What Is yield farming in DeFi?

If you are a seasoned crypto trader, you have come across the term “yield farming” countless times in the recent past. This topic is trending since it makes investing in decentralized finance an incredibly profitable practice. Keep reading to learn about this cryptocurrency trading approach and how you can benefit from it.

What is Yield Farming?

Yield farming refers to a mechanism whereby yield farming protocols incentivize the farmers to lock up or stake their digital assets in smart contracts on a liquidity pool. The incentives can be in the form of interest from lenders, a fraction of transaction fees, or a governance token.

As the number of investors that add funds to a particular liquidity pool increases, the issued returns’ value also increases.

Ethereum blockchain and smart contracts are designed with the needs of yield farmers in mind. So, most informed followers of this practice rely on multiple techniques to gain more profits than their counterparts in the same industry. In other words, popular De-Fi protocols currently operate on Ethereum and offer liquidity mining.

Yield Farming and Staking

As we have seen, farming primarily involves helping the crypto lending ecosystem grow by contributing your digital assets to the system to make huge profits.

Staking, on the other hand, refers to participating in a network of governance. In most cases, stakers make decisions that influence the creation of the blocks that form the blockchain for Proof of Stake coins.

In short, yield farming is a more complex and vague process, as you are only providing liquidity to be lent to others. Staking involves having the required authority to determine how your resources are used on the protocol.

Liquidity Pool

This common term, “Liquidity pool,” refers to a collection of crypto tokens locked into smart contracts. They provide the liquidity that De-Fi protocols require to remain operational 24/7.

Comp Token

This was one of the first governance tokens that Compound began to issue to its platform users as additional compensation. Today, most farming protocols have adopted the same strategy and reward their liquidity providers with various types of governance coins to trade on decentralized and centralized exchanges.

DeFi tokens

Currently, ERC-20 tokens are the best well-known De-Fi tokens. They are designed on the Ethereum platform and used on its own.

You can share and exchange these tokens for others. Moreover, you can transfer them to your compatible crypto-wallet.

How Much Can You Earn with Yield Farming?

The amount you can earn depends on the APY, compounding, transaction fee, and more.

Since yield farmers must go to DEX liquidity pools to trade, liquidity mining significantly influences the earnings. New tokens typically have a high APY that ranges between 1% daily and 6% daily, which helps to attract investors to provide liquidity.

Without compounding, if the liquidity mining is 1% daily, the farmer earns 365% profit annually.

Please note that we assume here that the LP token will remain stable throughout the year.

With compounding, a farmer who earns 1% daily can expect 101%^365-1 = 3,678%. The APY can exceed hundreds of billions at 6% compounded hourly.

However, remember that these projects run on public blockchains. So, during the yielding processes, the users will likely have to pay slots of transaction costs, reducing the earnings.

However, you can maximize your yield farming profits. Some of the ways to do this are:

• Minimizing ETH gas fees
• Be on the lookout for new micro and macro projects
• Manage risks

Risks of Yield Farming

Yield farming has costly risks that any user with an objective of maximizing returns needs to understand and mitigate. Cryptocurrencies are highly volatile, so buying and holding them is highly risky. In 2017, Bitcoin hit $ 20,000 USD. In the recent past, it was less than $ 3.000. Today, the price has reached over $50,000.

Other than this, yield farming faces the following unique risks:

• Developers of De-Fi projects are anonymous, so the team can stop offering the service at will
• Some developers can create loopholes to steal staked assets
• Any website can be hacked
• Rug-and-pull

The rug-and-pull presents the highest risks for liquidity mining. It describes a developer who has the sole intention of stealing the liquidity pool when launching the investment project.

The good news is that yield farmers can reduce these risks by:

• Investing on De-Fi projects that various credible organizations has audited
• Ensuring the developer has not replace audited contracts
• Ensuring there is a long time-lock on contracts- There should be about 24 hours delay between contract update and execution

De-Fi Platforms to Use to Earn with Yield Farming

If you are looking for the top De-Fi platforms that you can use in 2021 to optimize the returns on your staked funds, then here is a list of the top options to consider.

• Yearn. Finance: This is a leading decentralized aggregation protocol that allows investors to use an assortment of lending protocols such as Compound and Aave. It made significant waves in 2020 when YFI, the governance token, climbed to more than $40,000.
• Synthetix: This derivatives liquidity protocol is best known for allowing users to create synthetic digital assets. In early July 2020, it was ranked number seven in terms of market capitalization.
• NFTfi: It merges the best features of DeFi and the non-fungibles.
• Defi Yield Protocol: It eliminates the need to convert your rewards to ETH and conversion fees. Moreover, this platform provides quick withdrawals.
• Sync Network: This DeFi platform features ERC-721 and ERC-20 contracts, which implies that it gives users plenty of ways to supply liquidity.

Pros and Cons of Yield Farming

Pros

• High returns: Offers better ways to earn attractive returns on investment. You can expect yield farming Ethereum-based to offer you over 100 times higher returns than traditional banks.
• STurbo-charge returns: The users can earn more by turbo-charging the returns with liquidity mining. In this case, farmers get tokens, in addition to high interest, from their borrowers.

Cons

• Vulnerable to hacks: DeFi apps are open source, so hackers can attack them, especially if users fails to follow the requires security procedures
• Liquidation problems: When farmers trade in quick succession to take advantage of the ecosystem, their collateral value may drop. This means the trader may lose all their capital.

Conclusion

Yield farming has been exceptionally popular in the DeFi space since 2020 for good reasons. Crypto asset holders are pleased to learn that it offers them lots of opportunities to generate higher returns. Although it is a risky endeavor, yield farmers who do due diligence before investing continue to enjoy it as a profitable money-making practice.