Crypto yield farming is a carefully designed system that allows crypto holders to deposit their crypto into a pool for investment purposes. In other words, it is an investment strategy where you lend your holdings via DeFi or deposit them into a liquidity pool hoping to reap the additional benefits of your investment.
Liquidity pools collect deposits from various users who essentially borrow their money on a DeFi platform and earn interest or more crypto in return for their investment. Once borrowed, users’ crypto is locked into a decentralized app (dApp) for tokenized rewards. It can be anything from a crypto wallet to a decentralized exchange.
In most cases, crypto owners rely on the decentralized exchange to borrow, stake, or lend the coins, which in turn allow them to earn interest on that deposited or borrowed sum.
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Yield farms are DeFi tools based on smart contracts. Unlike traditional financial systems, smart contracts allow us to cut out the middleman, such as B. a centralized bank to take out of the picture. However, since yield farms rely on smart contracts, users always know the terms of their agreements.
Yes, smart contracts are excellent fraud prevention tools, but unfortunately, rogue crypto yield farms still exist in the market. So, crypto yield farming is a risky investment not only because of market volatility, but also because not all yield farming projects are credible. But more on that later.
The use of smart contracts allows anyone to contribute to a liquidity pool as long as they have a cryptocurrency wallet. That’s both good and bad, but that’s the beauty of decentralized ecosystems.
How does yield farming work?
We could compare liquidity pools to the standard savings account you would normally open at your local bank. If savers deposit regularly, they earn interest. With this, the bank would like to say thank you for allowing us to lend your money for the needs of our other customers. Of course, this does not mean that you will lose money from the account. It just means that the cash you deposit doesn’t stay in the vault, it circulates and benefits the economy.
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However, decentralized systems work a little differently than the standard, centralized ones. In this particular example, instead of using your deposited cryptos to fund a client’s mortgage, the cryptocurrency deposited in a yield farm is used to fund a smart contract app.
So when crypto owners put their digital coins into a staking pool via a dApp lending protocol, their liquidity is there, meaning others can borrow that liquidity and use it to fund their own investments. However, yield farms can hold your investments for a pre-arranged period of time to keep the ecosystem alive and thriving. More importantly, depending on the terms of your agreement, your crypto can also be used as collateral.
What are potential yield farming rewards?
Yield farming usually rewards early investors the most. The most lucrative reward in this ecosystem is the governance token.
Now, governance tokens offer various privileges, e.g. B. the right of the owners to have a say in the management of the project. The more Governance Tokens you have in your possession, the more power you have to change the trajectory of the project. With this in mind, governance tokens are the be-all and end-all of any decentralized autonomous organization (DAO) that operates without the influence of a central authority.
So in a way, governance tokens also represent how much they have contributed to a liquidity pool. For example, let’s say you have invested around $1,000 in your liquidity pool. If the total investment or value of the pool is $10,000, you would own 10% of that pool.
And then of course there is interest. Crypto holders, or in this case liquidity providers, can earn a percentage of each transaction for investing in a liquidity pool.
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Depending on the project, some other rewards may be involved. More importantly, remember how I mentioned early investors getting governance tokens as a reward? Well, the rewards change depending on the reward logs, hierarchy and contribution to the pool.
Yield farming types
Anyone wishing to become a crypto yield farmer must first become familiar with the types of yield farming. So, here are your options:
- loan: This type of yield farming allows crypto owners to lend their assets to borrowers. It does this through smart contracts, and lenders earn income from the interest borrowers pay on their loans.
- Lend: Borrowing in crypto yield farming refers to borrowing a coin by providing other tokens as collateral. This is a common yield farming method as it allows farmers to keep their initial coins while farming the yield of the borrowed coins. Both coins can increase in value over time, so you can get an idea why this type of yield farming is trending.
- Mark out: When we talk about staking crypto, we usually refer to participating in the validation of blockchain transactions. When crypto holders stake their coins, they first place their crypto in a staking pool. The pool then earns rewards for solving complex math problems and adding another block to a chain. The prizes are split between the contributors of the staking pool. But staking is also often used in yield farming. Yield farmers deploying their crypto holdings pair their tokens with a platform and provide liquidity to it. This allows them to earn additional income. That’s because they earn rewards for providing liquidity, but they can also use those rewards to generate more returns.
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Pros and Cons of Crypto Yield Farming
Similar to trading leverage, crypto yield farming can be quite lucrative. However, it is a high-risk, high-reward opportunity to make money. Some say it’s as risky as leverage, but for different reasons. So let’s see if it’s really worth dipping your toes into crypto yield farming.
Some of the yield farming pros are:
- High interest rates: Investing in a yield farm could reward you with high interest rates. A yield farm could potentially give you returns in excess of 100% APY. However, keep in mind that this is not always the case. But even lower yields are profitable.
- Custody of lucrative assets: Yield farming allows you to keep all invested assets in your custody. Even if you have to keep them in a pool for a period of time, at the end of the day they’re still yours to spend, sell, or borrow.
- Smart Contracts: Smart contracts are both a blessing and a curse. While they allow anyone to join a farming pool, smart contract failures can put all your stocks at risk. Nevertheless, they are the basis of decentralization and improve efficiency and transparency in a decentralized ecosystem.
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Disadvantages of Crypto Yield Farming:
- market volatility: If the crypto you put in a liquidity pool is put in said pool or locked up for a period of time, the value of those coins will still follow the real-time market value. This means that if the price falls significantly, you couldn’t just take them out of the pool and sell them, meaning you could lose a lot more than you would get by holding your coins in a staking pool and earning interest. However, it’s also possible that you wouldn’t panic sell these coins anyway, so it’s not necessarily a devastating outcome. Additionally, if you are considering crypto yield farming for savings purposes, remember that you need to invest in a stable currency, preferably one that is pegged to the US dollar. Some crypto farms will offer you 15% interest on bitcoin, but if the value of BTC plummets, your savings will plummet as well.
- carpet pulls: Rug pulls are crypto scams. In most cases, scammers whitewash the story about their projects just to attract investors and run away with their fortunes. However, a rug pull also occurs when developers abandon crypto projects without announcing the decision to the public. This prevents crypto holders from selling their assets before it’s too late. In this scenario, crypto owners would keep their coins or tokens, but these digital assets would be completely worthless, giving them no chance to sell them and recoup their losses.
- Possible losses: If the coin value skyrockets and you are unable to take it out of the staking pool, the interest you earn may not match the profit you could have made from selling the asset.
- Steer: Depending on the country you live in, crypto might not be a viable investment after all. For example, if crypto payments are not regulated in your country, you may have to pay taxes on your profits and initial investment. Let’s say you invest $1,000 in crypto and make a $100 profit. When you exchange that crypto for fiat and transfer it to your bank account, your bank may ignore the fact that only $100 of that sum is your profit. The bank will have a record of an additional $1,100 to your name, and since crypto is unregulated, you would not be able to separate profits from your investments and therefore cut your taxes in half. In other words, your earnings can go down the drain.
Crypto yield farming protocols to consider
As mentioned earlier, many scammers profit from crypto yield farming, which is why it is imperative to invest in credible projects that have been in the market for some time.
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Some of the most popular and credible crypto yield farming protocols are:
- coin base– Coinbase is a good option because it is a well-known and regulated broker.
- Uniswap– Uniswap is the largest decentralized exchange on Ethereum and one of the most popular platforms offering crypto yield farming.
- DeFi kingdoms: It is a game, a liquidity pool and a decentralized exchange in one.
- MELD– MELD is a new startup project on the Cardano network. According to the founders, it is the first non-custodial DeFi banking protocol.
Now that you know what it is, is crypto yield farming worth the time and effort?
While it can be profitable, crypto yield farming does come with certain risks. If you don’t want to take those risks, it’s always best to move on and find another project that you can stay in your comfort zone with.
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