The financial market is continuously evolving and paving ways for innovations. It was not long ago that blockchain technology and cryptocurrency stole everybody else’s thunder and facilitated digital transactions on a decentralized platform. Different industries have been harnessing their potential, and it is not restricted by the boundaries of the financial world.
Over the years, blockchain technology has been able to introduce brand new products or services that make the ecosystem even more transparent and efficient. Be it smart contracts or the proof-of-work approach; there are plenty of blockchain marvels that have made our lives easier.
The Decentralized Finance or DeFi movement was the biggest movement in the blockchain world that proved to be seamless and secure. DeFi is an umbrella term for all the financial applications and services in the cryptocurrency or blockchain area. If you have even just a little interest in the cryptocurrency market, you would know about DeFi.
As the blockchain promises to offer secure payments and make it universally available, Decentralized Finance aims to take that promise a step further by introducing related applications. DeFi crypto includes smart contracts and wallets, which eliminates the need for middlemen. In layman terms, DeFi works as an open financial network where you can lend, send, or borrow money without the need for joining any private network.
DeFi has proved beneficial for traders in the blockchain space, and now a new and improvised player has entered to make things even more effortless. We are talking about yield farming, a brand-new way of earning rewards through DeFi crypto holdings with the help of permission-less liquidity protocols. It is an efficient technique to keep earning passive income with a decentralized network through the money legos on Ethereum. It is anticipated that yield farming can turn the tables for investors who are looking to build a fortune in the blockchain world. In terms of yield farming, traders are asked a simple question: why hold on to your assets when you can earn interest in crypto? Indeed, crypto yield farming is the future of blockchain that can bring everyone closer to the blockchain space.
Do you want to learn more about yield farming, how it works, and how you can benefit from it? Then you have come to the right place. In this article, we are going to discuss everything regarding DeFi yield farming. So, without further ado, let’s get started.
What is Yield Farming?
Before moving any further, it is essential to know about the basic meaning of yield farming. Let’s break it down like this.
Farmers engage in farming to earn profits from their yields. Or when you make deposit in a bank, you will get interest in return for keeping it there.
Similarly, crypto yield farming is earning interest on your cryptocurrency holdings. It is more of a liquidity mining where you lock up your cryptocurrencies and keep earning passive income from it.
You can also compare yield farming with the term stacking—however, many complexities work in the background. Users, called liquidity providers, are also involved in it: they add funds to the liquidity pools. So, what is the liquidity pool? It is a smart contract that comprises the fund. For providing more liquidity to the pools, the liquidity providers will get rewards. These particular rewards can come from fees generated from the DeFi platform or some other sources.
Multiple tokens can be used for the payout of the rewards, which can be deposited to other liquidity pools to earn rewards, and the cycle goes on. You can witness how a complex process can become seamless. You need to understand that liquidity providers will have to deposit funds into the liquidity pool in return for some reward.
Yield farming crypto is completed with ERC-20 tokens on the Ethereum network, and the rewards are also usually given through ERC-20 tokens. Though most of the yield farming activities are done in the Ethereum ecosystem, things can change really quickly in the future.
However, it is anticipated that the cross-chain bridges and other related transformations might help the DeFi apps become the blockchain technology’s future. Eventually, there is a slight scope that DeFi apps can run on other blockchains that will support the smart contract.
Yield farmers will have to move their funds to different protocols to search for better yields. Hence, DeFi platforms will also offer additional incentives in order to bring more capital. You can think of it like this: liquidity attracts more liquidity.
Is It Really Happening?
It is quite evident that cryptocurrency is different from the already established currencies that have plenty of money in circulation. Cryptocurrencies have to put up a balancing act in order to sustain its growth in the market. Currency can only grow in a financial market when there are enough people to use it. So, there will be an incentive to issue the new units that will help increase the user base.
Unlike the 2017’s crypto-mania, traders don’t have to wait for a spike in asset prices to earn interests. The new yield farming phenomenon allows traders to lend or borrow cryptocurrency to avail interest or loan and receive brand new DeFi tokens. Instead, the crypto traders just have to visit sites that let them loan out cryptos in return for high interest. Sites like Compound and Maker are powered by the decentralized network of borrowers and lenders who utilize smart contracts for payment terms and collateral.
The best example is the newly issued cryptocurrency COMP that ignited a keen interest in yield farming. COMP tokens are the governance tokens of the Compound Finance ecosystem. The COMP tokens give the owners the authority to be a part of the Compound. A primary way of starting any decentralized blockchain is to distribute the governance token with liquidity incentives attracting the farm’s liquidity providers. June was the highest price recorded for COMP, i.e., $350, which was later leveled off to $175.
Initially, it focused on experimenting on the crypto world’s outer edge, but the year 2020 was remarkable as it attracted real money. According to the August data, approximately $4 billion were locked in smart contracts. And that’s when the phenomenon of yield farming, where traders can lend or borrow crypto in return for interest, began.
Though the launch of COMP tokens was not as successful as it was deemed to be, it indeed gave a thrust to the phenomenon of yield farming. Since then, DeFi projects have been coming up with different innovations for attracting liquidity.
Colleen Sullivan, the CEO of the crypto trading company, CMT Digital Holdings, prefers yield farming over airlines’ miles. Recently, she claimed that the traders have been hustling to bag more bonus tokens, similar to the veteran travelers who used to take extra flights to get the extra status.
The quest for yield farming has got the traders to search for different exchanges that can provide them with better results. In the case of new token YAM, traders put in around $400 million into its farming on Uniswap, an exchange. But later, the YAM’s creator found a bug in the token’s code that totally degraded its value and made it worthless. Irrespective of the setbacks, crypto experts are optimistic about the merits and predicting that DeFi and yield farming can be the future of the blockchain space.
What Do You Need To Know About Total Value Locked (TVL)?
DeFi yield farming is efficient in every sense, but how do you measure the overall performance? Total Value Locked helps in calculating the amount of crypto is locked in your DeFi lending and other marketplaces. You can call TVL as the aggregate liquidity found in the liquidity pools to measure the yield farming earnings. It is a helpful index to measure the health of the yield farming market and DeFi. TVL is also a great metric to compare the market share involved in different DeFi protocols.
DeFi Pulse is a starting point to measure the yield farming. With this, you can ensure which platforms have the maximum amount of ETH or other cryptocurrencies in the DeFi system. It will help you in understanding the current state of the yield farming market. The general thumb rule is, the more value is locked in the DeFi; the more yield farming will be happening. Another important point you need to focus on is that you can measure the TVL in USD, ETH, and even BTC. Each will provide you with a different perspective regarding the DeFi market.
How Does The Yield Farming Work?
The most crucial part that is yet to be understood is the proper working of yield farming. If you have heard about the automated market maker (AMM), you will get an idea about yield farming. Yield farming is nothing but a network of liquidity providers and liquidity pools.
As mentioned earlier, liquidity providers will deposit the fund into a liquidity pool that powers the marketplace where users can borrow, lend, or exchange tokens. The fees extracted from these platforms are paid to the liquidity providers concerning their shares in the pool. This is basically how an AMM works. But, the implementations can differ significantly. There’s no doubt in asserting that we are going to witness new innovations and approaches that are deemed to improve the current performances.
Apart from the fees, the incentives for liquidity providers can be the distribution of the tokens. For instance, you might not be able to buy a token in an open market, but you can accumulate them in order to give more liquidity to a specific pool. The rules regarding the distribution totally depend on the implementation of the protocol. The basic explanation is that the liquidity providers will get returns according to their liquidity in the pool.
Generally, the funds deposited here are stablecoins pegged to US dollars. The commonly used stablecoins include DAI, SDC, BUSD, USDT, etc. There are some protocols that will help in minting tokens representing your coins in the system. If you deposit ETH to the Compound, you will receive cETH; it is as simple as that. It is essential to understand that these chains can sometimes be complex and become hard to follow, so it is better to keep things straightforward from the beginning.
How Can You Calculate The Yield Farming Returns?
Yield farming is all about increasing your rewards and mounting up the passive income. The yield farming returns are calculated annually, estimating the returns that you can avail by the end of the year. There are some commonly used metrics that you need to focus on, like Annual Percentage Rate (APR) and Annual Percentage Yield (APY). The basic difference between both the metrics is APR will not show the effect of compounding in the account, whereas APY will be doing that.
In this context, compounding means reinvestment of profits in order to generate more returns. It is also important to note that APR and APY can be used interchangeably. Both APRs and APYs are mere estimations and predictions. It is often difficult to make an estimate of short-term rewards, as well. Yield farming has become highly competitive these days and moving quickly in the market.
Hence, it has become strenuous to make even a slight prediction. As a result, DeFi may have to find different metrics for calculation because APR and APY are from the legacy markets. So, the sensible thing to do would be to make weekly or monthly estimates for a better result.
What Do You Need To Know About DeFi Collateralization?
Be it fiat currency or cryptocurrency; you need to put something in the collateral when you are borrowing. That’s exactly what happens with the yield farming. When you are borrowing assets, you need to cover your loan with collateral. It is more like an insurance for the loan that majorly depends on the type of protocol you are using for funding. It is important to consider the collateralization ratio. If the collateral’s value falls below the threshold that is needed by the protocol, the collateral will be liquidated in the open market.
So, what can be done to avoid such a situation? You can add more collateral. In simpler terms, every platform has a set of rules regarding its collateralization ratio, and they also work on the concept of over-collateralization. In this, the borrower has to deposit more than the value of what they intend to borrow. It helps in reducing the risks involved in the market, like the violent crashes that are capable of liquidating a large sum of collateral.
Let’s take an example to understand it better. Suppose your lending protocol has a collateralization ratio of 200%, which means for every 100 USD invested, you can borrow 50 USD. So, it is evidently safer to add more collateral to reduce the risk of liquidation. As a result, plenty of systems have mounted up their collateralization ration (750%) in order to bring security into the platform and safeguard the users from the risk of liquidation.
What Are The Risks Involved in Yield Farming?
By now, you must have understood that yield farming is not a piece of cake. It takes thinking, estimations, and strategies to bring the required outcome. All the profitable yield farming strategies are complicated and often hard to understand. Just like any other blockchain marvel, yield farming is prone to risks. Suppose you don’t understand how yield farming works, you can end up in chaos. As mentioned earlier, collateral plays a significant role in the liquidation. But there are other risks as well that you need to be aware of.
One of the evident risks that needs to be taken care of is smart contracts. Owing to the nature of DeFi, plenty of the protocols are built within small budgets and small teams. This automatically creates an alarming situation and opens up the avenue for the smart contract bugs. It can be highly detrimental for the traders who are expecting profits and rewards. Even the protocol audited by the reputed firms, vulnerabilities, and bugs can be found. As a result, users can lose their funds and drown into losses. Hence, it is important to consider these risks before locking the funds into smart contracts.
Another vital point to note is that the most significant advantage of DeFi is its greatest risk as well, i.e., the composability. As DeFi protocols and applications are permissionless and easily integrating into each other, it makes the DeFi ecosystem dependable on the building blocks. That’s exactly what can be said about composable applications; they can easily work together.
But how does it become a risk? If one of the building blocks fails to perform accordingly, the entire ecosystem will come falling down like a Lego house. It is one of the biggest risks that yield farmers have to go through during the process. You have to trust the protocol you deposited your funds into and all the other systems that it relies upon. So, it is essential to take note of all the risks involved in the yield farming and remain vigilant.
What Are The Yield Farming Platforms And Protocols?
There are yield farming platforms that have their sets of rules for the process. If you want to be part of yield farming, you need to know about the decentralized liquidity protocols and how they work. Here are some of the popular platforms that are involved in yield farming:
#1 Compound Finance
It is an algorithmic money market that lets users borrow and lend assets. Those who have an Ethereum wallet are eligible to supply assets to the liquidity pool of Compound. Also, Compound is one of the core protocols involved in yield farming.
It is a decentralized protocol meant for lending and borrowing, and the interest rates on the conditions are aligned algorithmically. Lenders will receive aTokens, which will start compounding interests on the deposit. Flash loans is another advanced feature of Aave that users can enjoy.
It is a decentralized exchange protocol facilitating trustless token swaps. Liquidity providers will have to deposit value equivalent to the two tokens to establish a market. It has always been a popular platform for trustless token swaps because of the frictionless feature.
#4 Curve Finance
It is a decentralized exchange platform designed for stablecoins swaps. Curve Finance provides users the ability to make high-value swaps with stableclions. Curve pools have become a key portion of this infrastructure due to the abundant presence of the stablecoins.
The Bottom Line
Blockchain technology is breaking records every day. DeFi was an innovative approach to make the trading process even more streamlined and secured for the traders, and DeFi yield farming just changes the entire scenario altogether. Crypto traders are looking for brand new ways to enhance their earning system and put their cryptocurrencies to good use. That’s when the idea of yield farming took birth. With yield farming, traders are able to lend crypto assets to DeFi platforms and earn massive returns on them in the form of fees and other gains.
Since its massive popularity, yield farming is also deemed to be the best and refined used cases of DeFi applications, and it is said that it will be the next best thing happening in the blockchain space. There’s no doubt that DeFi money markets are capable of creating open financial systems that can bring new innovations to the market and provide traders with a seamless way of stable income.
This article was an ode to the current craze in the cryptocurrency world, i.e., yield farming. So, what else can yield farming make happen in the space? It will be exciting to witness the advancements brought by this futuristic DeFi use case. If you are a crypto trader, yield farming is something that should excite you at this very moment. Explore and delve deep into it.