The arrival of decentralized finance (DeFi) has created many investment opportunities. Developers create many products that investors can use to earn decent passive income. One of such products is yield farming. However, what is yield farming, and how does it work? This article will answer all these questions.
What is Yield Farming?
We will refresh our minds on how conventional banks work before defining yield farming. One way of generating income with a bank is depositing your funds in a plan that earns interest. In this case, you lend the bank your money, and they reward you in interest.
Often, the bank can use the funds to power other banking activities such as withdrawals. The bank will charge users a fee for those services. The bank will then use the profit to pay the interest for the deposits and retain the surplus. From an investor’s perspective, the whole process involves using funds to support banking activities and, in return, to earn more money.
Now, yield farming follows the same principle since it involves investing funds to earn more money. However, some critical differences exist between yield farms and banks deposit accounts.
First, banks are centralized. Therefore, bank management determines and executes the interests and other terms of the contract. On the other hand, yield farms are decentralized since they operate on decentralized finance (DeFi) ecosystem. As a result, the smart contract determines and executes the terms of the contract. Second, banks deal with fiat currency. Therefore, you deposit your money in fiat and earn interest in traditional currency. On the other hand, yield farms deal with cryptocurrencies.
In brief, yield farming involves lending cryptocurrency to a DeFi platform to earn interest. It draws analogies to farming since it involves users growing their own cryptocurrency. The interest could be fixed or variable and is measured in annual percentage yield (APY).
How Does Yield Farming Work?
DeFi platforms offering yield farming lock up yield farmers’ funds into liquidity pools. These pools are essentially smart contracts for holding funds.
The funds in liquidity pools provide liquidity to DeFi protocols, thus facilitating trading lending and borrowing. The platform earns fees for providing liquidity. It then pays out the investors (yield farmers) according to their share of the liquidity pool.
Liquidity pools are essential for automatic market makers (AMM). AMMs are an alternative to the traditional system of buyers and sellers. They use liquidity pools to offer trustless and automated trading. The investors lending their funds are sometimes called liquidity providers. The platform issues liquidity provider (LP) tokens to track their contributions to the liquidity pool.
For example, if you want to exchange Ethereum (ETH) for Uniswap token (UNI), you pay a fee. The platform will use the fee to pay the liquidity providers according to their contribution to the pool. The more funds an investor contributes to the pool, the more rewards they receive.
APY and APR
Annual percentage yield (APY) is the most popular metric for investors’ interest. However, some protocols use the annual percentage rate (APR) metric. They main difference between these two metrics lies in the type of interest. APY considers compound interest, which involves reinvesting the user’s interest to generate more income. On the other hand, APR considers simple interest. Therefore, neither the income rate nor the principal increases.
Total Value Locked
Total value locked (TLV) is the total amount of assets locked in the DeFi lending protocol. However, it does not measure the number of outstanding loans but rather the total amount of the underlying assets. TLV helps in assessing the overall condition of a yield farming protocol. A protocol with high TV is more liquid hence healthier.
Pros and Cons of Yield Farming
Like any other investment strategy, yield farming has both advantages and disadvantages. Below we will present both the pros and cons of Yield Farming.
- Yield farming enables effortless earning. You can earn crypto by simply locking your funds into the autonomous staking pools. The model differs from crypto trading that demands your continuous analysis of the market moves.
- Yield farms offer highly attractive returns on investments. Some projects provide up to 100% APY. Such returns are much higher than traditional investments such as real estate, bonds, and stocks.
- Some firms pay out the interest in governance coin. Such users can participate in proposing and voting on the governance policies of the protocol.
- First, there is volatility risk. Crypto assets are highly volatile, meaning the value of your assets can drop significantly within a short time.
- Another major problem is fraudulent activities. Some projects are malicious and may steal all the users’ funds. For example, rug pools are common in the DeFi industry. Such malicious schemes lure investors into putting their money in a project, which they abandon after receiving funds.
- Smart contracts may also contain bugs that can significantly affect the running of the protocol. Additionally, these contracts are targets of hackers.
- There are also regulatory risks. Some local and international authorities still hold stringent regulations against crypto activities.
What to Consider in a Yield Farming Platform
First, assess the reputation of the platform you want to use. It is risky to deposit your funds in any platform you come across. Reputable platforms often have many users and good online reviews.
Second, compare the interest rates different platforms offer. You should prefer projects which provide the best reasonable interest. However, do not overlook security in pursuit of high interest.
Finally, consider the ease of use of the platform you want to invest with. Any platform is only as good as you can use it.