Yield Farming Explained in 3 Minutes
Another day, another blockchain term we could provide so that you could gain more insights about the crypto world. Today, we’ll help you navigate yield farming as a newbie.
What is Yield Farming?
Yield Farming (aka liquidity farming or liquidity mining) is a method of earning interest on your cryptocurrency. It is similar to the way you earn interest on any money in your savings account. However, while bank interest rates are extremely low, yield farming can produce APYs in triple digits in some circumstances. Yield farming involves locking up your cryptocurrency for a period of time conducive to interest or other rewards. This is called “staking”.
How does Yield Farming work?
In yield farming, you need to draw attention to the term “liquidity providers” (LP), who provide their cryptocurrencies for the functioning of the DeFi platforms. LPs are allowed to stake their coins by depositing them in a lending protocol through a decentralized app (Dapp). Other investors then can borrow the coins through the Dapp and make attempts to gain profits off of sharp swings they anticipate in the market price.
Methods of Yield Farming
Below are some ways for you to be involved in yield farming:
- Liquidity pools: Users deposit 2 coins to a DEX to provide trading liquidity. A small fee to swap the two tokens are charged by the exchanges, which is then paid to the LPs.
- Lending: Coin/token holders can lend crypto to borrowers through a smart contract and earn yield from the interest rate paid on the loan.
- Borrowing: Farmers can use one token as collateral and receive a loan from another. Users can then farm yield with the borrowed token. By doing this, the farmers can keep their initial holdings, which may both increase in value over time and earn yield on their borrowed coins.
- Staking: There are 2 forms of staking in the DeFi planet. The first one is the Proof-of-Stake blockchains, where a user is paid interest to pledge their tokens to the network to provide security. The second one is to stake LP tokens earned from supplying a DEX with liquidity, which allows investors to earn yield twice as they are paid for supplying liquidity in LP tokens which they can then stake to earn more yield.
Benefits of Yield Farming
Yield farming is a strategy that can be implemented today with various targets and spaces. Currently, there are several DeFi protocols that are dedicated to yield farming, and some of them with several years of operation and proven robustness.
In addition, yield farming also allows farmers to obtain quite pronounced benefits in their “harvests”. Generally, these harvests happen in periods of 6 months to 1 year, and are reinvested to produce higher levels of profits. Indeed, yield farming is a strategy that favors cryptocurrency whales.
Risks of Yield Farming
The execution of yield farming strategy best favors those who have large amounts of capital to deploy, that is, whales, then comes smart investors. Another serious problem is that yield farmers might unconsciously put their coins in the fraudulent projects. In fact, fraud and misappropriation take up the vast majority of the $1.9B in crypto crimes in 2020 concerning a report by CipherTrace. The report also shows that nearly 99% of the major fraud happened in the second half of 2020 was due to rug pulls and other exit scams.
Yield farming is undoubtedly one of the most exciting aspects of DeFi. It hands control to each investor and offers the opportunity to put cryptocurrency to work. The industry is still in its infancy, which comes with associated risks. Therefore, investors should really do their own research and carefully study the projects they are interested in so that they can control the risk possibilities of their investments.
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Disclaimer: The information herein is for educational purposes only and should not be considered financial, investment, or trading advice. Please conduct your own research and due diligence before making investment decisions. You understand that you are using the Information provided at your own risk.