Yield Farming: Understanding the Basics

Just as farmers expect a yield from their products, so are cryptocurrency investors expecting maximum returns from their investments. In the world of crypto, the investors are just like farmers who have invested a substantial proceed in cryptocurrency. A look at the latest modern fintech will give you the comprehensive knowledge and an idea about what DeFi is all about. DeFi is just like a financial institute of cryptocurrencies. It includes a term for different financial applications in cryptocurrency designed to disrupt the conventional financial intermediaries.

Data from the DeFi Pulse shows that over $10 billion in crypto assets are currently locked in DeFi right now. Earlier this year in July, the amount was around $2 billion, and just in a couple of months, the DeFi market has grown in huge numbers.

However, since people believe that farmers determine their profit through investments, DeFi advocates have now held onto the farming metaphor. They have now tagged its existence as “yield farmers” – that is people who measure the yields that are gotten on top of crypto assets like DAI, USDc when utilized in DeFi platforms like Compound.  

You might be wondering what DeFi is? 

What is DeFi? 

If you have been following cryptocurrency as far back as 2018, the concept of open finance first started traction among the crypto community. However, the name seems to have faded into a new term called “DeFi”. It stands for Decentralized Finance. 

DeFi is just a term used for different financial applications in cryptocurrency leveraging the Blockchain technology designed to replace the conventional financial intermediaries or middlemen. One can also define the DeFi concept as anything that allows you to play with money in a trustless system along with anonymity.  In DeFi space, there’s no place for a credit score or going through the troubles of long paperwork procedures. 

There are a range of projects and DAO (Decentralized Autonomous Organization) working in DeFi space to build different kinds of protocols. For the most part, the emergence of various DeFi protocols can be attributed to the Ethereum Smart Contract platform. As almost all of the protocols are leveraging ERC-20 based-tokens so far. 

Now, let’s jump into the concept of Yield Farming. 

What is Yield Farming? 

You can say that yield farming is a process that allows users to earn fixed or variable interest on their crypto-asset by leveraging various strategies. Yield farmers tend to move their assets continuously across a range of DeFi platforms using a set of complicated strategies.

Basically, yield farming is a technique to use underlying crypto assets to generate a maximum possible return. It involves leveraging various unique features offered by DeFi platforms such as Compound, Curve, Uniswap, etc. These platforms allow users to participate in permissionless and trustless liquidity protocols. Thus removing the need for custodians or middlemen. Yield farming often involves looking for a liquidity pool that offers the best annual percentage yield.

Since it is a fairly new trend in the world of cryptocurrency, it is crucial that investors understand the risk associated with yield farming. Given the surging competition between investors and high gas prices, it is necessary to note that yield farming is only profitable if you can put a significant sum of money to work. For example, putting $100 to $1000 in crypto in yield farming might not give you the result you wish. However, if you are just getting started and checking out how the whole stuff works, you can start with a small amount, but it is not profitable.  

How Yield Farming Works

The working of yield farming and the possibility of making good returns is based on the features of the individual DeFi application. One of the significant ways is by giving users a percent of the transaction fees for contributing liquidity to a specific application, including Balancer and Uniswap. 

However, the common technique of yield farming is by utilizing a decentralized application that allows users to earn a project token in return. We saw that practice earlier this year when Compound revealed its intention of issuing its COMP governance token to borrowers and lenders who have been using the compound application for some time. This strategy became so popular that it pushed Compound to the top of DeFi rankings. So far, we have seen many projects spring up by creating different DeFi applications with the native token and offering their token as a reward to users in return.  All these creations of new tokens have now led to more innovations as projects are fiercely competing for the available users. 

The latest information shows that most successful yield farmers get their return by utilizing more complicated investment strategies like staking tokens in a chain of protocols to generate maximum yield. Most of the coins that yield farmers stake include; Tether (USDT), USD Coin (USDC). Since it provides a more accessible avenue of tracking profits and losses. However, yield farmers can also stake other cryptocurrencies like Ether (ETH).  

Risks associated with Yield Farming 

Even though yield farming provides an avenue for profit, there are still risks associated with yield farming. One of the risks involved is the staking of money. Yield farmers are required to deposit a considerable value of the initial capital so that they can have a significant gain. However, due to the highly volatile nature of cryptocurrency, mostly DeFi tokens, yield farmers are exposed to so many risks like liquidation, which happens in the eventuality that the market crashes as it happened with HotdogSwap. 

Another risk is the complex nature of yield farming. The process of becoming successful in yield farming can be intriguing sometimes, especially when it comes to these underlying protocols.

Why is yield farming so hot right now?

It can be attributed to liquidity mining since it supercharges yield farming. It is a way of earning rewards in exchange for providing liquidity for a specific token.  Liquidity mining is basically a new methodology to replace market makers with a bot i.e automated market maker (AMM). It helps in maintaining orders on an exchange order book.

According to Richard Ma, of smart contract auditor, Quantstamp, the goal is to understand that the platform’s stimulating increases the value of the token, thus creating a positive usage loop to draw users. 

Conclusion:

Yield farming has evolved over the months and has drawn the attention of a lot of people. Those who are hoping to get their feet wet in yield farming must remember that it is something that requires extensive learning and understanding so as not to encounter losses. It is necessary to understand that one should not farm with money they are unwilling to lose when the tide turns upside down.

Keep an eye on our Top 10 section for best yield farming opportunities and follow us on Twitter, Facebook or Instagram.

Written by Narender Charan

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