Blockchain
Earn Free Crypto on Your Existing Crypto Holdings: Yield Farming 101
Earn Free Crypto on Your Existing Crypto Holdings: Yield Farming 101
For many crypto investors, knowledge of crypto is limited to crypto trading, but there are many ways to make significant profits alongside trading.
An extended part of the Crypto world is DeFi, which is based on Blockchain technology. DeFi, Decentralized Finance, is an alternative financial system. DeFi supports peer-to-peer financial transactions between users without the interference of an intermediary or a third party. Many financial services are offered on the DeFi platforms with the help of smart contracts. One such part of the DeFi platform is yield farming.
Now you must be wondering what yield farming is. Is it like the game Farmville? Not nearly.
Yield farming and its liquid mining innovation are gaining popularity and have been a phenomenal growth driver for the burgeoning DeFi ecosystem. Yield farming is an investment strategy that allows you to earn interest on your cryptocurrency. In the traditional sense, you earn interest on fiat currencies from your savings account. Crypto can be earned by lending or borrowing your existing cryptocurrency and interest is earned in return for performing the services.
Just like depositing your fiat currencies into a bank account for a period of time to earn interest, just like locking your cryptocurrencies, known as staking, on a cryptocurrency exchange platform for a period of time and earning more cryptocurrency as a reward in return .
Instead of letting your wealth go unused, put it to work and earn extra cryptos as interest. Here’s how to use the crypto even while you HODL. It is an excellent strategy for long-term holders to earn more cryptos based on already held cryptos in their exchange wallets.
Mark Cuban, the Shark Tank star, said that he entered the world of DeFi through yield farming and he sees over 200% annual returns by being a liquidity provider on DeFi exchanges.
But it’s not always profitable for investors. It can be a risky and volatile investment and we’ll discuss why shortly. First, let’s start with what yield farming is.
What is yield farming?
Yield farming involves locking cryptocurrencies into smart contracts, i.e. pools of liquidity, in order to receive rewards in return. Yield farming, also known as liquidity mining, allows farmers to earn rewards from their existing cryptocurrencies.
With the launch of the liquidity mining program, it focused on the governance token “COMP” launched by the lending protocol Compound Finance, which gave COMP token owners voting rights over proposed changes on the platform. The hype surrounding the COMP token has propelled Compound to a top position in the DeFi ecosystem. This led to the growth and mass adoption of yield farming applications and protocols.
In order to get more yield, farmers use different tactics and do not disclose such tactics because the more people know about them, the less effective they become. Yield farmers are constantly moving their cryptos across different marketplaces to take advantage of different opportunities to earn rewards in the DeFi ecosystem, applications, and market.
Since most of the dAapps are based on the Ethereum platform, the rewards earned are in ERC-20 tokens.
Yield farming working mechanism
Yield farming relies heavily on the liquidity provider and liquidity pools (LP) creating a DeFi marketplace for token borrowing, lending and swapping.
Liquidity providers deposit their crypto assets in smart contracts programmed to offer a pool of liquidity. Yield farming is based on the Automated Market Maker (AMM) model.
AMM eliminates the traditional order book that contains all buy/sell options on cryptocurrency exchanges. Liquidity pools are created by AMM using smart contracts and using the predetermined algorithm, the pools execute trades.
DeFi marketplace users pay trading fees for using services available on the marketplace, these fees are shared with liquidity providers according to their contribution to the liquidity pool, and in addition, liquidity providers also receive LP tokens as a reward to stake.
DAI, USDT, USDC, BUSD and others are the most used stablecoins in the DeFi ecosystem.
Income from yield farming
Yield farming returns are typically calculated annually, ie the expected return over a full year.
Returns are calculated as either Annual Percentage Rate (APR) or Percentage Annual Return (APY), where APY accounts for the effect of compounding and APR does not. Compounding means the reinvestment of income from the underlying deposit to generate further profits. The concept of APR and APY comes from traditional financial markets.
Because yield farming is extremely competitive and ever-changing, the rewards are constantly fluctuating. Therefore, these returns are usually projections and not actual returns.
Let’s discuss the different types of yield farming to better understand its mechanism.
Types of yield farming
Understanding the types of yield farming will give us a deep knowledge of yield farming. The core of yield farming is the deposit of cryptocurrency in smart contracts. Types of farming largely depend on the type of smart contract. There are basically two approaches to yield farming, namely liquidity pool farms and staking farms.
Liquidity Pool Farming (LPs)
Liquidity providers, i.e. users who deposit two trading cryptocurrency pairs in the liquidity pool, smart contracts programmed to offer liquidity on decentralized exchanges, or decentralized finance applications. In exchange for depositing LPs, LP tokens are given away by DeFi apps to liquidity providers.
DeFi apps also provide the ability to lock or stake LP tokens generated as a reward.
stake farming
In staking farming, crypto assets are deposited into smart contracts that are programmed to offer a staking pool. Unlike liquidity pools, staking pools only trade a single cryptocurrency asset. It acts as a decentralized vault for a specific asset. Stake farms provide security for crypto assets and allow users to earn crypto more easily.
No LP is earned from staking, just a single passive income.
arbitrage mining
Yield farms that incentivize arbitrage traders, i.e. traders who profit from price differences of the same commodity in different marketplaces.
insurance mining
Yield farms, where users deposit crypto assets into decentralized insurance funds and earn rewards for doing so, are insurance mining farms. Insurance mining farms are considered very risky.
Trading Mining
Trade mining falls in the same vein as arbitrage mining, the only difference being that simple trades are made to earn token rewards.
Let’s get to the concept of Total Value Locked in Yield Farming
What is the total blocked value?
It’s like an index to measure the overall health of the DeFi and yield farming market. Total value locked means how much crypto assets are locked on the DeFi lending marketplace, i.e. how much crypto has been deposited into the liquid or staking pool. It also helps in comparing the market shares of different protocols.
The more value locked in the DeFi lending marketplace, the more yield farming is going on.
Let’s further discuss how safe yield farming is and the risks involved.
Is yield farming safe?
Even if the return generated by yield farming is much higher than that offered by traditional and legacy financial systems. Yield farming is less secure than them. Let’s see why?
- Yield farming smart contracts can have bugs and be vulnerable to hacking.
- Newcomers with little experience and knowledge may suffer losses as it is a complex platform.
- Crypto assets cannot be insured and there is no recourse for mishaps as there is no regulation.
- Users can fall victim to scams when operating with less than legitimate protocols.
Let’s go through a list of risks associated with yield farming.
Risks Associated with Yield Farming
Fraud
There are many ongoing scam projects in the Crypto marketplace, users can accidentally invest in fraudulent or fraudulent protocols and lose all the coins deposited in the pools.
volatility
The crypto space is extremely volatile, there are extreme ups and downs in the market in short periods of time which can cause the price of the tokens to rise or fall drastically while locked in the pool.
Smart Contracts
As the DeFi ecosystem is a nascent space, the smart contracts are not extremely secure as they can be hacked or bugs built into the smart contracts. But with third-party audits, the smart contracts become more secure over time.
carpet pulls
Rug pulls are exit scams where developers collect tokens from investors for a project and then exit the project without returning the tokens or funds to the investors.
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