield farming, we will advise you to examine DeFi platforms and learn how they work. Every program has its norms and odds which can change very often. Although the idea is the same, realizations differ greatly. Some of the widely-used platforms yield farmers practice are Compound Finance, MakerDAO, Synthetix, Aave, Uniswap, Curve Finance, Balancer, Yearn.finance.