Yield farming for beginners: A lucrative opportunity in DeFi | by Ben Baiju | coin monks | July 2023

DeFi or Decentralized Finance has revolutionized the financial industry. DeFi is one of the most important uses of crypto. And in DeFi, yield farming is one of the main methods that we can use to make money or passive income. In this article I will explain what yield farming is, the risks involved and give an example of how it works.

Photo by Shubham Dhage on Unsplash

Understand yield farming

Yield farming, also known as liquidity mining, is a DeFi practice that involves providing liquidity to decentralized platforms in exchange for rewards. By becoming a Liquidity Provider (LP), you are listing your cryptocurrencies in liquidity pools that enable various DeFi services such as: B. decentralized exchanges or credit platforms. And when you provide your cryptocurrencies to the exchange, the exchange pays out rewards.

The mechanisms of liquidity pools

Liquidity pools are smart contracts that hold funds provided by Liquidity Providers (LP). These pools allow users to trade or borrow assets seamlessly without the need for traditional intermediaries. As an LP, you add your crypto holdings to the pool and receive LP tokens that represent your share of the pool’s total liquidity.

earn rewards

The rewards you earn as an LP will vary depending on the platform and its native token. The most common method is to earn trading fees or interest generated by the DeFi protocol. Additionally, some platforms offer governance tokens as rewards, allowing LPs to have a say in the platform’s decision-making process.

Risks and Temporary Loss

Yield farming can be profitable, but it comes with certain risks. Significant risk is a temporary loss that occurs when the value of your deposited assets fluctuates significantly compared to when you first provided liquidity. While a temporary loss is temporary in nature and can be offset by rewards, it’s important to thoroughly understand this concept.

examples

Example of yield farming in the normal case:

In a normal yield farming scenario, let’s say you provide liquidity to a decentralized exchange (DEX) by depositing the equal value of two tokens, token A and token B. In return, you receive Liquidity Provider Tokens (LP), which represent your share of the liquidity pool. When traders switch between token A and token B on the DEX, they earn part of the trading fees in the form of additional tokens. This process allows you to earn rewards in the form of both the tokens you provide and trading fees.

Example of yield farming with evanescent loss:

Now let’s consider a situation where you provide liquidity to a DEX, but the price of the tokens you have deposited changes significantly during your time in the liquidity pool. Suppose you deposited 1 token A and 1 token B, even though both were worth $100 each. Over time, Token A’s price increases to $150 while Token B’s price decreases to $50.

If you decide to withdraw your liquidity at this point, you will receive more Token A and fewer Token B compared to what you originally provided. The increase in the value of Token A offsets the decrease in the value of Token B , but you will suffer a temporary loss, meaning your total value will be less than if you simply kept the tokens in your wallet.

This temporary loss arises because the value of your LP tokens will fluctuate as the price of the tokens changes and may not match the value of the tokens you initially deployed.

Diploma

Yield farming is one of the most lucrative options on the blockchain if used properly. It is important to note that this strategy may involve risks, and it is important to learn more about the strategies and risks before committing to it.

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