Decentralized finance (DeFi) has emerged as a booming industry that demonstrates some of the efficient and creative possibilities of the crypto industry. Tens of billions of dollars in crypto assets are locked in DeFi today, a significant increase from 2021.
One reason it continues to grow is the appeal of “yield farming,” a strategy that leverages crypto assets and helps users maximize their returns. The strategy allows crypto investors to maximize their cryptocurrency rewards across multiple DeFi platforms through different strategies given below.
Yield farming creates an intriguing opportunity, but it also requires complex strategies and a keen eye. There is also a significant risk of losing your capital if you are not careful.
How did the concept of “yield farming” come about?
The concept of yield farming gained traction in the summer of 2020 after Ethereum (ETH)-based lending market Compound began distributing governance tokens, known as COMP, to its users. The governance tokens gave holders voting rights on proposed platform changes. The increased demand for the COMP token – triggered by its automated distribution – led to the start of the DeFi yield craze.
As demand increased, the term “yield farming” gained popularity. The term summarizes the practice of devising strategies to integrate cryptocurrency into some DeFi applications in order to earn more cryptocurrency for the owners.
How does DeFi income generation work?
When investors generate income in the DeFi ecosystem, they deposit tokens or coins into decentralized apps (dApps) such as lending and lending logs, decentralized social media outlets, and decentralized exchanges (DEXs). Yield farmers use decentralized platforms to lend, borrow or stake various coins to earn interest while actively speculating on the price movement of underlying crypto assets. Smart contracts are used to facilitate yield farming. These contracts are pieces of code used to enforce financial agreements between two or more people. There are different types of yield farming:
Liquidity Provider
Liquidity is a term you’ll hear quite a bit in DeFi, as yield farming is often intertwined with liquidity mining, which provides liquidity to the decentralized protocol.
Liquidity providers are users who deposit two coins on a decentralized exchange to offer trading liquidity. The DEXs charge a fee for a token swap, which is then paid to the providers. The fee is sometimes paid via liquidity pool tokens.
For example, I can put $1,000 worth of ETH and UNI into an ETH/UNI pool ($500 of each asset) and earn a percentage of the return on all trades.
lend or borrow
Yield farmers also do a fair amount of borrowing or borrowing to generate income. A party can lend cryptocurrencies to a borrower via smart contracts and then earn a percentage return on the interest paid.
When someone borrows cryptocurrency, they post collateral and receive another token for the loan. Users can then farm the yield with the borrowed coins/tokens, allowing the yield farmer to keep the original inventory. The inventory can appreciate in value over time while the borrowed coins generate returns at the same time.
Example: Party A loans Party B $1,000 for 30 days. Party B agrees to pay Party A 5% for the 30-day loan. To relieve Party A, Party B posts $1,300 worth of crypto collateral. That means if party B doesn’t repay the loan, party A gets the collateral.
Mark out
There are two types of staking to facilitate yield farming. The main type of staking is done on proof-of-stake blockchains. On these blockchains, users are paid interest to pledge tokens to the network for security purposes. The alternative staking method uses liquidity pool tokens earned by providing liquidity to decentralized exchanges. Users can earn returns twice with the latter method by paying for the pools to be deployed in liquidity tokens, which they can then stake to earn more returns.
How do you calculate yield farming returns?
Returns are typically annualized with all expected returns calculated over one year.
Annual percentage return (APY) and annual percentage rate of return (APR) are two commonly used metrics. Unlike APY, APR accounts for compounding, the reinvestment of profits to accumulate larger returns.
It’s important to emphasize that APY and APR used in yield farming are estimates rather than definitive figures, so a bit of guesswork must be used when calculating potential returns. Both measurements are forecasts and not guarantees. Yield rates are difficult to quantify because yield farming is a highly competitive world with ever-changing incentives. When yield farming strategies work over time, other yield farmers will copy them, causing those strategies to stop producing high returns. It is a 24/7 fluid market where the party and the counterparty are always trying to employ strategies that benefit them at the expense of the other.
What should you consider with Defi Yield Generation?
Yield farming involves risk, whether you are a lender or a borrower. Markets are unpredictable, with price slides and volatility being common. As tokens are locked in, values can rise or fall sharply, which poses a risk for yield farmers, especially when crypto markets experience bear runs like we’re witnessing in mid-2022.
Regulatory risk comes with yield farming as crypto is still in doubt with the Securities and Exchange Commission (SEC) declaring some digital assets as securities. Also, some states have issued cease and desist orders against more reputable centralized crypto lending sites.
In addition, there are potential smart contract hacks, although security improvements have been made thanks to streamlined third-party audits and code review. There are now scams like Rug Pulls, where crypto developers collect investment funds for projects, but abandon them and get away with the money without returning the money to investors.
Always make sure you know what you are investing in and how it works. Make sure you understand how returns are generated. Never bet more money than you can afford to lose, and especially if it seems too good to be true, it probably is.
The information provided here is not investment, tax or financial advice. You should consult a licensed professional for advice regarding your specific situation.
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