What is Yield Farming?
The concept of “Yield Farming” refers to the yielding of high annualized returns by providing liquidity for the projects. It is similar to the traditional practice of staking coins where users are controlled by their assets which are temporarily locked in the crypto exchanges for certain gains. The method aims to harness cryptocurrencies that remain idle such as tokens, coins, and stable coins. Such idle currencies then take an active role in the form of Decentralized Finance which further generates interest rates varying differently for conservative and popular tokens.
In the DeFi economy yield farmer acts as a bank, for lending funds to enhance the use of cryptocurrencies. Hence, the crypto holders own funds and participate in the lending activities too which makes them a one-person commercial bank. The yield farming market is known for generating “fast gains” in the era of the vulnerable money market.
Thus, it is basically the use of a platform for movement and swapping of crypto currency’s funds for maximizing the returns. To ensure the better performance of currencies in yield farming it is essential to consider mentioned three elements:
• Liquidity Mining: The process incorporates the distribution of tokens to the users of the protocol for the healthy liquidation in the provided pool such as Synthetix and Compound.
• Leverage: It refers to the process where the borrowed liquid funds or assets are used as collateral for the high Annual Percentage Yield.
• Risk: The risk factor in the yield farming needs to be given greater regard as the protocol is highly prone to risks such as a bug in the smart contract, attack on liquidation pool, liquidation of Collateralized Debt Position, etc.
How Yield Farming Works?
Yield farming has close relation with the Automated Market Maker (AMM) which involves the active role of Liquidity Providers (LPs) and Liquidity Pools. The LPs deposit their funds in the liquidity pool where this pool strengthens the lending, borrowing, and exchange mechanism of cryptocurrencies.
The usage of this platform bears certain fees that are paid to the providers in proportion to their share in the liquidity pool. Apart from receipt of fees by LPs, there exists an additional incentive for distributing new tokens.
The protocol and the procedures vary with the unique implementation of tokens. The deposited funds are generally stable coins like DAL, USDT, USDC, BUSD; etc.The user can lock their coin using the Metamask browser plug-in which means that the wallet will interact with the smart contract in the Ethereum blockchain.
With the aim of smoothening the process plenty of resources have been introduced as follows:
• The page Yield Farms on the Etherscan provides the unfiltered and extended list of projects to ensure the better functioning of yield farming campaigns.
• The systematic list of projects yielding high farming opportunities is provided on the site yieldfarming.info in order to estimate annual percentage yield on each project too.
• The crypto market data site named Coingencko contains a newly framed Farms page which hosts the lucrative yield farming alternatives and facilitates the user with the tools such as APY calculator, an impermanent loss calculator, etc.
Yield Farming Platform
The yield farming protocol can be executed in the following platforms to ensure ease of use and better performance to the users.
- Compound Finance: It is one of the recently framed money market algorithms which facilitate users to lend and borrow funds. There is a wider scope of earning interest in the most straightforward and easiest way. It emerged as the first platform amongst all to support and enhance the working of yield farming.
- Aave: This platform also offers lending and borrowing facility for crypto tokens and coins. It operates on the Ethereum blockchain as a smart contract that enables the regulation of assets on a distributed network. It fetches frequent interest for the users as it works on the mechanism of flash loans which also helps to curb the arbitration involved in the process.
- Maker DAO: It is the decentralized platform which is built on Ethereum blockchain and supports the development of DAI (a stable coin based algorithm for the USD value). It is expected that in the upcoming days’ Maker would be able to lock the collateral assets to smoothen the transaction. The debt in the Maker bears the interest which is known as stability tax which is determined by the MKR token holders.
- Uniswap: It is an Ethereum based crypto exchange that allows swapping of ERC-20 tokens. The liquidity providers deposit the equivalent value of two tokens to create demand, eventually; these tokens are sold by the traders against the pool of liquidity. In return, the providers receive fees from traders. Many platforms designed to work with yield farming strategies that enable users to add liquidity to the pools and then stake those LP tokens for yield farming.
- Synthetix: It is a protocol designed to adhere to the needs of synthetic assets. Here, the Synthetic Network Token (SNX) or ETH is locked as the collateral which in turn mints synthetic properties. Yearn. Finance: It is an ecosystem that is shared by aggregators for the loan services and aims to optimize the most profitable lending services using the calculative algorithm. After the deposition of funds to rebalance and maximize the profits, these funds are converted to an equivalent amount of tokens.
The Benefit of Yield Farming
The Ethereum- based yield farming has paved way for a credit-based market where there are new strategies framed for the owner to earn lucrative returns on their currencies, which are ideally 100 times more than the traditional process of financing. The yield farmers get to twin charge they are earning with liquidity mining and by receiving tokens from the company that borrows their funds. Additionally, provides them with the scope of high interest earning.
What are the Risks of Yield Farming?
All types of cryptocurrency carry a certain amount of risks despite all the prevailing precautionary norms. So, the scenario is no different for yield farming too.
• The fund locking in the vaults adhering to smart contract protocols is inarguably risky as it exploits and abuses the reasoning of a contract to yield high returns. Furthermore, the liquidations of funds have emerged as a major threat to collateralized funds.
• Yield Farming is also associated with the risk of pegging DAI stable coin which should ideally retain its $1 value. The continuous breaking of the peg will depreciate the value of loans and will result in the situation of panic sell and the absence of liquidity.
• The sudden progress of the concept has also given rise to several untested protocols which led to malfunctioning in the ecosystem. As initially, YAM Protocol fetched nearly $300 million funds but the hassle – execution resulted in an unrequited number of printed tokens leading to unnecessary fund loss.
• The concept of yield farming has resulted in close resemblance with the debt bubble where the circulating value for the cryptocurrencies is amplified artificially by the yield farmers.
Undoubtedly, yield farming has emerged as the hottest concept in the DeFi platform with innovative strategies and protocols to strengthen the liquidation and rate of return on idle assets. Yet the challenges and risks associated need to be tackled timely to step towards a much better money market mechanism. Thus, the need of an hour is to wisely analyse and ascertains the risks and profit margins scenarios before investing in yield farming unless the protocol is structured on the firm base.