In the world of decentralized finance (DeFi), yield farming can be extremely lucrative. But if you want to be successful, you need to understand the ins and outs. So we’ve broken down some common strategies – and pitfalls – you should know before picking up your plow.
1. What exactly is yield farming?
Less than 1 minute reading time
Yield farmers try to get the highest possible income – or rate of return – from their digital capital by switching between different DeFi platforms and strategies. Think of it like a farmer rotating the crop in a field to get the most output out of the soil.
There are a number of different ways to “farm yield” so to speak, but the idea is the same: earn a return on your crypto by locking it in DeFi platforms’ smart contracts. Now let’s look at some common yield farming strategies.
2. Provision of Liquidity
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When you deposit coins and tokens on a decentralized exchange (DEX), you provide the platform with liquidity – i.e. crypto to transact with. Exchanges require a supply of crypto for users to trade. And in return, liquidity providers earn a portion of those trading fees.
Traders on, say, Uniswap could swap DAI for Ether. And as a liquidity provider, you need to deliver equal values of DAI and Ether to the DEX. By providing 1% of the DAI Ether liquidity pool, you earn 1% of the fee every time a trader trades between the two assets.
But that reward isn’t risk-free: you’ll be exposed to something called impermanent loss. The math behind the temporary loss calculation can be complex. But without addressing if the prices of coins in a liquidity pool change in a way that you would have been better off keeping those coins in your wallet instead – and not making that liquidity available to the DEX.
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4. Borrow and Borrow
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Just as you earn interest when you deposit funds into a savings account, you can earn returns by lending your crypto to borrowers on DeFi lending platforms. Only the return you get in DeFi is usually much higher than what you get from a bank – but there is also a lot more risk involved.
As a lender, your biggest risk is that your smart contract contains a bug in the code – that lures hackers to break in and siphon off your funds. So make sure you use reputable DeFi platforms and spread your crypto across a few different ones.
Yield farmers could also borrow money from one platform and lend the same funds on another. In other words, this is leveraged lending. Your potential return is very high, but so is your risk: it’s a double whammy, not for the faint of heart.
The central theses:
- Yield farmers are scouring the DeFi universe for the highest possible return on their crypto.
- Two common yield farming strategies are providing liquidity to decentralized exchanges and using lending and lending platforms to earn crypto interest.
- Yield farming can be lucrative if you know what you’re doing — but make sure you understand the (often huge) risks before you jump in.
This guide was created in partnership with Ledger.
Visit Ledger’s mini site at finimize.com.
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