{"id":467,"date":"2021-09-21T05:03:48","date_gmt":"2021-09-21T05:03:48","guid":{"rendered":"https:\/\/digitalcoinprice.com\/blog\/?p=467"},"modified":"2023-03-29T05:25:59","modified_gmt":"2023-03-29T05:25:59","slug":"guide-defi-yield-farming-how-it-works","status":"publish","type":"post","link":"https:\/\/digitalcoinprice.com\/blog\/guide-defi-yield-farming-how-it-works","title":{"rendered":"Guide to DeFi yield farming and how it works"},"content":{"rendered":"<div id=\"ez-toc-container\" class=\"ez-toc-v2_0_73 counter-flat ez-toc-counter ez-toc-custom ez-toc-container-direction\">\n<div class=\"ez-toc-title-container\">\n<p class=\"ez-toc-title\" style=\"cursor:inherit\">Table of Content<\/p>\n<span class=\"ez-toc-title-toggle\"><a href=\"#\" class=\"ez-toc-pull-right ez-toc-btn ez-toc-btn-xs ez-toc-btn-default ez-toc-toggle\" aria-label=\"Toggle Table of Content\"><span class=\"ez-toc-js-icon-con\"><span class=\"\"><span class=\"eztoc-hide\" style=\"display:none;\">Toggle<\/span><span class=\"ez-toc-icon-toggle-span\"><svg style=\"fill: #223c50;color:#223c50\" xmlns=\"http:\/\/www.w3.org\/2000\/svg\" class=\"list-377408\" width=\"20px\" height=\"20px\" viewBox=\"0 0 24 24\" fill=\"none\"><path d=\"M6 6H4v2h2V6zm14 0H8v2h12V6zM4 11h2v2H4v-2zm16 0H8v2h12v-2zM4 16h2v2H4v-2zm16 0H8v2h12v-2z\" fill=\"currentColor\"><\/path><\/svg><svg style=\"fill: #223c50;color:#223c50\" class=\"arrow-unsorted-368013\" xmlns=\"http:\/\/www.w3.org\/2000\/svg\" width=\"10px\" height=\"10px\" viewBox=\"0 0 24 24\" version=\"1.2\" baseProfile=\"tiny\"><path d=\"M18.2 9.3l-6.2-6.3-6.2 6.3c-.2.2-.3.4-.3.7s.1.5.3.7c.2.2.4.3.7.3h11c.3 0 .5-.1.7-.3.2-.2.3-.5.3-.7s-.1-.5-.3-.7zM5.8 14.7l6.2 6.3 6.2-6.3c.2-.2.3-.5.3-.7s-.1-.5-.3-.7c-.2-.2-.4-.3-.7-.3h-11c-.3 0-.5.1-.7.3-.2.2-.3.5-.3.7s.1.5.3.7z\"\/><\/svg><\/span><\/span><\/span><\/a><\/span><\/div>\n<nav><ul class='ez-toc-list ez-toc-list-level-1 ' ><li class='ez-toc-page-1'><a class=\"ez-toc-link ez-toc-heading-1\" href=\"https:\/\/digitalcoinprice.com\/blog\/guide-defi-yield-farming-how-it-works\/#What_is_Yield_Farming\" title=\"What is Yield Farming?\">What is Yield Farming?<\/a><\/li><li class='ez-toc-page-1'><a class=\"ez-toc-link ez-toc-heading-2\" href=\"https:\/\/digitalcoinprice.com\/blog\/guide-defi-yield-farming-how-it-works\/#Understanding_Yield_Farming_and_DeFi\" title=\"Understanding Yield Farming and DeFi\u00a0\">Understanding Yield Farming and DeFi\u00a0<\/a><\/li><li class='ez-toc-page-1'><a class=\"ez-toc-link ez-toc-heading-3\" href=\"https:\/\/digitalcoinprice.com\/blog\/guide-defi-yield-farming-how-it-works\/#Calculating_Returns_in_Yield_Farming\" title=\"Calculating Returns in Yield Farming\u00a0\">Calculating Returns in Yield Farming\u00a0<\/a><\/li><li class='ez-toc-page-1'><a class=\"ez-toc-link ez-toc-heading-4\" href=\"https:\/\/digitalcoinprice.com\/blog\/guide-defi-yield-farming-how-it-works\/#Yield_Farming_Risks\" title=\"Yield Farming Risks\u00a0\">Yield Farming Risks\u00a0<\/a><\/li><li class='ez-toc-page-1'><a class=\"ez-toc-link ez-toc-heading-5\" href=\"https:\/\/digitalcoinprice.com\/blog\/guide-defi-yield-farming-how-it-works\/#Smart_Contract_Risks\" title=\"Smart Contract Risks\u00a0\">Smart Contract Risks\u00a0<\/a><\/li><li class='ez-toc-page-1'><a class=\"ez-toc-link ez-toc-heading-6\" href=\"https:\/\/digitalcoinprice.com\/blog\/guide-defi-yield-farming-how-it-works\/#Capital-intensive_and_Intricate_Process\" title=\"Capital-intensive and Intricate Process\u00a0\">Capital-intensive and Intricate Process\u00a0<\/a><\/li><li class='ez-toc-page-1'><a class=\"ez-toc-link ez-toc-heading-7\" href=\"https:\/\/digitalcoinprice.com\/blog\/guide-defi-yield-farming-how-it-works\/#Liquidation_Risks\" title=\"Liquidation Risks\u00a0\">Liquidation Risks\u00a0<\/a><\/li><li class='ez-toc-page-1'><a class=\"ez-toc-link ez-toc-heading-8\" href=\"https:\/\/digitalcoinprice.com\/blog\/guide-defi-yield-farming-how-it-works\/#Impermanent_Loss_Risk\" title=\"Impermanent Loss Risk\">Impermanent Loss Risk<\/a><\/li><li class='ez-toc-page-1'><a class=\"ez-toc-link ez-toc-heading-9\" href=\"https:\/\/digitalcoinprice.com\/blog\/guide-defi-yield-farming-how-it-works\/#What_is_New_About_DeFi_Yield_Farming\" title=\"What is New About DeFi Yield Farming?\u00a0\">What is New About DeFi Yield Farming?\u00a0<\/a><\/li><\/ul><\/nav><\/div>\n<p><span style=\"font-weight: 400;\">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.\u00a0<\/span><\/p>\n<p><span style=\"font-weight: 400;\">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.\u00a0<\/span><\/p>\n<p>&nbsp;<\/p>\n<h2><span class=\"ez-toc-section\" id=\"What_is_Yield_Farming\"><\/span><b>What is Yield Farming?<\/b><span class=\"ez-toc-section-end\"><\/span><\/h2>\n<p><span style=\"font-weight: 400;\">Yield farming is a practice that lets holders of <\/span><a href=\"https:\/\/digitalcoinprice.com\/\"><span style=\"font-weight: 400;\">cryptocurrency earn rewards<\/span><\/a><span style=\"font-weight: 400;\"> on their holdings. The practice requires an investor to deposit cryptocurrency units into a lending platform to earn interest arising from trading fees.\u00a0<\/span><\/p>\n<p><span style=\"font-weight: 400;\">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.\u00a0<\/span><\/p>\n<p><span style=\"font-weight: 400;\">Yield farming platforms allow investors to <\/span><a href=\"https:\/\/www.relite.finance\/blog-posts\/how-defi-yield-farming-can-make-you-great-crypto-money\" target=\"_blank\" rel=\"noopener\"><span style=\"font-weight: 400;\">earn crypto with DeFi yield farming<\/span><\/a><span style=\"font-weight: 400;\">. 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.\u00a0<\/span><\/p>\n<p><span style=\"font-weight: 400;\">The returns are in annual percentage yield.\u00a0<\/span><\/p>\n<p>&nbsp;<\/p>\n<h3><span class=\"ez-toc-section\" id=\"Understanding_Yield_Farming_and_DeFi\"><\/span><b>Understanding Yield Farming and DeFi\u00a0<\/b><span class=\"ez-toc-section-end\"><\/span><\/h3>\n<p><span style=\"font-weight: 400;\">The 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.\u00a0<\/span><\/p>\n<p><span style=\"font-weight: 400;\">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.\u00a0<\/span><\/p>\n<p><span style=\"font-weight: 400;\">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.\u00a0<\/span><\/p>\n<p><span style=\"font-weight: 400;\">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.\u00a0<\/span><\/p>\n<p>&nbsp;<\/p>\n<ul>\n<li>\n<h3><span class=\"ez-toc-section\" id=\"Calculating_Returns_in_Yield_Farming\"><\/span><b>Calculating Returns in Yield Farming\u00a0<\/b><span class=\"ez-toc-section-end\"><\/span><\/h3>\n<\/li>\n<\/ul>\n<p><span style=\"font-weight: 400;\">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).\u00a0<\/span><\/p>\n<p><span style=\"font-weight: 400;\">The main difference is that APR does not take into account compound interest. For a while, a yield farming strategy can deliver high returns but if many farmers adopt it, it will result in a profitability drop.\u00a0<\/span><\/p>\n<p><span style=\"font-weight: 400;\">The decentralized finance markets are quite volatile and risky for lenders and borrowers.\u00a0<\/span><\/p>\n<p>&nbsp;<\/p>\n<ul>\n<li>\n<h3><span class=\"ez-toc-section\" id=\"Yield_Farming_Risks\"><\/span><b>Yield Farming Risks\u00a0<\/b><span class=\"ez-toc-section-end\"><\/span><\/h3>\n<\/li>\n<\/ul>\n<p><span style=\"font-weight: 400;\">Despite its potential upside, the practice of yield farming has its risks. According to <\/span><a href=\"https:\/\/www.forbes.com\/sites\/kenrapoza\/2021\/06\/06\/defi-yield-farming-what-is-it-how-should-you-invest-in-it\/\" rel=\"no-follow noopener\" target=\"_blank\"><span style=\"font-weight: 400;\">Forbes<\/span><\/a><span style=\"font-weight: 400;\">, compared to banks that pay 0.25%, some cryptos will earn you 6% or more for locking your funds in a DeFi platform.\u00a0<\/span><\/p>\n<p><span style=\"font-weight: 400;\">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, and protocols they are running on and can withstand losing most of their investment.\u00a0<\/span><\/p>\n<p>&nbsp;<\/p>\n<ul>\n<li aria-level=\"1\">\n<h3><span class=\"ez-toc-section\" id=\"Smart_Contract_Risks\"><\/span><b>Smart Contract Risks\u00a0<\/b><span class=\"ez-toc-section-end\"><\/span><\/h3>\n<\/li>\n<\/ul>\n<p><span style=\"font-weight: 400;\">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.\u00a0<\/span><\/p>\n<p><span style=\"font-weight: 400;\">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.\u00a0<\/span><\/p>\n<p><span style=\"font-weight: 400;\">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.\u00a0<\/span><\/p>\n<p><span style=\"font-weight: 400;\">Since blockchain is immutable, most DeFi losses cannot be undone. So, you should familiarize yourself with the risks of yield farming.\u00a0<\/span><\/p>\n<p>&nbsp;<\/p>\n<ul>\n<li aria-level=\"1\">\n<h3><span class=\"ez-toc-section\" id=\"Capital-intensive_and_Intricate_Process\"><\/span><b>Capital-intensive and Intricate Process\u00a0<\/b><span class=\"ez-toc-section-end\"><\/span><\/h3>\n<\/li>\n<\/ul>\n<p><span style=\"font-weight: 400;\">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.\u00a0<\/span><\/p>\n<p><span style=\"font-weight: 400;\">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.\u00a0<\/span><\/p>\n<p>&nbsp;<\/p>\n<ul>\n<li aria-level=\"1\">\n<h3><span class=\"ez-toc-section\" id=\"Liquidation_Risks\"><\/span><b>Liquidation Risks\u00a0<\/b><span class=\"ez-toc-section-end\"><\/span><\/h3>\n<\/li>\n<\/ul>\n<p><span style=\"font-weight: 400;\">Like in conventional finance, DeFi platforms rely on 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.\u00a0<\/span><\/p>\n<p><span style=\"font-weight: 400;\">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.\u00a0<\/span><\/p>\n<p>&nbsp;<\/p>\n<ul>\n<li aria-level=\"1\">\n<h3><span class=\"ez-toc-section\" id=\"Impermanent_Loss_Risk\"><\/span><b>Impermanent Loss Risk<\/b><span class=\"ez-toc-section-end\"><\/span><\/h3>\n<\/li>\n<\/ul>\n<p><span style=\"font-weight: 400;\">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.\u00a0<\/span><\/p>\n<p><span style=\"font-weight: 400;\">The risk is probable since automated market makers do not update token prices to reflect movements in the market. For example, when an asset\u2019s price falls on a centralized exchange, the change does not reflect immediately on decentralized exchanges.\u00a0<\/span><\/p>\n<p>&nbsp;<\/p>\n<h3><span class=\"ez-toc-section\" id=\"What_is_New_About_DeFi_Yield_Farming\"><\/span><b>What is New About DeFi Yield Farming?\u00a0<\/b><span class=\"ez-toc-section-end\"><\/span><\/h3>\n<p><span style=\"font-weight: 400;\">DeFi has a simple premise. Today, most investors purchase crypto hoping the value will rise like Bitcoin.\u00a0<\/span><\/p>\n<p><span style=\"font-weight: 400;\">The strategy has largely worked fine. However, the recent development of stablecoins which are designed to keep their value constant is changing the calculation. With these, DeFi presents vast passive income opportunities.\u00a0<\/span><\/p>\n<p><span style=\"font-weight: 400;\">The <\/span><a href=\"https:\/\/hbr.org\/2021\/02\/what-happens-when-cryptocurrencies-earn-interest\" rel=\"no-follow noopener\" target=\"_blank\"><span style=\"font-weight: 400;\">Harvard Business Review<\/span><\/a><span style=\"font-weight: 400;\"> acknowledges that for the first time, you can be paid for owning cryptos, which brings tangible utility to digital currencies.<\/span><\/p>\n","protected":false},"excerpt":{"rendered":"<p>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.\u00a0 Yield farming is a hot trend in decentralized finance. It rewards investors for locking their crypto assets [&hellip;]<\/p>\n","protected":false},"author":4,"featured_media":460,"comment_status":"closed","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":{"footnotes":""},"categories":[9],"tags":[],"class_list":["post-467","post","type-post","status-publish","format-standard","has-post-thumbnail","hentry","category-guide"],"_links":{"self":[{"href":"https:\/\/digitalcoinprice.com\/blog\/wp-json\/wp\/v2\/posts\/467","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/digitalcoinprice.com\/blog\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/digitalcoinprice.com\/blog\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/digitalcoinprice.com\/blog\/wp-json\/wp\/v2\/users\/4"}],"replies":[{"embeddable":true,"href":"https:\/\/digitalcoinprice.com\/blog\/wp-json\/wp\/v2\/comments?post=467"}],"version-history":[{"count":4,"href":"https:\/\/digitalcoinprice.com\/blog\/wp-json\/wp\/v2\/posts\/467\/revisions"}],"predecessor-version":[{"id":2328,"href":"https:\/\/digitalcoinprice.com\/blog\/wp-json\/wp\/v2\/posts\/467\/revisions\/2328"}],"wp:featuredmedia":[{"embeddable":true,"href":"https:\/\/digitalcoinprice.com\/blog\/wp-json\/wp\/v2\/media\/460"}],"wp:attachment":[{"href":"https:\/\/digitalcoinprice.com\/blog\/wp-json\/wp\/v2\/media?parent=467"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/digitalcoinprice.com\/blog\/wp-json\/wp\/v2\/categories?post=467"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/digitalcoinprice.com\/blog\/wp-json\/wp\/v2\/tags?post=467"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}