As Decentralized Finance is on the way to creating an ecosystem without third parties and intermediaries, various projects are launched on its basis. Investors also have a wide range of investment opportunities due to various DeFi projects. Yield farming is one such investment strategy that is gaining popularity these days.
What is yield farming?
It is a method of earning interest on cryptocurrencies. This method requires you to move your crypto across different marketplaces. Yield farming is considered one of the main reasons for the growth of the DeFi sector. It works much like you earn interest on your balance in a savings account.
How does yield farming work?
Liquidity provider is the term used for users providing their crypto for the functioning of a specific DeFi platform. The LPs are intended to provide coins and tokens to the liquidity pool. Liquidity pools are dApps based on smart contracts composed of all funds. When the LPs lock the coins/tokens in a liquidity fund, they receive a reward or fee from the underlying DeFi platform.
Put simply, yield farming is a type of income opportunity where you lend your coins/tokens via a decentralized application (dApp). This entire lending process is dependent on smart contracts and no intermediary.
The liquidity pool is used to build a marketplace where you can lend or borrow coins/tokens. When using these marketplaces, users incur certain fees. This fee is then made available to LPs for staking their coins/tokens in the pool. Most of the yield farming takes place on Ethereum, and most of the rewards are ERC-20 tokens.
How is the return on yield farming calculated?
The yield in the yield farming process is estimated in APY (Annual Percentage Yield). It is defined by the return that a user makes over a year. The APY calculation also has a compound interest section.
Why did it become popular?
When the Compound Finance ecosystem launched its COMP token, there was a boom in yield farming. COMP is a governance token, allowing users to participate in its decision-making process. Other popular yield farming platforms are Uniswaps, Sushiswap, Aave, etc.
Risks of yield farming
- Due to the lack of specific regulations surrounding cryptocurrency, there is a significant risk of cyber fraud and hacks associated with most digital assets.
- The volatility of the crypto industry also poses a threat to users’ investments and contributions to the liquidity pools.
- Several small teams with significantly smaller budgets have created many DeFi protocols. This leads to an increase in the risk of smart contract bugs on the DeFi platforms.
Conclusion
Yield farming is one of the most popular ways to earn interest in the decentralized finance ecosystem. This process involves staking and locking the cryptocurrency. So, with the increasing popularity of crypto, yield farming will soon become mainstream as well. While it offers you great returns, the risks are always there. You never know what can happen when your digital assets are locked. Therefore, always make a wise investment.
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