Yield farming is used to earn interest on your cryptocurrency by staking it for a certain amount of time. Similar to depositing money into a savings account, yield farming entails depositing crypto assets to earn interest or other rewards.
Yield farming can be likened to traditional loans made through banks. The amount lent is repaid with interest. The same principle applies to cryptocurrencies. Assets that would otherwise remain unused in an account can be loaned out and generate higher returns via interest.
Since its inception in 2020, yield farmers have received triple-digit returns in annual percentage yields, or APY. Though this may seem enticing, the risks and extreme volatility needs to be accounted for.
The coins and tokens staked are subjected to various precarious events such as rug pulls, where developers abandon a project and abscond with investors' funds.
Alternatively referred to as liquidity farming, the yield farming process includes utilizing decentralized applications (dApps) to allow investors to stake coins by depositing them into a lending protocol. Other participants of the dApp can then borrow the coins and employ them in speculation strategies. These investors aim to profit from fluctuations anticipated in the coin's market price. Yield farming is an excellent rewards program for beginners.
Applications based on blockchains encourage users to provide liquidity by staking their coins. Staking involves a centralized cryptocurrency platform taking possession of a user's deposited funds and lending them out to users seeking credit. These creditors pay the interest the depositors will ultimately receive.
The smart contracts employed by the blockchain networks operate as liquidity pools. This appropriates referring to yield farmers as liquidity providers.
Investors who deposit funds on the yield-farming protocol generate incomes for the interest, which increases when the coins' value escalates.
Yield farmers essentially provide the necessary liquidity for newly developed blockchain applications to sustain growth and long-term expansion. These proceedings promote community participation by rewarding users with transaction fees and governance tokens.
Another encouraging incentive for staking is to assemble enough shares of the crypto asset to realize a hard fork when deemed necessary. A hard fork occurs when a fundamental change to a cryptocurrency's network protocol leads to transactions being either invalidated or validated, compelling developers to upgrade their protocol software.
Hard forks are imperative to improve cryptocurrency protocols and ensure sustainable evolution. Crypto investors acquire power and influence similar to what share voting means for stockholders.
Shareholders influence the decision-making process of matters concerning the direction of a company's growth, just as cryptocurrency holders can utilize hard forks to steer a protocol in a particular direction.
Coin staking shifts crypto from a cash-like investment to a quasi-equity investment.
Volatility refers to the extent to which the price of an investment fluctuates. If an investment is volatile, its price movement is relatively unpredictable and can reposition rapidly. In yield farming, the value of your tokens could potentially surge or alternatively crash while they are locked up.
Yield farmers run the risk of depositing their coins into fraudulent projects or scamming procedures that simply disappear with investors' money. This risk should not be underestimated, evidenced by the $1.9 billion in crypto crimes in 2020.
With smart contracts being an innovation in its infancy, yield farming is subjected to hacks and bugs. Although third-party audits are actively working to improve the security of smart contracts, your cryptocurrency is still at moderate risk.
Rug pulls are exit scams where a corrupted developer collects invested funds and abandons the particular project, taking the funds with them. The vast majority of fraudulent activity regarding yield farming involves rug pulls.
The oscillation of coin prices may cause unrealized losses while yield farmers' coins are staked. However, these losses are only permanent if the farmer decides to withdraw the lessened funds. Therefore, if you experience such declines in value, it is best to leave your funds where they are susceptible to trade and can potentially generate a greater reward than your initial stake.
Despite the SEC stating that certain digital assets are considered securities and therefore fall under its jurisdiction, many regulatory questions remain.
Many yield farmers employ Defi platforms that offer various methods of optimizing the returns on staked coins.
Aave is an open-source liquidity protocol that allows users to lend and borrow crypto assets. Depositors earn interest in the form of AAVE tokens on their staked coins. The market borrowing demand majorly determines the interest rates, and users can operate as depositors and borrowers using deposited assets as collateral.
Compound is an open-source protocol designed for developers who use an autonomous, algorithmic interest rate protocol to establish the interest rate that depositors will ultimately earn. Investors earn interest on their staked coins in the form of COMP tokens.
Curve Finance is a liquidity pool built on the Ethereum network and uses a market-making algorithm, allowing users to exchange stablecoins. Stablecoins and the pool in which they reside are frequently safer as another exchange medium backs their values.
Uniswap is a decentralized exchange where both sides of the pool are staked equally by liquidity providers. Users earn UNI governance tokens as well as a portion of the transaction fees involved.
Instadapp is customized for developers and enables users to manage their Defi portfolios themselves.
As with any investment, the returns will inevitably be greater if a high risk is involved. Luckily, platforms are developed with the specific purpose of providing rankings and statistical analysis on various liquidity pools' daily and yearly APY. CoinMarketCap is an example of a necessary tool to make better-informed decisions regarding your investment strategy.
With yield farming, impermanent loss is a persistent risk that frequently bestows doubt upon investors. In general, the profitability of yield farming is still speculative and unpredictable.
Your eventual profit is highly dependent on how much cryptocurrency you are willing and able to stake.
APR considers all fees borrowers have to pay, including the interest rate. However, APR ignores the compounding impact.
The basic formula is thus:
APR= [(fees+interest)÷principal] × (total number of years) × 100
Enter the platform you wish to use to yield your farm and search for the section where all the available pools are listed. These may be stablecoin pools or Ethereum pools. The percentage yield will be listed for your consideration.
Connect your crypto wallet to the platform and select the number of coins you wish to deposit. Then, if you are confident in your decision, click "deposit."
You will be required to confirm the transaction from your crypto wallet. A pop-up window would typically appear in your browser, where you will be able to view the gas fees involved in the transaction.
Next, you will need to directly add liquidity to the appropriate liquidity pool on the relevant platform.
Liquidity mining incentivized yield farming to a great extent. Liquidity mining simply means that yield farmers are rewarded with a new token in addition to the usual return in exchange for the liquidity they provide.
The fundamental motivator to this idea is that the value of a token will increase as usage of the platform is stimulated.
In 2020, Compound announced that they are striving to genuinely decentralize their product in addition to giving adequate ownership to the users that enhanced their popularity by using it. COMP tokens validate this ownership.
At the time of Compound's inception, the creators and investors of the platform owned more than 50% of the total equity. Giving a portion to the users was bound to increase their popularity and establish a reputation as an excellent place to lend.
Compound commenced a four-year plan where COMP tokens are given to users daily until it has run out. The applied protocol evaluates every user's daily dealings and rewards them with tokens accordingly. Token holders, in turn, gain more influence over the protocol just as stakeholders control publicly traded businesses.
The consequences of this implementation were immense and even surprised the platform's most enthusiastic promoters.
This structure was the first of its kind and seemed almost too good to be true. Borrowers cannot usually earn returns on a debt, but Compound has completely changed the common construct of lending and borrowing.
The value of a COMP token peaked at $900 in 2021 due to wealthy investors recognizing the earning potential Compound can offer while they simply continue with their regular proceedings.
It is now possible to borrow from Compound, lend to it and deposit what you borrowed. This can be done numerous times. Instadapp has even applied tools to optimize capital efficiency.
Because the total amount of COMP tokens in circulation is relatively low, this incentive will cease by the end of the four-year period, causing the token's value to drop. Experienced investors who understand the trends of the cryptocurrency market are earning as much as they can from COMP now because they realize the prices will decrease drastically in the future. This is due to the currently low amount of COMP that can be freely traded, contributing to the higher value of the token. As the float of COMP will never be this low with passing time, the high prices will not persist indefinitely.
Following the knowledgeable instincts of experienced and successful crypto traders is sure to avoid failure due to imperfect timing. Although this strategy will make the rich richer, it will significantly benefit the trading experience of all users.
Balancer emulated Compound's protocol in the hope of achieving the same level of success. Balancer now offers governance tokens called BAL to their liquidity providers. Moreover, protocols such as Synthetix, Curve, and Ren followed suit in these ventures.
Stating that many more renowned Defi projects will present coins that liquidity providers can mine is a reasonable assumption.