Welcome to the fourth of PYMNTS’ eight-part series on Decentralized Finance (DeFi).
In the coming days we will look at every part of DeFi – the biggest, hottest, most rewarding and riskiest part of the blockchain revolution.
In the end, you will know what DeFi is, how it works, and the risks and benefits of investing in it.
See Part 1: What is DeFi?
See Part 2: What are the top DeFi platforms?
See Part 3: What is a smart contract?
So what is yield farming? Start with that. It earns passive interest on your crypto holdings — generally at rates far higher than you could earn from a savings account.
Then continue with that. It’s risky. As with any other investment, the higher the return, the higher the risk. Bank savings accounts now earn a small fraction of 1% APY (Percentage Annual Return) or APR (Percentage Annual Interest), the difference being that APY allows the earnings to be reinvested for compound interest. Yield farming rewards start at a few percent and can go into the hundreds of percent.
By lending your crypto holdings to a decentralized finance or DeFi project, you can earn far more. But even with ridiculous interest rates, yield farming takes money to make money and lets it sit for long periods of time.
One of the larger DeFi lending projects is Aave with $24.4 billion locked. On December 13, it was offering 2.87% APY on USD Coin and 5.44% on Binance USD – both stablecoins – but only 0.01% APY on Ethereum. But the Curve DAO token offered 12.15%.
For the greater reward, they lend funds to more obscure DeFi projects, with the higher returns coming from the more obscure projects. This means that the potential for hacks, fraud and outright “rug pulls” – the creator of a project running by any means necessary – is significantly higher than established DeFi lending protocols like Curve, Yearn or Aave.
What you are doing?
Let’s take a step back and look at how DeFi projects work. One of the largest forms of DeFi projects are lending protocols. They work like this: Person A locks crypto — typically dollar-pegged stablecoins — in a liquidity pool on a DApp borrowed from Person B, who pays interest. (Yield farming is also called liquidity farming.)
Funds are locked or deployed in smart contracts that control the pools of liquidity that DeFi lending protocols rely on. These are simply pooled funds from which borrowers draw funds. Pool members earn a share of the interest they earn based on how much they have locked up. Pool rules can get complex, so make sure you know what you’re getting yourself into.
Among the many folds is that some projects offer rewards in their own tokens as rewards. This has a number of potential benefits and pitfalls. For one, you are essentially investing in that token and hoping it will go up. It also provides access to tokens which are difficult to buy as they are from a new project and have limited availability. And are therefore very volatile.
In June, billionaire investor and crypto fanatic Mark Cuban tweeted that he lost a fair chunk of money when an obscure DeFi token he owned called Titan crashed, falling from around $60 to almost zero.
Another aspect of the combination of yield farming and crypto volatility is what is known as “impermanent loss”. Staked cryptos can rise and fall in value while locked in a liquidity pool, creating temporary gains or losses – sometimes scary ones – on paper. However, if you withdraw your crypto from a pool at the wrong time, those losses become permanent.
Where yield farming gets really complex — and is best left to investors who have experience and knowledge of how DeFi works — is when you reinvest those reward tokens into other liquidity pools and earn other tokens. Complex investment chains can be set up.
Next: What is staking?
Another big area of DeFi is staking, and it’s the most important in some ways. Most new blockchains run on Proof-of-Stake rather than Bitcoin’s power-hungry Proof-of-Work – even Ethereum is transitioning. Staking is how new tokens are minted (rather than “mining” bitcoins) and how new information is added to those blockchains. But unlike bitcoin mining, anyone can participate and earn rewards through staking.
New PYMNTS study: How consumers are using digital banks
A PYMNTS survey of 2,124 US consumers shows that while two-thirds of consumers have used FinTechs for some aspect of banking services, only 9.3% cite them as their main bank.
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