What Is Yield Farming and Why All the Hype?

Yield farming is the emerging trend in the crypto world that has grabbed the attention of many cryptocurrency enthusiasts. It looks very promising and is now considered one of the most popular ways of generating rewards with cryptocurrency holdings.

The crypto space is not only about Bitcoin. New multiple strategies and techniques have appeared within the decentralized finance (DeFi) infrastructure aimed at providing users with more opportunities to generate larger incomes. Currently, one of the hottest crypto trends is yield farming, which seems to have taken DeFi by storm.

Yield farming is about lending your funds to others with the help of ingenious computer programs called smart contracts. As a result, you earn fees in the form of cryptocurrency in exchange for your services. Sounds simple enough, right? But let’s not rush — there are a lot of pitfalls and complexities that you might encounter during the process. That’s why it’s important to ensure you have enough background knowledge before you get started.

What is Yield Farming?

Yield farming has rapidly forced its way into the decentralized finance (DeFi) world. It’s viewed as an effective strategy that investors turn to when they want to increase their investment returns.

Yield farming provides the opportunity for crypto holders to lock up their holdings in return for rewards in the form of additional cryptocurrency.

How Does Yield Farming Work?

Yield farming requires liquidity providers and liquidity pools. To become a liquidity provider, all you have to do is to add your funds to a liquidity pool (smart contract), which is responsible for powering a marketplace where users carry out several procedures with their tokens, including borrowing, lending, and exchanging. Once you’ve locked up your funds in the pool, you’ll get fees that have been generated from the underlying DeFi platform or reward tokens. In addition, some protocols can even provide payouts in the form of multiple cryptocurrencies, allowing users to diversify their assets and lock those cryptocurrencies into other protocols to maximize yields.

Keep This In Mind

Before getting into yield farming, make sure that you’re fully aware of the following basics:

Liquidity providers deposit their funds into a liquidity pool.
Deposited funds are stablecoins related to the USD such as DAI, USDC, USDT, etc.
Your returns depend on how much you invest and what rules the protocol is based on.
You’re able to create complex chains of investment once you decide to reinvest your reward tokens into other liquidity pools, which in turn offer various reward tokens.
You should be aware that simply investing in ETH itself, for instance, isn’t considered to be yield farming. Lending out ETH on a decentralized non-custodial money market protocol and receiving rewards afterward — that’s yield farming.

Why All the Hype?

The key advantage of yield farming is it offers an opportunity to provide investors a good profit. Currently, yield farming can potentially return more attractive interest rates than traditional banks.

However, keep in mind there are some potential risks too.

During 2020 we witnessed a big increase in the popularity of yield farming. Large sums of revenue were generated via the Ethereum network; many yield farming platforms and DeFi projects are currently running on the Ethereum platform. In addition, yield farming grants benefits to various protocols, most of which are just emerging.

Yield farming is becoming widely popular due to its ability to help a broad variety of projects gain initial liquidity and benefit lenders and borrowers. Yield farming also contributes vastly to greater efficiency when it comes to taking out loans.

What are the Advantages
and Disadvantages of Yield Farming?

Profit is one of the most obvious advantages of yield farming. Yield farmers who are among the first to implement a new project may be rewarded with tokens that rapidly appreciate. Huge gains are possible if they sell tokens at the right time. Those profits can be re-invested in other DeFi projects to increase yield even more.

Yield farmers must typically invest a substantial amount of money upfront to make any significant profits — even hundreds of thousands of dollars may be at stake. Yield farmers face a major liquidation risk if the price drops unexpectedly, as it did with HotdogSwap, due to the highly volatile nature of cryptocurrencies, particularly DeFi tokens.

Also, the most effective yield farming techniques are complex. As a result, those who don’t completely comprehend all of the underlying protocols are at greater risk.

Yield farmers have put their money on the project teams and the smart contract code that underpins them. Many developers and entrepreneurs are entering the DeFi space because of the opportunity for profit. They start projects from the ground up or even copy the code of their predecessors. Even if the project team is trustworthy, the code often remains untried, making it prone to bugs and vulnerable to attackers.

The Opportunities and Challenges with Yield Farming

The majority of the DeFi applications use the Ethereum blockchain, presenting some significant challenges for yield farmers. The Ethereum network is suffering scalability issues ahead of the 2.0 update. As yield farming becomes more common, the Ethereum network becomes clogged, resulting in long confirmation times and rising transaction fees.

Due to this situation, some have surmised that DeFi could end up self-cannibalizing. Ethereum’s problems, on the other hand, seem to be more likely to support other networks in the long run. The Binance Smart Chain, for example, has emerged as a viable alternative for yield farmers who flocked to the network to take advantage of new DeFi DApps like BurgerSwap.

Additionally, Ethereum’s existing DeFi operators are attempting to solve the problem with their second-layer solutions for the network. As a result, assuming that Ethereum’s issues do not prove fatal to DeFi, yield farming will continue to exist for some time to come.

The Five Yield Farming Protocols

To maximize the returns on their staked funds, yield farmers will frequently use a variety of DeFi platforms. These platforms include a variety of incentivized lending and liquidity pool borrowing options. Here are seven of the most popular yield farming techniques.

Compound

It is a money market for lending and borrowing funds, where users can gain algorithmically modified compound interest as well as the COMP governance token.

MakerDAO

It is a decentralized credit pioneer that allows users to borrow DAI, a USD-pegged stablecoin, by securing crypto as collateral. A “stability tax” is chargeable in place of interest.

Aave

It is a decentralized lending and borrowing protocol that allows users to borrow assets and receive compound interest for lending using the AAVE (previously LEND) token. Aave is popular for promoting flash loans and credit delegation. Borrowers can receive loans without putting up any collateral with this protocol.

Uniswap

Is a well-known decentralized exchange (DEX) and automated market maker (AMM) that allows users to swap almost any ERC20 token pair without the use of a third party. Liquidity providers must stake 50/50 on both sides of the liquidity pool to gain a share fee and the UNI governance token.

Yearn.Finance

It is a decentralized aggregation automation protocol. It enables yield farmers to use different lending protocols such as Aave and Compound to get the best yield. Yearn. finance uses rebasing to optimize the benefit of the most efficient yield farming services.

Curve, Harvest, Ren, and SushiSwap are some other notable yield farming protocols.

Yield Farming vs. Other Strategies

Those who’ve just entered the cryptocurrency world may not be able to differentiate yield farming from other concepts such as liquidity mining, crypto mining, and staking. Even though they all have something in common and may look the same, in reality, they differ from one another and follow entirely different complex algorithms. We’re here to ensure that you won’t mix these concepts in the future and will be able to tell them apart.

We hope in this article we’ve provided a fundamental understanding of Yield Farming. We will address Yield farming vs other strategies in an upcoming article, stay tuned.

About the Author:

Peter Spoleti is CEO of Vertex Markets. Vertex uses AI to make B2B introductions providing a business
networking site free from guesswork as to where the most valuable business
interactions are found.

Contact Vertex Markets here.

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