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What Is Yield Farming? The Rocket Fuel of DeFi, Explained

Growing Money with Yield Farming

In late 2017, Bitcoin value skyrocketed to over $20,000, largely due to advancements in crypto mining frame capabilities, while the value of other digital tokens—many of them fly-by-night projects—inexplicably increased. Today, something similar is occurring, which yield farming! 

Previously lost in the shadows of Bitcoin (BTC), Ethereum (ETH) gained a full hold on the market in 2020 during the decentralized finance summer. Developed to recreate conventional financial systems with fewer intermediaries, DeFi is currently being utilized throughout lending, borrowing, and the buying and selling of tokens. The bulk of these decentralized apps (dApps) are based on Ethereum network, which saw activity on the network massively grow during 2020. This activity also trended upwards due to yield farming, also known as liquidity mining, which is the process of enabling holders to create rewards using their cryptocurrencies.

Yielding Farming Explained

Yield farming is a relatively new trend that has rapidly infiltrated the world of decentralized finance (DeFi). It is regarded as a profitable strategy that investors employ when seeking to increase their profits. As of 10th September 2021, CoinMarketCap data indicates that the total locked value of liquidity pools in yield farming projects exceeded $ 7.5 billion. It is a practice in which users attempt to maximize their gains from crypto assets by providing liquidity for DeFi protocols.

In essence, yield farming is similar to depositing money in a bank. However, you are depositing cryptocurrency into exchanges or DeFi protocols, not fiat currency. A smart contract will lock in this expenditure. 

As with Bitcoin, the larger DeFi world is fuelled by a libertarian ideology and a desire for money. However, unlike during the 2017 crypto craze, experienced traders do not have to depend on asset price movements to generate a profit.

Rather than that, they may turn to different platforms that allow users to lend their crypto, sometimes at exorbitant interest rates. Most of these platforms, most notably Compound and Maker, rely on a decentralized network of lenders and borrowers who negotiate collateral and payment arrangements using smart contracts. Initially, the sites were little more than experiments on the outskirts of the crypto world, but by 2020, they had begun to draw real money                          

At its most basic level, yield farming is a practice that allows cryptocurrency users to lock up their assets, which in turn provides them with rewards.

Liquidity Mining

Liquidity mining is a process in which a project makes its tokens available to anybody willing to deposit cash into a smart contract. For example, consider the following hypothetical scenario: “Goose Finance” offers “Cranberry Coins” a liquidity provider token to any customer who deposits Cranberry and Ether (ETH) on Uniswap. Thus, along with earning fees on trades between EGG (Goose finance token) and ETH on Uniswap, anybody who stakes their liquidity provider tokens in a smart contract can earn additional tokens from the project.

Annualized returns from liquidity mining programs can range from double-digit yields on the low end to annual percentage rates of over 10,000 percent on riskier initiatives, depending on the price of EGG token, the pace of Cranberry rewards, and the amount of liquidity delivered.

Even the most ardent industry optimists have been taken aback by the growth of both liquidity mining and decentralized finance. Today, DeFi’s market capitalization exceeds $80 billion, with a total locked value of over $67 billion (in comparison to the $5.4 billion generated in 2017 through ICOs). While large-scale liquidity mining will not begin until mid-2020, it is evident that a new era has begun.

How Are the Returns on Yield Farming Calculated?

Generally, yield farming returns are estimated on an annualized basis. This is because it calculates the potential returns over the course of a year. Annual percentage rate (APR) and annual percentage yield are two frequently used metrics (APY).

What Is the Process of Yield Farming?

First and foremost, it should be noted that yield farming needs the involvement of liquidity providers and liquidity pools to work. To become a liquidity provider, all you have to do is contribute your funds to a liquidity pool (smart contract), which is responsible for powering a marketplace where users can engage in various activities with their tokens, such as borrowing and lending.

Following the deposit of your fund into the pool, you will get fees that have been produced by the underlying DeFi platform or reward tokens, which will be sent to you. As an added bonus, some protocols may even payout in several cryptocurrencies, allowing users to diversify their holdings and lock those tokens into other protocols to optimize their returns.

What You Should Keep in Mind About Yield Farming

Before you start yield farming, make sure you understand the following fundamentals:

      • Liquidity providers deposit a liquidity pool.
      • Stablecoins linked to the US dollar, such as DAI, USDC, and USDT, are the deposited funds.
      • Your profits are determined by how much you invest and the protocol’s regulations.
      • If you decide to reinvest your reward tokens into other liquidity pools, which in turn offer various reward tokens, you can create complex investment chains.

Yield Farming Tools

Yield farming can incorporate one or more DeFi elements, such as borrowing and lending platforms, decentralized exchanges (DEXs) and liquidity pools, staking, and so-called “second-layer” farms that leverage the more prominent protocols. Each tool rewards crypto holders differently for locking their assets, and each tool plays a unique function within the wider DeFi ecosystem. Compound, Aave, and Uniswap are all well-known initiatives that serve as safe entry points to yield farming. Newer, second-layer initiatives may provide higher profits, but at the expense of increased risk, as they may not have been thoroughly tested or audited.

The pursuit of the highest possible annual percentage yield has also resulted in the creation of certain worthless products that entice yield farmers with enticing incentives, but token hyperinflation implies low returns and the danger of suffering a large loss. As a result, it’s critical to grasp the benefits and drawbacks of each tool, as well as what they perform and which ones you’re comfortable using.

The Risk

The number of Yield Framing projects rises daily. Many are risky, while others are copycat ventures with a worthless coin. Recently, a few protocols have emerged that question the status quo, seek to increase farm efficiency, or improve upon the present system. Also, mistakes are bound to happen when you engage in yield farming. 

Regrettably, many have had to learn things the hard way in order to comprehend them truly. Interest rates on new DeFi projects should settle as they gain credibility and security. At the moment, though, rates may easily outperform anything in traditional banking. Among the most apparent dangers include smart contract abuse, price fluctuation, and temporary loss.

Bottom Line

There are several strong reasons for considering yield farming as a potential investment option. First, YF is likely to develop into a highly efficient industry with several chances to uncover high return rates compared to traditional approaches. Thus, as cryptocurrency becomes more widely accepted, the need for cryptocurrency-based financial services will increase. However, it is a somewhat complicated approach as well. As a result, if you intend to play an active role in the digital asset market, you should thoroughly research the concept.

Featured Image: Twenty20

About the author: With more than a hundred articles, blog posts, whitepapers, and case studies, Omoalhaja Abiola is an experienced content writer with a specialization in cryptocurrency, blockchain, fintech, and SaaS. When he's not reading, you will see him drinking NAN with Mubeenah - his JEWEL.

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