Without a doubt, the Decentralized Finance (DeFi) movement has been the dominant talk of the town in the crypto industry recently. This year’s elevated interest surrounding the polarizing sector has successfully propelled it to more than a handful of news headlines now. Breaking every record there is to break, attracting more and more eyes towards it – DeFi is undisputedly white-hot right now!
Although there may be hundreds of different reasons why crypto players are attracted to the very concept of decentralized finance, it is seemingly the practice of yield farming that is responsible for most. It is a brand new trend to garner massive rewards via crypto holdings utilizing permissionless liquidity protocols. Basically, it enables anyone to enjoy passive income by way of the decentralized space built within several DeFi protocols, more specifically, on the Ethereum network housing them.
The crypto industry already has its share of inventive concepts based on the physical world. It already has miners and lenders. And now, it has farmers as well. With that being said, how does the concept really work? What are the yields you can get out of it? How does one become a yield farmer? We know that yield farming may prove unfamiliar to a lot, but don’t worry. It is our pleasure to go ahead and explain all the aspects surrounding the thriving DeFi practice.
Here is everything you need to know about yield farming.
What really is Yield Farming?
Yield Farming is the term coined for the practice of generating substantial rewards using cryptocurrency holdings. In its very essence, yield farming means locking up your cryptos in exchange for greater rewards. That same concept has also led many to confuse yield farming with staking. Although there may indeed be quite a number of similarities, there are also several complex elements surrounding yield farming that separates it from its counterparts. Most specifically, the fact that it works with liquidity providers (LP), the term used for its users, that add funds to many liquidity pools.
So, what are liquidity pools? At its very core, liquidity pools are simply smart contracts that hold funds. With that said, yield farming is basically LPs contributing their respective liquidities in exchange for rewards. These particular rewards may then come from the fees garnered within the DeFi platform, or from an alternative source altogether.
Although the majority of liquidity pools today work the same, some pay their rewards in varying tokens. These reward token may then be deposited to another liquidity pool altogether to earn rewards there as well. Thus, creating a loop wherein LPs commit liquidity on a particular pool to then jump into another one for more rewards. If it isn’t that apparent already, yield farming possesses overwhelming amounts of complex strategies, and as days continue to pass by, it will only grow much larger. However, despite the many complexities and confusing aspects, the practice’s core concept is still the same – LPs deposit funds into liquidity pools in exchange for rewards.
As it currently stands, yield farming is mostly done with the use of Ethereum’s ERC-20 tokens. Notably, the rewards users get from it are in the form of ERC-20 tokens as well. ERC-20 tokens are predominantly used for yield farming because most of the activity itself is performed within the Ethereum network. However, now that the crypto space is leaning towards cross-chain developments, DeFi applications such as yield farming may be rendered blockchain-agnostic in the near future. This means that the practice may now be performed outside Ethereum. Since yield farmers are mostly known for their activity of moving around funds frequently for higher yields, it wouldn’t be anything new once they do decide jump between blockchains.
What makes Yield Farming so popular today?
The short answer is because of liquidity mining, which is more than capable of amplifying the already-substantially qualified yield farming.
Liquidity mining is a method within the yield farming practice wherein yield farmers receive new tokens on top of the usual rewards produced as discussed above in exchange for their deposited liquidities. Basically, farmers are stimulating the platform’s usage, resulting in their token’s receiving higher market values. This would then create a positive usage loop that is proven to attract more and more users, making it beneficial for both the platform itself and the yield farmers.
Another major factor that contributes to the strong interest built within yield farming is the launch of Compound Finance’s governance token – COMP tokens. For those unfamiliar with the term, governance tokens are a special kind of token which grants governance rights to its holders. This means that governance token holders can contribute to their respective platforms’ decisions by way of their token holdings. Think of it as a right to vote.
Although COMP tokens were not the sole responsible for the invention of yield farming nor the only one of its kind today, COMP’s successful launch has indeed elevated the method of distributing governance tokens algorithmically to the mainstream. COMP tokens have successfully reinforced the process of LPs farming new tokens by committing liquidities – which is the very foundation of yield farming itself.
A deep dive to how Yield Farming is performed
What we discussed above is the general concept of yield farming. How it actually works deserves a section of its own. With that being said, let us try and get down to the specifics and methodologies employed within the complex practice of yield farming.
Yield farming, as briefly discussed, is made when liquidity providers – its users – deposit their respective funds into a liquidity pool. This particular pool, on the other hand, is what powers the marketplace wherein LPs could lend, exchange, or borrow token assets. As a reward for their contribution to the pool, LPs would be compensated according to their actual pool share once the incurred fees via the usage of such platforms are collected. Basically, the higher you stake, the greater your reward – that is the very foundation of yield farming.
Aside from the usage fees, another fruitful incentive LPs could receive from adding in more funds to the liquidity pool is the distribution of new tokens. Tokens that are generally unavailable in the open crypto market can actually be received by those that provide liquidity to specific liquidity pools, thus, granting LPs the chance to have a particular token locked to those outside the yield farming practice.
It is well worth noting that applications and implementation processes can vastly differ from one platform to another. However, the core concept of liquidity providers receiving rewards correlating to the amount of liquidity they committed is similar.
Now you may wonder, “How are the rewards calculated?” Typically, the approximated yield farming rewards are calculated annualized. The most common metrics utilized for the calculation are Annual Percentage Yields (APY) and (APR). Although both may mirror each other to some extent, APY takes into account the compounding effect, while APR readily disregards it. Compounding, in this particular instance, is when users are directly reinvesting their profits in order to generate more rewards. Notably, the majority of LPs today are doing just that.
It is best to always remember that as much as how carefully these calculations are performed, they are but projections and mere estimations. It is worth noting that even the smallest of rewards are still quite challenging to accurately estimate. This is because yield farming is one of its kind; while rewards are constantly fluctuating, it is still massively competitive and a proven substantial market. This, in turn, made it possible for a now-working yield farming strategy is ultimately unfruitful once the majority of farmers jump on the bandwagon. Within yield farming, innovation is the key to success, while stubbornness could spell doom.
As the DeFi sector continues to rack up more interest, the sector finding it’s very own metric to calculate yield farming rewards may just be a matter of time.
Just like everything else, yield farming has its very own set of benefits and inherent risks. It has long been emphasized how complex yield farming is, and as like most profitable strategies out there, it is only recommended for advanced users. Furthermore, considering the very nature of the practice itself, yield farming is definitely more suitable for those that already have massive amounts of capital at their disposal.
Although the very concept of yield farming sounds simple, it isn’t as easy as it seems. Heading into yield farming without any relevant experience or substantial insights is as good as throwing money down the drain. On top of being a very complex and meticulous practice, yield farming also has its glaring risks.
One of the glaring risks that surround yield farming is its over-dependence on smart contracts. Because yield farming is performed within the DeFi sector, which has many varying protocols built and run by small-budget teams, smart contract bugs are rendered more likely. However, bugs and vulnerabilities aren’t exclusive to small-time DeFi protocols. Even the most prominent and biggest DeFi projects out there have its set of security problems as well. Due to its very nature, it’s as if engaging in yield farming is the same as putting your assets at constant risk. The phrase: “The higher the risk, the greater the reward” is most appropriate here.
There you have it! An in-depth look at the most current trend taking the crypto industry by storm – yield farming. We have defined the term itself, identified what makes it that much popular, discussed how the practice actually works and noted its most glaring risks – we hope that you now have a more comprehensive insight regarding yield farming after this.
With the way it is right now, DeFi sweeping the world by its heels, there is no telling what the future holds at this point. It is impossible to foresee the new applications that may pop up that build on these current trends. With all that being said, there is no question that yield farming would play a massive role in the look and feel of the future crypto space. But right now, let us enjoy what it is and appreciate the fact that yield farming has indeed successfully made its mark in the world of cryptocurrencies, despite being relatively new.