If you are looking to increase your returns on your cryptocurrency investments, you may be interested in yield farming. Yield farming is the process of using decentralized finance (DeFi) protocols to generate additional revenue from your crypto holdings.
This article covers what yield farming is, how it works, and the benefits and risks of using yield farming to increase your cryptocurrency returns.
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yield farming
When people talk about yield farming, they discuss it in terms of Annual Percentage Yield (APY). This often invites comparison to the interest rate you could earn on a savings account at a bank. And while bank rates are extremely low, in some cases yield farming can yield triple-digit APYs (although those returns come with significant risks and are unlikely to last long).
There are several ways to generate income from your crypto holdings. One option is to place your tokens on a blockchain. Blockchains that use a proof-of-stake system — like Solana (CRYPTO:SOL), Cardano (CRYPTO:ADA), and Polkadot (CRYPTO:DOT) — reward stakeholders for confirming transactions on the blockchain. Ethereum (CRYPTO:ETH) is also moving towards a proof-of-stake system with Ethereum 2.0 and will offer rewards to those who stake its ether cryptocurrency.
The Proof-of-Stake system is an alternative to the energy-intensive Proof-of-Work system that rewards cryptocurrency miners.
The second way is to use a credit protocol to become a lender. Borrowers can use lending protocols — like Compound (CRYPTO:COMP) or Aave (CRYPTO:AAVE) — to borrow against their crypto assets. The interest is made available to the people who deposit capital. So if you are a depositor, you earn interest from borrowers.
The last way we will discuss is to become a liquidity provider for a decentralized exchange – like Uniswap (CRYPTO:UNI) or Pancakeswap (CRYPTO:CAKE). Providing a pair of crypto tokens in equal amounts on a decentralized exchange allows it to run swaps for investors looking to exchange one cryptocurrency for another. In return, as a liquidity provider, you earn a portion of the fees charged by the exchange.
This is how yield farming with staking works
If you believe in the long-term potential of a blockchain project using the Proof-of-Stake system, you may be interested in buying the native token and staking it for additional rewards.
Cryptocurrency staking works by pledging your tokens to a blockchain protocol like Solana. The protocol then selects a person from those stakes to confirm the next block in the blockchain. The more you bet, the more likely you are to be selected. The selected person will receive a reward for confirming the ban.
In practice, the easiest way to start earning staking rewards is by staking through your exchange like Coinbase (NASDAQ:COIN). The exchange takes care of all the technical details and adds any rewards you earn to your balance.
How yield farming with lending works
If you decide to put your crypto assets on a lending protocol, you can earn even higher returns. Several lending protocols have emerged, offering crypto holders the opportunity to access the value of their cryptocurrency holdings without having to liquidate their assets and pay taxes. They do this by offering over-collateralised loans. So, to get a loan for $100 worth of crypto, a borrower might need to post $200 worth of collateral.
When you become a lender under one of these protocols, you receive the interest that borrowers pay for your assets. The interest rate is determined by supply and demand and can vary from minute to minute. Some protocols will work to stabilize interest rates for lenders seeking more consistent returns.
Yield farming as a lender requires you to use a DeFi protocol like Compound or Aave. If you want to lend, exchange the tokens you want to lend for their corresponding tokens. The exchange rate of these tokens is constantly improving as loans collect interest from borrowers. If you exchange your tokens back into your original cryptocurrency, you will receive more than what you originally exchanged.
Here is a simplified example: If you deposit $100 worth of Compound 100 DAI (CRYPTO:DAI), you will receive $100 worth of cDAI in return. Let’s say the exchange rate was 1:1 when you made your deposit. If the interest rate on DAI is 10% and stays there for one year, the DAI to cDAI exchange rate after one year is 1.1:1. If you remove your DAI from the log, you will get back 110 DAI worth $110.
This is how yield farming with liquidity pools works
Another way to generate additional income from your crypto assets is to become a liquidity provider for a decentralized exchange. For example, if someone goes to Uniswap to exchange their Ether for DAI, Uniswap will take some DAI from the liquidity pool and add the Ether that the user exchanges. This allows Uniswap to offer exchanges for just about any cryptocurrency pair you can think of without having to hold cryptocurrencies yourself.
Uniswap pays out the fee charged by exchanges to liquidity providers. The amount each provider receives is proportional to their share of the protocol’s total liquidity pool.
For example, let’s say you provide $100 Ether and $100 DAI ($200 total) to the liquidity pool, which has a total value of $20,000. Your share of the pool is 1%. If the fees charged for the day when exchanging between Ether and DAI are $100, you will earn $1.
Note that your trading pair’s percentage may shift over time, especially for more volatile cryptocurrencies. This can lead to inconsistent losses, ie a reduction in the value of your holdings compared to if you had simply kept your cryptocurrency out of the liquidity pool.
Why is yield farming popular?
As interest rates on traditional bank savings accounts remain extremely low, yield farming offers a way for those participating in the decentralized finance ecosystem to earn better returns from their holdings. Additionally, the use of yield farming techniques also strengthens many of the systems used in cryptocurrency and DeFi by enhancing the blockchain, increasing liquidity through lending, and ensuring decentralized exchanges can efficiently conduct currency swaps.
Benefits of yield farming
The advantages of yield farming are obvious. If you are already planning to hold a cryptocurrency for the long term, you can also try to increase the returns you can get from those holdings. Staking and lending offer a low-risk way to earn additional returns earned in the same cryptocurrency you already own. Participating in a liquidity pool can bring even higher returns, but it comes with more risk.
As mentioned above, participating in yield farming activities also supports the entire crypto ecosystem.
Yield Farming Risks
There are some risks to be aware of when it comes to yield farming.
Temporary loss as a liquidity provider is a key concept to understand. If the price of one part of the pair moves significantly relative to the other part, you will face a temporary loss. This occurs when the proportion of assets in a liquidity pool must be shifted by market demand and you receive less value from the pool than you would have if you had not pledged the assets in the first place.
Another risk to be aware of is the possibility that lending rates may change. Because interest rates are determined based on supply and demand, a sudden increase in the supply for an asset can result in a sharp drop in the interest you, the lender, receive.
And as always, there is a risk in holding cryptocurrencies as their price is generally more volatile than other asset classes.
Is yield farming safe?
While yield farming can be viewed as an alternative to holding cash in a savings account, it is far less secure. Here are some reasons why:
- Your assets are not insured. Banks in the United States include federal deposit insurance of up to $250,000 per account.
- The smart contracts used in yield farming could be prone to bugs or hacked by bad actors.
- If you use a less reputable protocol, you could become a victim of scams or scams without having any recourse due to the minimal regulation in the industry.
Yield farming is safe enough, but if you stick with reputable vendors and understand what you’re getting into, you should be able to manage the risks appropriately.
Is yield farming for you?
If you’re a long-term buy-and-hold crypto investor, you should look into yield farming. You can minimize your risks by simply staking or enter the world of DeFi by participating in lending or liquidity pools. There are many options to explore and it is possible that you can benefit greatly from them by increasing the returns on your crypto holdings.
Adam Levy has positions on Ethereum. The Motley Fool has positions in and recommends Aave, Coinbase Global, Inc., Compound, Ethereum, and Solana. The Motley Fool has a disclosure policy.
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