Due to the sheer creativity and flexibility it brings to conventional finance, Decentralized Finance (DeFi) has taken the world by storm. Yield farming is one of the more interesting features of DeFi.
What is yield farming?
Staking or locking up cryptocurrencies in exchange for incentives is known as yield farming. By investing crypto in a DeFi market, users can gain either fixed or variable interest. The concept is to place money in a liquidity pool – a series of smart contracts that hold money. The liquidity pools are the backbone of the marketplace, which allows users to trade, borrow, and lend tokens. You've legally become a liquidity provider if you've applied your funds to a pool.
When developers started offering users a small share of transaction fees in return for contributing liquidity to a specific app, such as Uniswap or Balancer, the concept of farming was born. However, Compound is the most well-known example of yield farming, as they gave COMP tokens to their lenders and borrowers in return for using their protocol. It was an immediate hit, and at one point, Compound was the world's largest DeFi project.
Defi yield farming: how it works?
1. Standard AMM model
The automated market maker (AMM) model, which includes liquidity providers (LPs) and liquidity pools, is closely related to the yield farming model. An AMM functions like this at its core:
A liquidity pool is formed when a liquidity provider deposits funds.
The pool serves as the backbone of a marketplace where users can lend, borrow, and exchange tokens.
The customer collects payments by using the pools, which are then paid to the liquidity providers.
While this is the basic principle, how it is applied varies from project to project. The total fees are charged to the LPs in exchange for their services.
2. Liquidity Mining
The distribution of a new token or liquidity mining is another fascinating phenomenon that financially incentivizes LPs. Let's assume there's a token called X that's hard to come by on the open market. The LP, on the other hand, may be rewarded with X tokens for providing liquidity to a particular pool. This will encourage LPs to deposit their tokens in a tank.
The protocol determines the rules that govern how these tokens are distributed. The basic principle is that they are paid for the amount of liquidity they provide to the pool.
The majority of the funds in the pools are stablecoins such as DAI, USDT, USDC, BUSD, and others. Some protocols will create tokens that reflect the coins you've put into their scheme. When you lick up DAI in Compound, for example, you get cDAI.
Defi yield farming: calculating returns
In most cases, yield farming returns are determined on an annualized basis. Annual Percentage Rate (APR) and Annual Percentage Yield (APY) are the most common metrics used to calculate these returns (APY). Compounded returns, or gains that are directly reinvested to generate further returns, are popular with APY. Bear in mind, though, that all of these APR and APY figures are just estimates. DeFi is a strange world, and yield farming in particular is a fiercely competitive industry. As a result, incentives can change frequently.
Defi yield farming: the advantages
The key benefit of yield farming is that it provides consumers with a profit opportunity. Early adopters will reap the benefits of an up-and-coming project's token rewards. Choosing the right project to farm on will result in substantial profits.
To earn yield, users can use a variety of DeFi protocols. Different protocols come with varying costs and benefits. A well-informed consumer will switch between these channels deftly to maximize their gains.
Allows farmers to continue farming and reinvesting their profits in order to continue earning incentives.
Since a large number of tokens are locked up as stakes, the total token velocity is greatly reduced.
Defi yield farming: the disadvantages
Yield farming is a difficult method that is not ideal for beginners. It necessitates a thorough understanding of advanced tactics and techniques.
Only if you already have a significant amount of stake locked up will you farm a significant amount of tokens. As a result, whales, or at least those with large crypto holdings, will benefit more from this strategy.
The DeFi industry is moving at a breakneck pace. While this pace of innovation is remarkable, it also results in defective contracts that a hacker could easily manipulate.
The Ethereum blockchain is currently used for the majority of DeFi applications. Scalability is still a work in progress for Ethereum. As a result, the underlying protocol can not be stable or fast enough to support sophisticated DeFi apps.
The extremely volatile nature of DeFi exposes yield farmers to major liquidation risks because many tokens are locked up.
Conclusion
DeFi farming is one of the most exciting aspects of DeFi and crypto in general, as it has resulted in rapid adoption. The DeFi market is now worth $40 billion. The primary cause of this exponential increase is yield farming. Although it comes with its own set of risks, the advantages it brings can be very appealing.
DeFi is definitely the future of financial services ! DeFi has also came to Bitcoin Cash. It's called DeToken, cool platform . Nice article by the way!