Introduction
In our previous blogs, you have already come to know about the basics of yield farming. In this blog, we shall take a deeper dive into this topic and discuss some other important factors related to it.
What Is Yield Farming?
Yield farming is the practice done by cryptocurrency owners to generate more cryptocurrencies by using their existing funds to lend or stake at the desired exchange to get the highest return possible. It is much more complex than it sounds.
These returns can be calculated using metrics like APR (Annual Percentage Rate) and APY (Annual Percentage Yield).
We have already discussed other metrics like TVL in our previous blog. Let us now study APR and APY values.
Difference Between APR And APY
Annual Percentage Rate or APR is the rate of interest that is generated by an amount of money over 1 year which is charged from the borrowers of the amount or earned by the investor of that amount. It should be noted that the APR does not take compounding the interest into account.
Annual Percentage Yield or APY is the actual rate of return of a particular investment over a period of 1 year as it takes the compounding of the interest into account. Hence it calculates the rate of return of a particular investment more accurately.
As APY takes the compounding interest into account, it is higher than APR. High-interest rates and shorter compounding periods result in a greater difference between the APR and APY values.
Methods Of Yield Farming
Providing Liquidity to Dexes
As the name suggests, liquidity providers provide liquidity to a decentralized exchange platform.
Investors can invest their cryptocurrency assets to a liquidity pool of any dexes and earn returns. The decentralized exchange charges a fee for every transaction that is taking place in its platform and uses that fee to incentivize the investors depending on their share in the liquidity pool of that protocol. Uniswap and PancakeSwap are examples of such dexes.
Lending and Borrowing
Lending and borrowing platforms like Compound and AAVE reward their lenders with high APR values hence making it a much better option to invest in than any other options in the traditional finance system. You can generate high returns by just lending your cryptocurrencies to such exchanges if you keep yourself updated with its APR values.
By locking your cryptocurrency in such exchanges you can still enjoy the value of your assets without having to cash out your crypto. If the value of the crypto you locked as collateral rises in price, you automatically profit. This also is a method of yield farming.
Another method that can be used in lending and borrowing platforms is called leveraged lending where you reinvest your loan back into the pool to get a higher APY and hence increase your returns quickly. However, there are various risks associated with this method of yield farming.
Staking
Staking is the method of “locking” your cryptocurrencies in the smart contract of a particular DeFi protocol to earn more of that same token at the end of a particular period of time.
By staking, you become a validator of that network. Any Proof-Of-Stake network relies on such validators to ensure the security of their network and hence incentivizes anyone who does that.
As setting up a staking node can be complicated, users can just use platforms like Coinbase to stake their tokens without having to go through the hassle and still earn rewards.
The Benefits of Yield Farming
The returns that yield farming gives its practitioners for their cryptocurrencies far exceeds anything from the traditional trade finance system be it banks, bonds, or stocks. These returns can further be increased through processes like liquidity mining. This is thus a very viable option rather than keeping one’s funds in a savings bank account.
Participants can somewhat overcome the risks of liquidation by investing large sums of cryptocurrencies into their desired protocols.
Apart from these benefits, the user interface of most yield farming tools is very user-friendly and does not require any prior technical knowledge. They have a very low learning curve as the tools of the trade do most of the complex calculations involved.
New and innovative methods are being developed and initiated regularly to make this market stable and guarantee a continuous flow of funds in the future.
All these factors make yield farming a great source of passive income for people having some idle funds lying around.
The Risks Of Yield Farming
The high returns in yield farming attract many farmers to invest their assets. However, yield farming is considered a high reward, high-risk game, and the farmers risk losing their entire investments in a matter of days if not hours.
Impermanent loss is a risk faced by traders when investing in a liquidity pool. It occurs when the value of your asset at the time of your deposit decreases from the value of your assets at the time of withdrawing them from the pool. We have already published a detailed blog explaining the impermanent loss.
High gas fees in Ethereum and other blockchains have caused problems for an average farmer to invest in small amounts of cryptocurrencies. On such blockchains, an investment of $1000 can be considered as the minimum amount required to earn profits.
Imperfections and bugs in the smart contracts of a DeFi protocol can result in hacks leading to severe financial losses.
An increase in the popularity of DeFi protocols has also increased the number of scam projects who promise a very high APY. “Rug pulling” is a (mal)practice where the developers of a DeFi protocol withdraw all the funds from their liquidity pools and escape without a trace.
Since any blockchain is immutable in nature, any financial loss is permanent and can not be recovered whatsoever.
Conclusion
The yield farming market is constantly evolving to overcome its limitations. Farmers need to do thorough research before investing their funds in any DeFi protocol to minimize the risks of loss. It sure will be interesting to see how this market changes in this coming year.
