Decentralised Finance (DeFi), an emerging financial technology that aims to remove intermediaries in financial transactions, has opened up multiple avenues of income for investors. Yield farming is one such investment strategy in DeFi. It involves lending or staking your cryptocurrency coins or tokens to get rewards in the form of transaction fees or interest. This is somewhat similar to earning interest from a bank account; you are technically lending money to the bank. Only yield farming can be riskier, volatile, and complicated unlike putting money in a bank.
Yield farming involves moving crypto through different marketplaces. There is also an element of yield farming where the strategy becomes less effective when more people know about it. But yield farming is currently the most significant growth driver of the DeFi sector, helping it expand from a market cap of $500 million to $10 billion in 2020 alone. Here's a primer on yield farming.
How does yield farming work?
Users providing their cryptocurrencies for the functioning of the DeFi platform are known as liquidity providers (LPs). These LPs provide coins or tokens to a liquidity pool—a smart contract-based decentralized application (dApp) that contains all the funds. Once the LPs lock tokens into a liquidity fund they are awarded a fee or interest generated from the underlying DeFi platform the liquidity pool is on.
Put simply, it is an income opportunity by lending your tokens through a decentralized application (dApp). The lending happens through smart contracts with no middleman or intermediator.
The liquidity pool powers a marketplace where anyone can lend or borrow tokens. The usage of these marketplace incurs fees from the users, and the fees are used to pay liquidity providers for staking their own tokens in the pool.
Most yield farming takes place on the ethereum platform. That is why the rewards are a type of ERC-20 token.
While lenders can use the tokens as they wish, most lenders currently are speculators looking for arbitrage opportunities by cashing in on the token's fluctuations in the market.
How did yield farming become popular?
The boom in the practice of yield farming can be attributed to the launch of the COMP token, a governance token of the Compound Finance ecosystem. Governance tokens allow holders to take part in the governance of a DeFi protocol.
The governance tokens will often be algorithmically distributed with liquidity incentives to launch a decentralized blockchain. This gives potential yield farmers an incentive to provide liquidity in a pool.
Some of the popular yield farming platforms are Aave, Compound, Uniswap, Sushiswap, Curve Finance.
How are yield farming returns calculated?
The estimated return in the yield farming process is calculated in terms of annual percentage yield (APY). It is the rate of return that the user gains over a year. Compound interest is also factored in the APY calculation.
What are the risks of yield farming?
Cyber theft and frauds are major concerns beyond regulatory risks that most digital assets are subject to due to the lack of concrete policies regarding cryptocurrencies worldwide. All the transactions involve digital assets which use the software as storage. Hackers can be adept at finding the vulnerabilities and exploits in the software code to steal funds.
And then, there is the volatility of tokens. Cryptocurrency prices have been historically known to be volatile. The volatility can also be in short bursts, so the price of a token can surge or cash when it is locked in the liquidity pool. This could create unrealized gains or losses, and it may result in you being better off if you had kept your coins available to trade.
Smart contracts in DeFi platforms are also not as infallible as they seem. Small teams with limited budgets build many of these emerging DeFi protocols. This can increase the risk of smart contract bugs in the platform.