What Is Yield Farming In DeFi?

The decentralized finance industry has attracted a lot of attention over the past year. Many cryptocurrency enthusiasts are always on the lookout for new money-making opportunities. Yield farming is an essential aspect of this industry, but what does it entail exactly? 

Table of contents

  • The Idea Behind Yield Farming
  • Entering The DeFi Industry
  • Generating Crypto Rewards
  • Cross-Chain Yield Farming Support Is Coming
  • The Total Value Locked (TVL) Concept
  • Yield Farming In Action
  • What Dictates The Returns?
    • Understanding Collateralization
  • Yield Farming Risks
  • Which Yield Farming Opportunities To Explore?
  • Closing Thoughts

The Idea Behind Yield Farming

Similar to traditional finance, it takes money to make money in the cryptocurrency world. Users can explore various options to achieve that goal. Some prefer investing for the long-term and letting value accumulate passively. Others will experiment with decentralized finance to put their assets to work to earn more crypto. Both approaches have their benefits and drawbacks, depending on one’s risk appetite and overall knowledge.

To begin the yield farming process, one must fully understand the consequences. It is a matter of lending your crypto assets to third parties via smart contracts on the blockchain. Users will be eligible to earn fees for providing this lending liquidity. The potential earnings will differ significantly from one DeFi protocol to the next. Moreover, they also depend on which asset you provide as liquidity, as stablecoins – which can’t fluctuate in value – tend to offer lower returns. 

To maximize one’s yield farming opportunities, it is helpful to compare lending marketplaces continually. As competing platforms often adjust their fees and returns on a daily basis, there is no reason not to switch when opportunities arise. Additionally, the more popular specific protocols become, the fewer overall revenue users will generate. Yield farmers aren’t just competing with other users but also against other DeFi protocols. 

Entering The DeFi Industry

The decentralized aspect of DeFi ensures everyone can become a market participant. As long as there is access to an internet connection, a compatible wallet, and the correct crypto assets, yield farming becomes a breeze. Additionally, there are no intermediaries or middlemen involved, creating a trustless environment for all participants. 

The liquidity protocols in the DeFi industry are also decentralized, creating a level playing field. Anyone can earn passive revenue with yield farming. While Ethereum is the most extensive ecosystem for decentralized finance today, competing blockchains gain momentum as well. There are many different opportunities to explore. Carefully evaluating them all is crucial before making any decisions or commitments.

Generating Crypto Rewards

The core concept of yield farming is generating crypto rewards through existing crypto holdings. It may sound simple on paper, yet the concept can still confuse some people. For example, it is insufficient to keep the funds in your own wallet when exploring liquidity mining. Funds must be transferred to a smart contract to accrue rewards. 

To create these rewards, users essentially contribute their funds to existing liquidity pools. This pool is a smart contract capable of holding funds. In exchange for liquidity, users will be rewarded through fees, native protocol tokens, or both. All revenue comes from fees generated by the DeFi platform itself  or other sources.

Should the protocol issue its native token as a reward, users have an exciting option at their disposal. The majority of DeFi platforms support a growing variety of assets. It is possible to “leverage” earned tokens through other pools and compound the overall rewards. Users can determine how simple or complex they want to make their yield farming strategies. 

Cross-Chain Yield Farming Support Is Coming

For the most part, DeFi efforts remain limited to one particular blockchain. Ethereum is the top ecosystem, but competitors are not resting on their laurels. Unfortunately, it can be challenging to access cross-blockchain assets or protocols with the current technology. 

That being said, there are solutions in the works. Cross-chain brides and interoperable blockchains will become more outspoken in the decentralized finance world. The purpose of this industry is to provide competitive and compelling solutions capable of rewarding and empowering users. Achieving a level of blockchain-agnosticism is mandatory but may take some time to achieve.

The Total Value Locked (TVL) Concept

For those who explore the DeFi industry, one metric will become apparent quickly. Their Total Value Locked or TVL often ranks platforms and protocols. It is an intriguing metric that can help gauge the popularity of service providers. As all funds for DeFi protocols reside in smart contracts, figuring out the balances is not difficult.

If a project has a high TVL, it often benefits from a higher “trust” rating among users. No one would pour billions of dollars into a smart contract they can’t trust, after all. However, if certain protocols have a much higher TVl than competitors, users will earn less revenue due to too much internal competition. The Total Value Locked is always a trade-off between potential earnings and trust in a platform.

Various websites and data aggregators will depict the current TVL. For Ethereum users, DeFi Pulse has all of the relevant information. It does not keep track of all individual protocols at this time, yet projects are added regularly. It is also essential to compare the TVL in different currencies. A platform may maintain its USD value but have fewer ETH after a recent price increase for Ether. Comparing the metric in different currencies can help determine the overall growth – or decline – in popularity for certain protocols.

Yield Farming In Action

Now that everyone has a basic concept of DeFi and yield farming, it is time to dig a bit deeper. Yield farming, or liquidity mining, requires users to deposit funds into a liquidity pool. The pool – represented by a smart contract – will let users lend, borrow, or exchange digital assets. Every time a transaction occurs via the contract, the protocol will charge a fee. Those fees are returned to liquidity providers based on their pool share. 

As mentioned earlier, it is possible liquidity providers also earn native protocol tokens. Not every Defi platform does so, but it is an extra passive revenue source. With or without tokens, all liquidity providers will accrue platform fees over time. How high those fees are depends on how the platform is developed. No one will get rich overnight from providing liquidity, however, but the fees can add up nicely over a year.

Most DeFi protocols will support a wide array of digital assets. Stablecoins are the most popular, as their values do not fluctuate. Commonly used stablecoins include DAI, USDT, USDC, and others. For those who prefer a bit more risk, Ethereum and other ERC-20 tokens can prove lucrative as well. They will often provide higher fees but are more subjective to price fluctuations.

What Dictates The Returns?

As every DeFi platform has a different yield rate, it is crucial to understand why these differences exist. Every platform or project has its own complex smart contracts to help determine the returns. Moreover, the figures you may see on a website are annualized and should not be interpreted as daily or weekly rewards.

Metrics to look out for include APR (Annual Percentage Rate) And APY (Annual Percentage Yield). These may seem similar at first, yet are different under the surface. The APR doesn’t consider compounding as a potential factor, whereas the APY does. It is often worth compounding one’s earnings into more liquidity for yield farming to achieve better returns. 

Furthermore, the rates one may see on a DeFi project’s websites are estimates. Results can vary greatly, as these rates can fluctuate significantly. Yield farming is very competitive, and there is tremendous liquidity to contend with. Certain high-APY or high-APR projects will attract more users, reducing the overall returns for everyone involved.

Whether there will ever be more manageable metrics for returns remains unclear. Using hourly, daily, or even weekly rates would make more sense in this ever-changing landscape. 

Understanding Collateralization

Although anyone can enter the world of DeFi and yield farming, certain aspects cannot be overlooked. Collateralization, for example, is crucial when borrowing assets. Depending on the protocol being used, users may supply funds to borrowers. In such a scenario, they need to keep a close eye on the collateralization ratio to avoid liquidation.

The rules for collateral will vary from one platform to the next. Most protocols have their own collateralization ratio to maintain at all times.  Moreover, there is often a concept of “over-collateralization”, making borrowers deposit more funds than they want to borrow. This latter approach can negate market volatility and prevent collateral liquidation.

Speaking of over-collateralization, it is not uncommon to see high rates. Some platforms will force users to maintain a ratio of 200%. Others, however, can have requirements as high as 750%. Always review the platform or protocol carefully before making any commitments. 

Yield Farming Risks

Making money is always a risky endeavor, regardless of how one wants to look at things. Yield farming is not different in this regard, as there are certain risks to contend with. It is a very complex procedure for those who are new to cryptocurrencies. Exploring the most prominent and profitable yield farms can be daunting and requires ample knowledge. 

At its core, yield farming is intended to let everyone participate. However, the system also favors those who can bring the most liquidity to the table. Small crypto hodlers will always compete with whales and wealthy individuals. Having more capital at one’s disposal will always lead to more considerable riches if you play your cards right. 

A second risk is the smart contracts powering DeFi protocols. These contracts consist of code written by developers. Bugs and exploits may be present, potentially costing users millions of dollars in stolen funds. The majority of Defi protocols are run by small teams of developers with little or no budget for security audits. However, an audit is never a guarantee for a bug-free contract as new vulnerabilities pop up regularly.

The composability aspect of yield farming also poses a risk. The permissionless nature of DeFi protocols allows for cross-integration yet also creates a weaker foundation. These protocols all rely on one another to survive, which can pose risks. If one of the blocks fails, the entire ecosystem can suffer. 

Which Yield Farming Opportunities To Explore?

The benefits of yield farming may be apparent, yet finding the right protocol to suit your needs is never easy. Numerous options exist, all of which have their benefits and drawbacks. Whether it is a decentralized credit platform, synthetic assets, lending and borrowing, a decentralized exchange, or liquidity protocols, there are many potential options to explore. 

In theory, there is no right or wrong approach. It all comes down to personal preference and risk appetite. Liquidity mining with crypto-assets or stablecoins is very different and incurs various risk factors. Weighing the risks and benefits is an absolute necessity before contributing your digital assets to any protocol. 

Closing Thoughts

The yield farming industry provides numerous money-making opportunities. Although it has a steep learning curve and primarily caters to advanced cryptocurrency users, it remains worthwhile to explore. Similar to other investment opportunities, it is best to look beyond the projected returns and determine if the protocol has any long-term plan or use. 

Many people see yield farming as a get-rich-quick scheme, making them take unnecessary risks. Ignoring the potential drawbacks of these protocols and how they manage funds is a recipe for disaster. Trustless protocols are only as strong as the code written by human developers. Over time, these creations will grow more complex, versatile, and robust. Until then, it is best not to take too many risks in search of quick riches. 

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