Tips, Tricks, and Guides

Guide to DeFi yield farming and how it works

by September 21, 2021 0
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For a while, cryptocurrencies have been shaping the future of finance. The decentralized finance (DeFi) world depends on various blockchain-based applications to improve the returns of cryptocurrency holders. This approach does not require intermediaries to earn passive returns. 

Yield farming is a hot trend in decentralized finance. It rewards investors for locking their crypto assets in a DeFi market. Read on to find out what is yield farming in DeFi and how it works. 


What is yield farming?

Yield farming is a practice that lets holders of cryptocurrency earn rewards on their holdings. The practice requires an investor to deposit cryptocurrency units into a lending platform to earn interest arising from trading fees. 

The way yield farming operates is similar to bank loans since banks charge interest on a loan. Yield farming operates the same way only that crypto holders like you are the banks. The practice uses idle crypto to provide liquidity in DeFi platforms. 

Yield farming platforms allow investors to earn crypto with DeFi yield farming. The platforms incentivize investors to lock up or stake their crypto assets in a liquidity pool. The incentive can be a portion of the transaction fees, governance tokens, or interest from lenders. 

The returns are in annual percentage yield. 


Understanding yield farming and DeFi 

DeFi market is powered by yield farming that collaborates with liquidity pools and liquidity providers. A liquidity provider refers to an investor who deposits funds in a smart contract. The liquidity pool refers to a smart contract filled with cash. 

Yield farming relies on the automated market maker model. The model is popular for decentralized exchanges. It eliminates the need for the conventional order book that lists all the buy and sell orders. 

The automated market maker model creates liquidity pools based on smart contracts instead of stating the price of a trading asset. These pools carry out trades using predetermined algorithms. 

The model is heavily dependent on liquidity providers who deposit funds in liquidity pools. Liquidity pools are the foundations of most DeFi markets where users borrow, swap, and lend tokens. The marketplace charges fees on the DeFi users which they share with liquidity providers. 


Calculating returns in yield farming 

Returns in yield farming are calculated per year. It shows the likely earnings you stand to gain after locking your crypto for one year. The most common metrics are annual percentage rate (APR) and annual percentage yield (APY). 

The main difference is that APR does not take into account compound interest. For a while, yield farming strategy can deliver high returns but if many farmers adopt it, it will result in a profitability drop. 

The decentralized finance markets are quite volatile and risky for lenders and borrowers. 


Yield farming risks 

Despite its potential upside, the practice of yield farming has its risks. According to Forbes, compared to banks that pay 0.25%, some cryptos will earn you 6% or more for locking your funds in a DeFi platform. 

However, Forbes recommends DeFi if you are not afraid of watching the value of your token fall by 20% or more. Most of the DeFi platforms are for investors with a deep understanding of cryptocurrency, protocols they are running on, and can withstand losing most of their investment. 


  • Smart contract risks 

With smart contracts, you get paperless digital codes containing the agreement between parties on predefined rules that self executes. These eliminate intermediaries, are safer and cheaper to do transactions. 

However, they are susceptible to bugs in the code and attack vectors. There are cases of users on popular DeFi platforms who have suffered losses as a result of smart contract scams. 

DeFi platforms are permissionless and rely on various applications to work seamlessly. When any of the underlying applications are exploited or fail to work as required, it can affect the whole ecosystem and result in the loss of investor funds. 

Since blockchain is immutable, most DeFi losses cannot be undone. So, you should familiarize yourself with the risks of yield farming. 


  • Capital intensive and intricate process 

Investing in yield farming is a capital-intensive endeavor. It is an issue for small participants compared to wealthier users with access to more capital. One of the cost concerns entails the issue of gas fees. 

Small participants may not withdraw all their earnings because of the high gas fees. Without experience in the crypto world, engaging in yield farming is a risky undertaking. You can lose all your investment since the yield farming field is volatile and fast-paced. 


  • Liquidation risks 

Like in conventional finance, DeFi platforms rely on the deposits from their customers to offer liquidity to their markets. A problem arises when the value of the collateral falls below the price of the loan. 

For example, say you take a loan in ether with bitcoin as your collateral. A price increase in ether would result in the liquidation of the loan since the collateral value would be less compared to the value of the ether loan. 


  • Impermanent loss risk

The model of yield farming in crypto requires a supply of funds into pools from liquidity providers for them to earn yields as well as trading fees from decentralized exchanges. It provides liquidity providers with market-neutral returns although it is risky during sharp market moves. 

The risk is probable since automated market makers do not update token prices to reflect movements in the market. For example, when an asset’s price falls on a centralized exchange, the change does not reflect immediately on decentralized exchanges. 


What is new about DeFi yield farming? 

DeFi has a simple premise. Today, most investors purchase crypto hoping the value will rise like Bitcoin. 

The strategy has largely worked fine. However, the recent development of stablecoins that are designed to keep their value constant, is changing the calculation. With these, DeFi presents vast passive income opportunities. 

The Harvard Business Review acknowledges that for the first time, you can be paid for owning cryptos, which brings tangible utility to digital currencies.