Yield farming involves investors locking or staking their cryptocurrencies within liquidity pools to gain more rewards in form of interests. It is one cryptocurrency investment strategy in Decentralized Finance (Defi) that generates substantial passive income, and has gained popularity due to its various benefits to decentralized exchanges (DeX) platforms. Yield farming uses the basic borrowing and lending protocol. In Defi, you can farm with different cryptocurrencies to earn rewards.
How Does Defi Yield Farming Work?
Firstly, what is a liquidity pool? A liquidity pool is a funding infrastructure from which Defi users borrow, lend and swap/trade. Automated Market Maker (AMM), an order-matching system that powers most decentralized exchanges, is required for yield farming to work. AMM evokes several liquidity pools through smart contracts to execute trades with predefined rules. Examples of platforms for yield farming include: pancakeswap, uniswap, binance, polygon etc. Check our article on ‘Top 5 Yield Farms in 2022,’ to know the best platform for yield farming.
Note that various cross-chain decentralized platforms are also compatible with different tokens and various Defi projects. Also, some Defi tokens allow you to fill the role of a liquidity provider on the Ethereum blockchain.
Pros and Cons of Yield Farming
- Defi yield farming is available to the general public with no governing or ruling parties involved.
- Decentralized exchanges and applications are abundant with massive popularity and tremendous utility, allowing everyone to participate in yield farming.
- Yield farming processes are straightforward as it just requires you to have cryptocurrencies and a crypto wallet.
- Due to the various risks involved in yield farming, rewards can fluctuate.
- Yield farming process based on a high gas fee network such as Ethereum reduces the farmer’s rewards with the gas fee taxed for every transaction.
Possible Gains (APR) in Defi Yield Farming
APR Annual Percentage Rate is the rate of the initial fund deposit returned within 365 days, and can vary significantly with token and platform. Anytime you provide liquidity to your liquidity pool, you may incur a non-permanent loss. The price of the deposited asset may change from the time of deposit, and the more significant the fluctuation, the greater the loss. Impermanent loss involves the fall in the value of dollars during withdrawal compared to when depositing, which results in a loss.
Investors receive a certain amount of interest as a reward for offering their tokens to the liquidity pool. They earn rewards coupled with the interest rate and other fees that borrowers must pay before borrowing from the liquidity pool.
To calculate the Annual Percentage Rate:
APR = [(fee + interest)/principal] x (years) x 100.
Note: the calculation depends on the various Defi protocols.
Is Yield Farming Safe?
Yield farming is considered a safer option when compared to other investment forms. However, it is still a risky venture that requires due diligence. Below are some of the key factors you should consider before participating in yield farming.
This is a source of worry for investors. A rug pull is when founders abruptly end a crypto project and run away with investors’ funds. This malicious act has happened to new projects with few communities. It is the reason you need to be extraordinarily selective whilst you pick out a platform for investment. Always attempt to keep away from rug pulls.
Yield farming does have an excessive degree of risk related to it. However, the rewards are much more significant as well. Impermanent losses cause not only shortage of funds but also volatility in crypto assets. In both cases, you want to determine if this funding is well worth your precise needs.
There is a risk that the venture may fail or the liquidity pool can be exhausted. When users potentially stop the usage of a platform altogether, loans will not be given out, and no transaction fee will be generated. This leads to the loss of the liquidity provider.
Yield farming has become a popular way of earning passive income from crypto currencies, leaving other strategies like crypto airdrops or staking being. It is a center of attention to many investors due to its high rewards. Despite this, there are some risks associated with yield farming. Investors are therefore advised to thread with caution.