Yield farming is a relatively new phenomenon in the cryptocurrency and decentralized finance (DeFi) world that allows investors to earn rewards or “returns” on their cryptocurrency holdings by providing liquidity to decentralized exchanges or lending platforms.
But how exactly does yield farming work and what rewards can yield farmers expect as a result of all their hard work? We take a closer look in this article.
yield farming: The TL;DR
Yield farming is a complex but potentially lucrative practice that allows investors to earn rewards for their cryptocurrency holdings by providing liquidity to decentralized exchanges and lending platforms. It can be seen as similar to staking, but with a higher level of complexity.
To participate in yield farming, investors become Liquidity Providers (LPs) by adding funds to liquidity pools. These pools are essentially smart contracts that hold funds and facilitate transactions on the underlying DeFi platform. In exchange for providing liquidity, LPs receive rewards in the form of fees generated by the platform or other sources.
Some liquidity pools offer rewards in the form of multiple tokens, which can then be deposited into other pools for additional rewards. This can create highly complex strategies, but the basic idea is that LPs deposit funds into a pool and receive rewards in return.
Most of the yield farming is currently taking place on the Ethereum blockchain, which holds $28 billion of the $48 billion total value (TVL) of the market. Yield farmers often move their funds between different protocols in search of the cheapest yields, and DeFi platforms can provide additional economic incentives to attract more capital to their platform. Finally, liquidity pools are often viewed as the lifeblood of the continued existence of DeFi platforms like Decentralized Exchanges (DEXes), and as such, incentivizing liquidity contribution is paramount.
How does yield farming work?
Yield farming typically involves LPs and liquidity pools. The LPs deposit funds into a liquidity pool that allows for the liquidity users need to lend, borrow or swap tokens on a DeFi platform. When users transact on the platform, they accrue fees, which are then distributed to LPs based on their contributions to the liquidity pool.
Besides fees, another incentive for LPs to add funds to a liquidity pool could be the distribution of a new token. For example, the terms of purchasing a specific token could include injecting liquidity into a specific liquidity pool. This gives users an additional incentive to bring liquidity to the pool.
Be it through dividends from transaction fees or qualifications to be placed on an allow list to mint an NFT or purchase a token, there are several ways for DeFi platforms to encourage participation in liquidity pools.
Funds deposited into the liquidity pools are often stablecoins pegged to the US dollar, although this is not a general requirement. Some of the most commonly used stablecoins in DeFi are DAI, USDT, USDC, BUSD and others. Some protocols mint tokens representing the LP’s coins deposited into the system. For example, if the LP deposits DAI into Compound, they will receive cDAI or Compound DAI. If the LP deposits ETH into Compound, they also receive cETH.
The most popular trading pairs in the market right now include WBTC/ETH with a TVL of $219.02 billion and DAI/USDC with a TVL of $211.51 billion.
Because yield farming can involve multiple sub-farming practices, LPs can escrow their cDAI in a different protocol that mints a third token to represent their cDAI, which can become increasingly complex as more layers are added to the process become.
Risks related to yield farming
Even though yield farming sounds like a lucrative way to generate passive income, it is still a complex process that requires advanced knowledge and is mostly suitable for users who have a lot of capital to invest. As with all types of financial investments, caution should be exercised before committing to it. In addition to the risk of collateral liquidation, there are several other risks that potential yield farmers should be aware of:
Vulnerabilities in Smart Contracts
A significant risk is the vulnerability of smart contracts, which yield farming protocols often rely heavily on, and which are used to automate and facilitate yield farming. Smart contract exploits have become increasingly common, especially as more smaller DeFi protocols emerge that may not necessarily have access to large amounts of money and thus may not have extensively tested their smart contracts for vulnerabilities.
However, even well-tested protocols can still have vulnerabilities that, due to the immutability of the blockchain, can lead to the loss of user funds and can be a target for experienced hackers and malicious attackers.
Composability Risk
Another major risk associated with yield farming is the concept of composability. DeFi protocols are designed to be composable, meaning they integrate seamlessly with each other. However, this also means that the entire DeFi ecosystem relies heavily on each of its building blocks. If one protocol malfunctions, it can potentially have a domino effect throughout the ecosystem, putting yield farmers and liquidity pools at risk. As DeFi ecosystems become increasingly interdependent, especially as we approach the age of greater multi-chain interoperability, it is important to trust not only the protocol you are depositing your funds into, but also everyone else that you rely on it may be dependent.
liquidity risks
Similar to most DeFi protocols and DEXes in general, yield farming protocols also have liquidity risks. Yield farming is also subject to market risks such as volatility and fluctuations in liquidity, which lead to high slippage rates and can have a significant impact on yield farmers. High slippage occurs when the executed price of a trade deviates significantly from the expected price. This can be due to low overall market liquidity and can result in a significant difference between the expected price of a trade and the actual executed price of the trade.
Close
Yield farming is indeed an innovative and novel hallmark of the DeFi landscape and is steadily growing in popularity as a means of generating passive income. However, users still need to be aware of the risks associated with yield farming such as: B. composability and smart contract risks, and should only engage in yield farming if they have extensive knowledge of DeFi protocols and are well versed in risk management strategies.
Would you like to try your hand at yield farming? BitKeep Wallet’s built-in DApp Explorer provides access to a variety of different DApps that you can try to get a taste of yield farming, such as: B. MakerDAO (for DAI) and Synthetix!
Take the necessary precautions, do extensive research, and good luck!
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