Crypto yield farming became the hottest topic in the DeFi summer of 2020. Since then, it has become one of the most sought-after crypto investment strategies by many looking to earn rewards for their crypto holdings.
Upon its creation, the total value (TVL) across all DeFi platforms reached an all-time high of $256 billion, recorded on December 2, 2021. Despite the current market conditions and risks that likely caused TVL to fall to around $112.33 billion, crypto yield farming is still one of the most profitable strategies crypto investors can implement today.
This article explains the different strategies you can use to make money from your wealth and the risks you need to be aware of before investing.
What is crypto yield farming?
Yield farming is a crypto investment practice that allows you to generate crypto rewards in exchange for your crypto holdings. In other words, it allows you to earn passively if you agree to freeze your crypto assets for some time.
The concept is similar to traditional banking systems that give interest on the amount you borrow. Yield farming rewards ROIs with additional cryptocurrency.
Some of the most notable cryptocurrencies that support yield farming include stablecoins like USDC, USDT, DAI, and BUSD. Other popular cryptocurrencies include Bitcoin (BTC), Ethereum 2.0 (ETH), Chainlink (LINK), Polkadot (DOT), Tezos (XTZ), Polygon (MATIC) and SwissBorg (CHSB).
How does it work?
Yield is a complex strategy that requires the involvement of Liquidity Providers (LP) to add funds to liquidity pools. As a liquidity provider, when you add funds to the pools, you are incentivized with cryptocurrencies to lock your assets.
Then what is a liquidity pool? Basically, it is a smart contract-based protocol where funds are kept. This decentralized platform ensures that all transactions are verified and executed seamlessly among all parties involved according to a preset algorithmic condition. Essentially, the pools provide the funding infrastructure that allows DeFi users to conduct various transactions, including borrowing, lending, and bartering.
Rewards distributed to liquidity providers are generated from transaction fees charged to users trading on DeFi platforms or from other sources such as interest from lenders or a governance token.
What APY and APR stand for in yield farming
The annual interest rate (APY) or the annual rate of return (APR) are the returns that you as an investor earn over the course of a year. Put more simply, it’s a way to calculate or track how much interest you’ll accumulate over time. Compound interest, which is interest you receive on both your principal balance and interest accrued over time, is also factored into APY.
It would be helpful to consider that some projects’ APY or ARR (depending on which one is used) may change depending on the number of participants, token distribution schedule and trading fees.
Still, let’s say your investment strategy is basically to get a return on your investment for simply holding your crypto. In that case, a cryptocurrency savings account with APR/APY might be all you need.
Various yield farming strategies
When it comes to yield farming crypto investments, there is no silver bullet. We recommend considering factors appropriate to your needs and circumstances, primarily judged by your risk tolerance, commitment and withdrawal preference.
Now let’s break down some different yield strategies to consider when trying to get on board.
Mark out
Crypto staking is one of the most popular ways for long-term crypto holders to invest in earnings using decentralized or centralized protocols. It is a low-risk, capital-protected investment plan that allows you to earn passive rewards simply by holding your cryptocurrencies. This allows your crypto assets to work for you and bring you some interest without having to sell them.
You can think of staking as the crypto equivalent of government bonds, popularly known as Treasuries. When you deposit your money into an interest-based savings account, you agree to lend it to the government for a period of time. In return, you receive a fixed interest rate that corresponds to your investment assets.
Similarly, if you deploy your digital assets, lock them down to participate in maintaining the security of the blockchain and keep it running. In return, if you allow the blockchain to use your capital, you get your incentives calculated in percentage returns.
The proof-of-stake consensus mechanism is widely used on the blockchain to select honest people to participate in the system and to ensure that no one can mint additional cryptocurrencies they have not earned. The mechanism also helps increase transaction speed and is carried out efficiently while reducing fees.
DeFi Lending
DeFi lending is an innovative way to use decentralized protocols to participate in a variety of lending activities. This is equivalent to investing in AAA corporate bonds such as Apple, Facebook, etc. Generally, AAA bonds are considered the investment with the lowest probability of default.
DeFi lending is relatively similar to staking, but the difference lies in the way your crypto is used and the length of time you can lend your money. Instead of locking up your assets to just benefit the blockchain, DeFi lending allows you to rent them out to other crypto borrowers. The decentralized platform charges borrowers certain interest rates from which you get your reward.
Elsewhere, while staking locks your crypto for a preset time, many lending platforms allow you to withdraw your funds at any time.
DeFi strategy
DeFi strategy is a key tool for advanced traders. It’s essentially about mixing different options, using increasing strategies to gain leverage and higher returns.
It can be likened to how traditional investors quench their insatiable thirst for yield in a variety of ways. For example, a traditional investor might buy real estate to generate income, buy high-dividend-paying stocks, or even trade OTC debt securities with enhanced yields to meet their return goals.
Likewise, many crypto investors realize their return goals using a variety of approaches, including lending on decentralized money markets, staking on a protocol’s native token, or simply collecting trading fees by depositing passive liquidity into an automated market maker.
Parachain Auction
Parachains are advanced Layer 1 blockchains consisting of independent platforms running in parallel within the Polkadot and Kusama ecosystems. Parachain use cases extend beyond various customizable industries including gaming and NFTs, DAOs, IoT, DeFi, and others.
The Parachain Auction is a way to fairly allocate available slots to determine the number of Parachains that will gain access to the Polkadot and Kusama Networks. When a parachain auction takes place, Polkadot (DOT) or Kusama (KSM) holders can participate by pledging their respective tokens to the project they believe deserves the parachain slot.
Once the auction starts, the project that has collected the most slots can commit to airdrop tokens or use other forms of reward structure to compensate their backers.
The Risks of Yield Farming
Like any other investment plan, crypto yield farming comes with risks. Some are benign, and sometimes they can be serious problems.
Be liquidated on your holdings
Liquidation in crypto takes place when the collateral price falls below the credit price. And since cryptocurrencies are known for their notorious volatility, knowing when to withdraw from a pool and when to stay in it could be a real challenge. In a liquidation, the liquidated fund is insufficient to cover the loan amount, resulting in a loss.
You can reduce your likelihood of liquidation by using the “stop loss” or “stop market order” strategy, especially when using leverage. This ensures that you can limit potential losses.
Risk of Temporary Loss
The net difference between the value of two cryptocurrency investments in a liquidity pool-based automated market maker is known as impermanent loss. During a strong market move, you may lose all your funds tied up in the liquidity pools.
You can minimize your risk if you take the time to understand everything about the pool, how it works, reviews from other users, and whether the protocol offers a solution to mitigate the fickle risk of loss.
Problems with the smart contract
The risks associated with DeFi smart contract lie in the computer codes entered by the developers. Seemingly minor bugs could lead to hackers exploiting the protocol, resulting in capital losses.
To reduce your risk, check if the contract is audited. Review the audit report to see how the contract was audited and track any updates if errors were found.
High gas fees
Unfortunately, if you are a participant with small funds, you could lose money due to Ethereum’s high gas fees. In this case, you may find that the gas fees for withdrawing funds are higher than your actual earnings.
your own strategy
How you approach your investment strategy can affect or hurt your returns. It’s important to understand that yield farming strategies change over time. You need to be constantly aware of the different market conditions. For example, you have to be sure when to jump into a pool or if you should plan for the long term.
Diploma
Yield farming crypto is a viable means by which you can earn passive rewards on your cryptocurrency assets using various strategies. To get the most out of your investment, it’s important to educate yourself on which methods are right for you and how to manage the various risks associated with returns.
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