What is Yield Farming In Decentralized Finance (DeFi)?
Yield farming is one of the ways of getting rewards in the crypto space which has become popular these days. It is an application of decentralized finance (DeFi) that has yielded big since 2020.
Cryptocurrency provides different means of making profits. Crypto enthusiasts need to understand these several ways by being updated.
In this post, we’ll discuss extensively yield farming in decentralized finance.
Table of Contents
What is Yield Farming?
Yield farming is a way of earning rewards with cryptocurrency holdings. This can be done by staking or lending crypto assets in order to generate high returns or rewards in the form of additional cryptocurrency.
This has been popular on DeFi (a system that offers financial instruments without relying on intermediaries such as brokerages, exchanges, or banks by using smart contracts on a blockchain).
DeFi yield farming is staking or lending crypto assets within DeFi protocols to produce high returns in interest, incentives or additional cryptocurrency.
While farming in crypto implies the high interest produced via the liquidity of different DeFi protocols.
Today, yield farming is the biggest growth driver of the DeFi sector. It has grown from a market cap of $500 million to over $10 billion in recent time.
It is important to note that in yield farming, both the borrowers and lenders are rewarded.
How Does Yield Farming Work?
Yield farming in DeFi applications provides opportunities for crypto holders to make passive income and returns. This is done by lending their holdings via smart contracts.
These Defi applications differs in terms of characteristics and functionalities. The uniqueness of the DeFi application decides how the yield farming will take place on its platform.
Yield farming majorly involves the role of liquidity pools (smart contracts) and liquidity providers (users who deposits crypto in the smart contracts). The liquidity providers are incentivized by the liquidity pools to stake or lock up their crypto assets in smart contracts-based liquidity pool.
These incentives can be a percentage of transaction fees, interest from lenders or a governance token. These returns are expressed as an annual percentage yield (APY). As more investors add funds to the related liquidity pool, the value of the issued returns decrease accordingly.
Most of the popular stablecoins are used by yield farmers in staking as well as some governance tokens on the Ethereum network. Tokens are farmed on these liquidity pools in exchange for providing liquidity to decentralized exchanges (DEXs).
Most yield farming protocols now reward liquidity providers with governance tokens, which can usually be traded on both centralized exchanges and decentralized exchanges.
How Yield Farmers Earn a Return on Investment
In yield farming, return on investment can be divided into three categories. They are discussed below.
1. Transaction fee income– There are differences in transaction fees as liquidity pools and protocols differ. For example, the fee set at the stage of pool creation by the user in the Balancer pool shows variation between 0.001% and 10%. Other pools like Uniswap charge a flat fee of about 0.03%. All fees are passed to liquidity providers. Hence, it is likely that governance token holders will receive a portion of the proceeds in the future.
2. Token rewards– Token rewards are used in the form of incentives to offer liquidity. These rewards get distributed over a specific period of weeks, months or even years. The tokens rewarded are often used to govern the system during issuance at any time. These tokens are traded both on centralized and decentralized exchanges.
3. Capital growth- This helps to compute the profitability of any challenging yield farming opportunity. Stablecoins are best to adopt for yield farming for its volatility. Other assets like BTC, REN, CRV can become volatile and move without correlation.
Top 5 Most Popular Yield Farming Protocols
As stated earlier, yield farming protocols and pools differs. However, the most popular and most used ones on DeFi are listed below.
Uniswap is a hugely popular DEX and AMM that enables users to swap almost any ERC-20 token pair without intermediaries. Liquidity providers must stake both sides of the liquidity pool in a 50/50 ratio, and in return earn a proportion of transaction fees as well as the UNI governance token.
Instadapp is the world’s most advanced platform to leverage the potential of DeFi. Users can manage and build their DeFi portfolio and developers can build DeFi infrastructure using their platform. As of August 2021, over $9.4 billion is locked on Instadapp.
Aave is an open source non-custodial decentralized lending and borrowing protocol to create money markets. Here, users can can borrow assets and earn compound interest for lending in the form of the AAVE token. This protocol has the highest TVL locked among all DeFi protocols, sitting at over $21 billion as of August 2021. Users can earn up to 15% APR for lending on AAVE.
4. Curve Finance
Curve Finance is a DEX that lets users and other decentralized protocols exchange stablecoins with low fees and low slippage using its unique market-making algorithm. It is the largest DEX in terms of TVL, with over $9.7 billion locked. Stablecoin pools are generally safer as they do not lose their peg value.
PancakeSwap is a DEX built on the Binance Smart Chain (BSC) network for swapping BEP20 tokens. The protocol uses an automated market maker (AMM) model where users trade against a liquidity pool. It has the highest TVL among BSC protocols, with over $4.9 billion locked as of August 2021. It focuses heavily on gamification features, with lottery, team battles and NFT collectibles.
Is There Any Risk With Yield Farming?
Yield farming is not without risk just like every other crypto endeavors. Yield farming can be incredibly complex and carries significant financial risk for both borrowers and lenders.
The high cost of Ethereum gas fees can only be worthwhile if thousands of dollars are provided as capital. The volatility nature of crypto assets is also a great risk so stablecoins are best for staking.
Yield farming is susceptible to hacks and fraud due to possible vulnerabilities in the protocols’ smart contracts. This has been recorded with some protocols such as the Yam Protocol which raised over $400m and lost over $20 million in a liquidity hack.
Yield farming is no doubt one of the hottest trends in cryptocurrency today. Farmers can earn double-digit interest rates, far higher than the rates one can get with dollars.
As profitable as it is, it is also very risk. As blockchain is immutable by nature, most often DeFi losses are permanent and cannot be undone. It is therefore advised that users really familiarize themselves with the risks of yield farming and conduct their own research.
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