Let’s assume you own some Ethereum, and now it’s sitting ideal in your wallet or crypto account. But what if you could reinvest your Ethereum without selling it, earning more cryptocurrency in the process? Yield farming is one method for earning extra cryptocurrency from your existing cryptocurrency.
The concept of yield farming, like most things linked to blockchain and cryptocurrencies, can be scary at first. But don’t worry; we’ll go over everything you need to know about yield farming in this article.
What is yield farming?
Yield farming is a technique to earn fixed or variable income by investing cryptocurrencies in a DeFi market. It involves lending cryptos to a DeFi platform in exchange for a profit, commonly known as yield.
Simply put, it’s similar to taking out a loan from a bank and repaying it with interest. In this situation, a cryptocurrency that would otherwise remain unused in a wallet or exchange is locked into liquidity pools via yield farming protocols.
These incentives can come in a percentage of transaction fees, loan interest, or a governance token. These returns are calculated as Annual Percentage Yield (APY).
How does yield farming work?
The first step in yield farming is to add funds to a liquidity pool. These pools are simply a collection of smart contracts containing cash. They fuel a marketplace where users can trade, borrow or lend tokens. Once you’ve added your funds to a liquidity pool, you’ve become a liquidity provider for that protocol.
In exchange for locking funds in the liquidity pool, you get rewarded with fees earned by the underlying DeFi platform. The yield earned can be deposited again in the pools. It’s a standard procedure for investors to move their cash between protocols to achieve higher yields.
The Annual Percentage Yield (APY) is the most commonly used metric for determining profits. The APY is the rate of return on a specific investment over a year. Usually, returns are calculated for a calendar year. Compounding interest, which is calculated regularly and applied to the amount, is also considered while calculating the APY.
What makes yield farming so lucrative?
The main advantage of yield farming is high profits. For example, if you arrive early enough to invest in a new project, you may be able to produce token rewards that rapidly increase in value. Yield farming can generate more profitable income than a regular bank, but there are associated risks.
For newbies, there is a significant danger. A seasoned crypto holder can earn up to 30–60% APY through yield farming, which, compared to standard savings bank interest rates of around 5% APY, is a much more advantageous way of letting your money work for you.
What are the dangers of yield farming?
Despite its enormous profit potential. Let’s have a look at the dangers associated with yield farming:
- It is difficult for newbies to understand. You will most likely lose your hard-earned money if you do something without understanding.
- Profitable strategies are highly sophisticated and should only be used by advanced users.
- Yield farming is ideal for individuals who have a large amount of wealth to invest and are willing to risk losing it.
- Because blockchain is immutable, vulnerabilities and bugs might result in the loss of user funds.
- Because liquidity pools are built with smart contracts, smart contracts are computer codes. They are vulnerable to faults, errors, and hacks.
In the end,
Understanding your risk appetite and doing research can help you profit from yield farming.
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