SUMMARY
Yield farming is a way to earn more crypto with your crypto. It involves lending your funds to others through computer programs called smart contracts. For this service, you earn a fee in crypto. Pretty simple right? Maybe it's not that simple.
Yield farmers use very complex strategies. They constantly move their crypto between different lending marketplaces to maximize their earnings. These people also try to keep their best yield farming strategies secret. From where? Because the more people know about a strategy, the less effective this strategy becomes. Yield farming is the wild west of Decentralized Finance (DeFi), with users competing to earn the highest returns.
Interested? Read on.
Entrance
One of the new concepts that has emerged is yield farming. Yield farming is a new way to earn rewards with cryptocurrency holdings using permissionless liquidity protocols. Anyone can earn passive income using the decentralized ecosystem of “money legos” built on Ethereum. As a result, yield farming could change how investors HODL in the future. Why keep your assets idle when you have the option to operate them?
How do yield farmers manage their savings? What kind of returns can they expect? And if you want to do yield farming, where can you start? We will answer all of these questions in our article.
What is yield farming?
Yield farming is similar to staking in a sense. However, the background of yield farming is much more complex. Most often, it works with users called liquidity providers (LPs) who add funds to liquidity pools.
What is a liquidity pool? At its most basic, it is a smart contract that holds funds. Liquidity providers earn a reward for offering liquidity to the pool. This reward may come from the revenue generated by the DeFi platform used from commissions or from another source.
Some liquidity pools may pay rewards in more than one type of tokens. These reward tokens can then be deposited into other liquidity pools to earn rewards from there, and the process can continue like this. Even with this much information, you can realize how extremely complex strategies can emerge in a short time. But the idea is that the liquidity provider deposits its funds into a liquidity pool and earns rewards in return.
Yield farming is typically done on Ethereum using ERC-20 tokens, and the rewards are usually in an ERC-20 type as well. But this situation may change in the future. From where? Because for now, the majority of this type of activities are located in the Ethereum ecosystem.
But cross-chain bridges and other similar developments could allow DeFi applications to be independent of blockchains in the future. This means that applications can also run on other blockchains that support smart contract features.
Yield farmers move their funds between different protocols quite frequently in search of high returns. As a result, DeFi platforms may also offer other economic incentives to attract more capital. Just like in centralized exchanges, liquidity tends to attract more liquidity.
What started the yield farming boom?
This sudden strong interest in yield farming can be attributed to the launch of the COMP token, the governance token of the Compound Finance ecosystem. Governance tokens offer governance rights to token holders. So how can these tokens be distributed if the network is to be decentralized to the highest degree possible?
One of the most common ways to launch a decentralized blockchain is to distribute these governance tokens algorithmically, with liquidity incentives. This approach directs liquidity providers to “farm” the new token by offering liquidity to the protocol.
Although COMP did not invent yield farming, the introduction of these tokens has increased the popularity of this type of token distribution model. Since then, other DeFi projects have created innovative structures to attract liquidity into their ecosystems.
What is Total Value Locked (TVL)?
A good way to measure the overall health of the DeFi yield farming world is Total Value Locked (TVL). TVL measures how much crypto is locked in DeFi lending and other types of money marketplaces.
TVL, in a sense, is the total liquidity in liquidity pools. It is a useful index to measure the health of the DeFi and yield farming market as a whole. It is also an effective metric for comparing the “market share” of different DeFi protocols.
DeFi Pulse may be a good choice to track TVL. You can check which platforms have the highest amount of ETH or other crypto assets locked in DeFi. This can give you a general idea about the current status of yield farming.
Naturally, the higher the locked value, the more yield farming can be done. It is also important to note that TVL can be measured in terms of ETH, USD and even BTC. Each of these offers a different perspective on the state of DeFi money markets.
How does yield farming work?
Yield farming is closely related to the automatic market maker (AMM) model. Here you typically find liquidity providers (LPs) and liquidity pools. Now let's examine how this works.
Liquidity providers deposit their funds into a liquidity pool. This pool powers a marketplace where users can lend, borrow, and exchange tokens. A commission must be paid for the use of these platforms, and these commissions are then paid to liquidity providers in proportion to their share in the liquidity pool. This is the basic working principle of an AMM.
But there can be big differences between applications – it should also be noted that this is a fairly new technology. It is certain that new approaches will emerge in the future to improve existing practices.
Besides commission income, another incentive to add funds to the liquidity pool could be the distribution of a new token. For example, there may be no way to purchase a token from the public market for more than small amounts. However, this token can be obtained by offering liquidity to a specific pool.
Distribution rules will depend entirely on your particular implementation of the protocol. But most fundamentally, liquidity providers earn a profit based on the amount of liquidity they provide to the pool.
The funds invested are usually stablecoins pegged to the USD – but this is not a general requirement. The most commonly used stablecoins in DeFi include DAI, USDT, USDC, BUSD, etc. takes place. Some protocols issue new tokens that represent the coins you have deposited into the system. For example, if you deposit DAI into Compound, you will receive cDAI or Compound DAI in return. Similarly, if you deposit ETH, you will receive cETH this time too.
As you can imagine, this can be a complex process with many layers. You can deposit your cDAI, which represents your DAI, into another protocol, and that protocol may issue a third token representing your cDAI. The process may continue like this with the addition of other platforms. These chains can become extremely complex and difficult to follow.
How are yield farming earnings calculated?
Estimated returns from yield farming are usually calculated annually. This results in an estimate of the returns you could achieve over a one-year period.
Commonly used metrics include Annual Percentage Rate (APR) and Annual Percentage Return (APY). The difference between these is that APR does not take into account the compounding effect, while APY does. Compounding in this case is the direct reinvestment of profits to generate greater returns. However, it should be noted that APR and APY can be used interchangeably.
It should also be noted that these are only estimates and predictions. Even short-term rewards are difficult to calculate accurately. This is because yield farming is a highly competitive and fast-paced market and rewards can change quickly. If a yield farming strategy works for a while, many people will want to take advantage of this opportunity, which may prevent the strategy from bringing high profits.
Since APR and APY are based on traditional markets, DeFi may need to come up with its own metrics to calculate returns. Due to the fast pace of DeFi, it may make more sense to calculate weekly or even daily estimated return rates.
What is collateralization in DeFi?
Generally, if you are borrowing an asset, you will need to post a collateral to cover your loan. This coverage basically acts as insurance for your loan. What does this have to do with DeFi? The answer may vary depending on which protocol you offer your funds to, but you may need to monitor your collateralization rate carefully.
If the value of your collateral falls below the threshold value determined by the protocol, your collateral may be liquidated on the open market. What can you do to avoid liquidation? You can add more coverage.
To emphasize again, each platform has its own rules for this, that is, platforms have their own required collateralization rate. In addition, platforms often operate with a concept called overcollateralization. This means that borrowers must deposit more than the value they want to borrow. This is to reduce the risk that severe market crashes will liquidate large amounts of collateral in the system.
Let's say the lending protocol you use requires a collateralization ratio of 200%. This means that for every $100 you put in, you can borrow $50. However, it is generally safer to deposit an amount higher than the required collateral amount to further reduce the risk of liquidation. However, many systems use very high collateralization rates (such as 750%) to keep the entire platform relatively safe from liquidation risk.
Risks of yield farming
Yield farming is not simple. The most profitable yield farming strategies are extremely complex and are only recommended for experienced users. In addition, yield farming is generally more suitable for people who have a large amount of capital at their disposal (whales).
Yield farming is not as easy as it seems and if you are not aware of what you are doing you are likely to lose money. We talked about how your collateral can be liquidated. So, what are the other risks you should be aware of?
One of the most obvious risks of yield farming is smart contracts. Due to the nature of DeFi, many protocols are built and developed by small teams with a limited budget. This may increase the risk of software bugs being found in the smart contract.
Security vulnerabilities and bugs pop up all the time, even in larger protocols that have been audited by reputable auditing companies. This may result in the loss of user funds due to the immutable nature of the blockchain. You need to take this into consideration when locking your funds in a smart contract.
Additionally, one of DeFi's biggest advantages is also one of its biggest risks. This feature is composability. Let's examine how this affects yield farming.
As we mentioned before, DeFi protocols are permissionless and can be seamlessly integrated with each other. This means that the entire DeFi ecosystem is highly dependent on all its building blocks. That's what we're talking about when we say these apps are combinable – the apps are pretty easy to work with.
Why does this pose a risk? If just one of the building blocks does not work as desired, the entire ecosystem may experience problems. This is one of the biggest risks to yield farmers and liquidity pools. You need to trust not only the protocol in which you deposit your funds, but also any other protocols that that protocol is based on.
➟ Do you want to enter the world of cryptocurrency? You can buy Bitcoin from Binance!
Yield farming platforms and protocols
How can you earn these yield farming rewards? There is no specific way to do yield farming. In fact, yield farming strategies can change hourly. Each platform and strategy has its own rules and risks. If you want to start yield farming, you need to have knowledge about how decentralized liquidity protocols work.
We already know the basic processes. You deposit funds into a smart contract and earn rewards for it. But there can be big differences between applications. So, blindly investing your hard-earned funds and hoping for high returns may not be a good idea most of the time. As a basic rule of risk management, you should be able to maintain control of your investment.
So, what are the most popular platforms used by yield farmers? What we present below is not an exhaustive list, but some of the protocols that are at the core of yield farming strategies.
Compound Finance
Compound is an algorithmic money market that allows users to lend and borrow assets. Anyone with an Ethereum wallet can contribute assets to Compound's liquidity pool and earn rewards that instantly start generating compound interest. Rates are adjusted algorithmically based on supply and demand.
Compound is one of the core protocols of the yield farming ecosystem.
MakerDAO
Maker is a decentralized lending platform that supports the creation of DAI, a stablecoin whose value is algorithmically indexed to the USD. Anyone can open a Maker Vault where they can lock collateral assets such as ETH, BAT, USDC and WBTC. Users can create DAI as a loan against this collateral they have locked. Over time, this debt begins to accumulate interest called a stabilization commission – commission rates are determined by MKR token holders.
Yield farmers can use Maker to extract DAI to use in their yield farming strategies.
Synthetix
Synthetix is a synthetic asset protocol. It allows anyone who wishes to lock (stake) Synthetix Network Token (SNX) or ETH as collateral and issue synthetic assets in return. What might a synthetic entity be? In practice, anything that has a reliable source of price information can be a synthetic asset. This allows almost any financial asset to be added to the Synthetix platform.
In the future, Synthetix may enable all types of assets to be used for yield farming. If you want to use your long-term gold investments in yield farming strategies, you can choose synthetic assets.
Ghost
Aave is a decentralized protocol for lending and borrowing. Interest rates are adjusted algorithmically based on current market conditions. Lenders receive “aTokens” in exchange for their funds. These tokens start earning and compounding interest as soon as they are deposited. Aave also enables other more advanced functions such as flash loans.
Aave is heavily used by yield farmers as a decentralized lending and borrowing protocol.
Uniswap
Uniswap is a decentralized exchange (DEX) protocol that enables trustless token swaps. Liquidity providers deposit equal value of two tokens to create a market. Traders can then trade against the liquidity pool. Liquidity providers earn commissions from transactions carried out in the pool in exchange for the liquidity they offer.
Uniswap is one of the most popular platforms for trustless token swaps due to its frictionless nature. This can be useful for yield farming strategies.
Curve Finance
Curve Finance is a decentralized exchange protocol specifically designed for efficient stablecoin exchanges. Unlike similar protocols such as Uniswap, Curve allows users to exchange high-value stablecoins with a relatively low price slippage.
As you can imagine, Curve pools are an important part of the infrastructure as stablecoins are heavily used in the yield farming world.
Balancer
Balancer is a liquidity protocol similar to Uniswap and Curve. But the main difference is that Balancer allows any amount of tokens to be deposited into a liquidity pool. This allows liquidity providers to create personalized Balancer pools rather than using the 50/50 split ratio that Uniswap mandates. Similar to Uniswap, here too liquidity providers earn commissions on transactions made in their pools.
Balancer is an important innovation for yield farming strategies thanks to the flexibility it brings to liquidity pool creation.
Yearn.finance
Yearn.finance is an aggregator decentralized ecosystem for Aave, Compund and other lending services. It aims to optimize token lending by algorithmically finding the most profitable lending services. Deposited funds are converted into yTokens, which are rebalanced periodically to maximize profits.
Yearn.finance is useful for people who want a protocol that will automatically select the best strategies for them.
final thoughts
We examined yield farming, the newest focus of attention in the cryptocurrency world.
What else can this decentralized finance revolution bring? It is impossible to predict what new applications will be added to existing elements in the future. However, trustless liquidity protocols and other DeFi products are undoubtedly the newest development in finance, cryptoeconomics, and computer science.
DeFi money markets can certainly help create a more open and accessible financial system for anyone with an internet connection.
➠ Do you have questions about DeFi and yield farming? You can visit Ask Academy!
