Yield Farming in DeFi
Yield Farming has undoubtedly become one of the most trending topics in decentralized finance and there is a well-defined reason for this hype.
Yield Farming may be defined as an effective mechanism to maximize the return of investments with the help of various DeFi protocols.
The process of Yield Farming involves various strategies where the yield farmers(people who follow the practice of Yield Farming) jump from one DeFi protocol to another with one common goal, maximizing their profits.
Yield Farming: A deep dive
Ethereum blockchain and smart contracts make it extremely easy for users to interact with multiple defi protocols as well as gain profits for the assets that they possess. This allows the yield farmers to come up with new techniques to multiply their crypto assets.
“Currently, Yield farming is done using ERC20 tokens on the Ethereum blockchain. However, the support for yield farming on other blockchain platforms and other token types is a prominent possibility in the near future.”
While there are a few yield farming techniques like Leverage, High Risk & High Returns, one of the most frequently used techniques by yield farmers is Liquidity Mining.
What is Liquidity Mining
Defi protocols have lending pools that store all the assets(liquidity) that can be borrowed by the users. However, a sufficient supply of liquidity is required to ensure that these pools can accommodate the needs of the users and that the protocol can work effectively.
This is where lenders play a significant role by providing their own assets in the pools to maintain liquidity.
Since liquidity providers play a significant role in the working mechanism of these protocols, they are rewarded with tokens for their investments. This distribution of tokens to the liquidity providers is what we now know as Liquidity Mining.
Therefore, liquidity mining is one of the most effective mechanisms for farmers to earn additional interest and incentives for the crypto assets they own.
While Synthetix introduced the world with Liquidity mining, the technique reached the zenith of its glory as soon as Compound introduced liquidity mining of COMP tokens(native tokens of Compound) that gave users higher rewards for using the protocol.
Returns in Yield Farming
When it comes to yield farming, The calculation of the returns is subject to the following two metrics:
- APR — Annual Percentage Return
- APY — Annual Percentage Yield
These metrics may seem similar but they are as different as chalk and cheese.
While APR simply depicts the simple interest rate annually, APY symbolizes the rate with the impact of compounding.
The Risk Factor
Every coin has two sides. Although Yield Farming provides incredibly high returns, significant financial risk is also accompanied by this financial service.
Yield farming involves the usage of multiple defi protocols and more often than not it leads to high gas fees, price slippage as well as Impermanent losses.
Moreover, the vulnerabilities and bugs in a smart contract code can also lead to huge losses in yield farming. For instance, Harvest Finance lost almost $20 million in a liquidity hack in October last year
Another major concern in the world of Decentralized finance is that, quite often, the losses in DeFi are permanent. This is mainly because of the immutable nature of blockchain.
Therefore, it’s highly advised to get familiar with the mechanisms of DeFi protocols, understand their pros and cons, and do some practice before entering the world of Yield Farming.
Final Thoughts
Yield farming gained enormous attention in the year 2020 and is, therefore, no more a buzzword in the DeFi space. Keeping in mind the profitable returns that users can generate with yield farming, it is gradually becoming a beneficial investment strategy for the crypto asset holders
Although there are some users who think of yield farming as just another lucrative bubble in the world of DeFi, yield farming still continues to be a profitable money-making practice that is here to stay.
