DeFi is a word that, unless you’ve been living under a rock for the past few years, you would’ve heard thrown around a lot. The DeFi, or Decentralized Finance movement, has taken the blockchain space by storm for one primary reason: DeFi applications are permissionless. This means anyone from any corner of the world with a decent internet connection can join in the fun and liberation of their money. For a more thorough understanding, check out this detailed guide to DeFi we published earlier.
Yield farming is one of the newer buzz-phrases in the DeFi world. It’s essentially a way to generate more returns with your existing crypto. The process involves lending out your assets, and you earn rewards in the form of cryptocurrency too. Since anyone on the DeFi network is technically welcome to try and earn passive income through yield farming, it holds the potential to revolutionize the way cryptocurrency traders operate now- by ‘HODL’ing assets instead of putting them to use.
The basic concept of yield farming might sound simple enough, but it’s honestly not. Let’s get into a little more detail and find out why that is, shall we?
What Is Yield Farming?
Yield farming is occasionally referred to as liquidity mining. In yield farming, a group of users called the liquidity providers (LPs) take center stage. These are the people putting their own crypto assets into liquidity pools and generating yields.
And what’s a liquidity pool?
Well, they are essentially smart contracts on a DeFi exchange platform, coded to hold funds. When an LP adds their fund to one of the said smart contracts, the program makes sure they earn rewards in return – usually as a portion of the trading fees the trading platform generates.
Yield farming is a concept that has been around for a while now, but the sudden hype is at least partially caused by the launch of the COMP token – the governance token of the Compound Finance exchange. Governance tokens allow holders to vote in the governance decisions of a particular exchange platform.
While Compound didn’t come up with the concept of yield farming, the team certainly did successfully utilize the token distribution protocol and gave its popularity the boost it needed. Compound brought forth a functional decentralized blockchain system by distributing their COMP tokens with liquidity incentives – presenting LPs with an opportunity to earn rewards by adding liquidity to the various pools and ‘farming’ COMP. Since then, quite a few other DeFi networks have worked out nuanced yield farming protocols with varied economic incentives to attract liquidity providers.
So, How Does Yield farming Work?
To start off, liquidity providers add their funds to a liquidity pool of their choice. These liquidity pools act as marketplaces where users can borrow, lend out, and exchange crypto coins. This is advantageous for the LPs since they get a fraction of the trading fees the exchange platforms earn according to their pools’ share.
However, there’s another inducement to fund a liquidity pool: the acquisition of a new token that cannot otherwise be bought in the open market. While the token distribution rules may vary with the exchange platforms, the basic idea is always the same – LPs will enjoy yields proportionate to the volume of the liquidity provided.
Since most DeFi platforms are currently running on the Ethereum blockchain, yield farming is commonly done using ERC-20 tokens. The funds deposited are mostly Ethereum-based stablecoins – USDC, USDT, and DAI being some of the regular ones. Some exchanges would even give you minted tokens that represent your deposited crypto in return. For instance, if you deposit USDC into a Yearn.Finance pool, you’d get USDC in return. Some liquidity pools even pass on rewards in the form of several tokens, that can, in turn, be deposited to other pools, and the chain goes on.
However, this also brings a lot of mind-boggling complexity into the yield farming system. You could invest your yUSDC into another liquidity pool and get a third token that symbolizes yUSDC, which symbolizes USDC, and so forth. Difficult to keep track of, right?
At the basic level, yield farmers move their assets around between different liquidity pools, chasing whichever one provides the best-anticipated interest. This brings us to our next question: how do these people figure out the amount of interest they will gain?
Yield Farming Returns: How Exactly Are They Calculated?
Approximate yields are usually computed through an annualized method that predicts the number of returns one could get over a year. Two of the most used methods are
A. Annual Percentage Rate (APR), and
B. Annual Percentage Yield.
The primary difference between these two methods is that with APY, the effect of compounding- reinvesting the earned interests for more returns- is counted in, while with APR, it’s not considered.
However, it’s important to remember that these methods produce only predictions, not guarantees of good returns. Yield farming is a quite volatile and competitive space; therefore, the estimations always stand to be proven wrong.
Got It! Is Yield Farming Safe, Though?
To put it simply, just like the rest of the DeFi world, yield farming is still in the development stage. You should be fully aware of all the risks before investing.
For starters, there’s the threat of capital losses. Investing your money in a smart contract means going through a completely virtual transaction without a centralized authority. Although unlikely, but if there’s ever any glitches in the smart contracts or any hacking attempts, your personal information can get leaked, and you stand to lose your capital. Plus, most yield farming strategies are highly tricky, and only seasoned crypto traders are counseled to try them out.
When you borrow assets, there’s the collateral you need to provide that acts as insurance. If your portfolio’s value ever falls below a particular exchange’s requirements, the collateral risks being liquidated.
The volatility in the prices of cryptocurrencies can also affect the yearly returns since the chances of a particular token’s price falling are ever-present.
Yield Farming Platforms
Now that you have a notion of the basic concepts of yield farming and the risks, the next logical step is to research some popular exchange platforms to try your hand at yield farming. To help you out, we’ve compiled a list of some exchanges yield farmers have been hyping up. Do keep in mind though this is by no means a comprehensive list.
- Compound Finance: The protocol that brought yield farming to the mainstream, Compound is an algorithmic protocol that allows any user with an Ethereum wallet to serve as a liquidity provider and earn rewards that, as per the platform’s objectives, start compounding right away.
- Yearn.Finance: One of the core players in the DeFi market, Yearn.Finance has taken yield farming one step further by providing users with the opportunity to easily automate the farming of the maximum yields while also saving up on transaction expenses. The goal of Yearn.Finance is to optimize token distribution by algorithmically seeking out the liquidity pools with the highest returns.
- Curve.Finance: Curve.Finance is a platform meant for stablecoin swaps at low transaction costs. Since stablecoins play a big role in yield farming, Curve.Finance is one of the better known DeFi exchanges.
- MakerDAO: MakerDAO is best known as the platform that mints DAI, one of the most used stablecoins in yield farming. Yield farmers regularly use MakerDAO to generate DAI for farming strategies.
What the future of yield farming might hold is anybody’s guess at this point. But one thing is for sure – yield farmers will keep looking for fresh opportunities and bringing innovation to the farming strategies. And keeping pace with the demands, DeFi protocols will evolve right alongside. It’ll come up with newer financial incentives to attract more capital to their respective platforms.Disclaimer: Cryptocurrency is not a legal tender and is currently unregulated. Kindly ensure that you undertake sufficient risk assessment when trading cryptocurrencies as they are often subject to high price volatility. The information provided in this section doesn't represent any investment advice or WazirX's official position. WazirX reserves the right in its sole discretion to amend or change this blog post at any time and for any reasons without prior notice.