What Exactly is Yield Farming? – A Beginner’s Handbook

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At its heart, yield farming is a technique that allows bitcoin users to lock up their assets and earn incentives.

It is difficult to navigate the crypto waters without continuously encountering fresh trends and terminology. One of the most current is yield farming, which is a compensation system that has taken the decentralised finance (DeFi) industry by storm in 2020.

Yield farming, perhaps one of the primary reasons people are lured to the DeFi world, has seen naive investors burnt and tech-savvy capitalists make their riches.

The notion of yield farming, like most things linked to blockchain and cryptocurrencies, might seem overwhelming at first, but don’t worry—we’ll cover everything you need to know below, beginning with what it is, how it works, and why you might be interested in exploring it more.

So, what exactly is yield farming, and what does it imply for the crypto world? Without further ado, let’s get started.

At its heart, yield farming is a technique that allows bitcoin users to lock up their assets and earn incentives. It is a method that allows you to earn either fixed or variable interest by investing crypto in a DeFi market.

Simply defined, yield farming is the practise of lending bitcoin over the Ethereum network. When banks make loans with fiat money, the amount lent is repaid with interest. The principle is the same with yield farming: bitcoin that would otherwise be sitting in an exchange or a wallet is leased out via DeFi protocols (or locked into smart contracts in Ethereum words) in order to earn a return.

Yield farming is normally carried out using ERC-20 tokens on Ethereum, with the rewards being a form of ERC-20 token. While this might change in future, almost all current yield farming transactions take place in the Ethereum ecosystem.

How does yield farming work?

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The first step in yield farming involves adding funds to a liquidity pool, which are essentially smart contracts that contain funds. These pools power a marketplace where users can exchange, borrow, or lend tokens. Once you’ve added your funds to a pool, you’ve officially become a liquidity provider.

In return for locking up your finds in the pool, you’ll be rewarded with fees generated from the underlying DeFi platform. Note that investing in ETH itself, for example, does not count as yield farming. Instead, lending out ETH on a decentralized non-custodial money market protocol like Aave, then receiving a reward, is yield farming.

Reward tokens may also be put in liquidity pools, and it is standard practise for users to move their assets across protocols in order to get greater returns.

It’s complicated. Yield farmers are frequently highly familiar with the Ethereum network and its complexities, and they will transfer their assets around to multiple DeFi platforms to maximise their profits.

It’s not easy, and it’s certainly not easy money. Those who supply liquidity are likewise paid based on the quantity of liquidity given, so those who reap massive benefits have equally massive sums of money behind them.

A quick rundown of yield farming

  • ? Liquidity providers deposit funds into a liquidity pool.
  • ? Deposited funds are normally stablecoins linked to USD, such as DAI, USDT, USDC, and more.
  • ? Another incentive to add funds to a pool could be to accumulate a token that’s not on the open market, or has low volume, by providing liquidity to a pool that rewards it.
  • ? Your returns are based on the amount you invest, and the rules that the protocol is based on.
  • ? You can create complex chains of investments by reinvesting your reward tokens into other liquidity pools, which in turn provide different reward tokens.

What’s so special about yield farming?

The main benefit of yield farming, to put it bluntly, is sweet, sweet profit. If you arrive early enough to adopt a new project, for example, you could generate token rewards that might rapidly shoot up in value. Sell the rewards at a profit, and you could treat yourself—or choose to reinvest.

Yield farming can now give more profitable income than a typical bank, but there are hazards associated as well. Interest rates can be unpredictable, making it difficult to anticipate what your returns will be in the future year—not to mention that DeFi is a riskier environment in which to invest.

Why should we be concerned?

Because yield farming platforms are based on Ethereum, an enormous amount of money has been generated (and lost) over the Ethereum network during the course of 2020. And the Ethereum platform is used by the vast majority, if not all, of DeFi solutions. The surge in popularity demonstrates how much the financial revolution promised by DeFi is dependent on ETH—a very young network.

Yield farming is essential because it may assist projects in gaining early cash, but it is also beneficial to both lenders and borrowers. It simplifies the process of obtaining loans for everyone.

Those that are generating large profits frequently have a lot of cash behind them. Those looking for a loan, on the other hand, have access to cryptocurrencies with extremely low interest rates—sometimes as low as 1% APR. Borrowers can also easily lock up the cash in a high-interest account.

Though the yield farming boom has slowed slightly since its peak in Summer 2020, there is still the prospect of generating an outsized yield on assets when compared to the world of traditional banking.

I personally am steering clear of the yield farming space completely until it settles down into something more sustainable. But I’m not particularly a “smart mind in defi” so…. https://t.co/1Db86JwP0D

— vitalik.eth (@VitalikButerin) August 31, 2020

Yield farming has been a contentious subject in the crypto realm. Not everyone in the community believes it is vital, and some in the crypto community have encouraged others to avoid it. For example, Ethereum developers have criticised flash farms (yield farming initiatives that appear for only a week or so) for their high risk. Ethereum co-founder Vitalik Buterin himself has said he will be staying away from yield farming investments.

Which projects are involved?

A number of DeFi projects are actively engaged in yield farming. Aave, a project that enables users to lend and borrow a variety of cryptocurrencies, is now the most valuable in terms of value locked within smart contracts.

Following that is yearn.finance, which attempts to shift users’ cash between several lending and liquidity protocols (Compound, Aave, and dYdX) in order to obtain the greatest interest rates.

Then there’s Compound, a DeFi platform that allows users to profit from the cryptocurrency they save.

Who can get involved?

If you have no prior expertise in the crypto realm, becoming engaged in yield farming might be difficult. Compound and yearn.finance are two projects that are aiming to make the world of borrowing and lending more accessible to everyone.

However, because yield farming has resulted in high gas fees on the Ethereum network, individuals generating big returns from lending their crypto are generally those who have a lot of cash to begin with.

What can yield farming do for you?

Top yield farmers have made up to 100% APR on popular stablecoins by employing a variety of techniques.

One strategy involves one of the world’s most popular DeFi platforms, Compound. The platform rewards investors with COMP tokens for both supplying and capital borrowing, and many users maximize their returns by doing both:

  • Borrowing funds on Compound provides COMP Token as a form of cashback. The more you borrow, the more COMP Token is provided.
  • If the cashback is worth more than the cost of the borrowing fees, you can keep on borrowing to farm the cashback rewards.
  • Because liquidity miners are compensated for both lending and borrowing, one strategy is to lend the highest interest rate asset, borrow as much as you can against the tokens, and then return the remaining assets back to the lending pool.
  • The (potential) end result is 100% APY instead of the 0.01%-1.00% that most banks offer, which is a very substantial increase.

In-depth strategies are beyond the scope of this article, but essentially, the method involves making a deposit, and then borrowing against it. It goes without saying that it’s extremely risky; as always, one should never invest what you cannot afford to lose.

Is yield farming sustainable?

Certain yield farming initiatives, as a lot of ETH engineers have informed Decrypt, will not continue and are simply not viable. These initiatives frequently raise large sums in a short period of time and then go away. Some have even been labelled as frauds, particularly flash farming initiatives.

Other yield farming “experiments” have used experimental (and unaudited) programming, resulting in unexpected outcomes.

The broad opinion among professionals is to invest at your own risk.

However, DeFi yield farming sites like as those mentioned above will be around for a long time. Perhaps not the same amount of money will be earned on them in the next years, but the world of loans will be transformed.

The future of yield farming

In such a fast-paced, unpredictable environment, forecasting the future is nearly impossible. The prevailing view, though, is that the profitable bubble will eventually collapse.

The present amount of excitement and anticipation may put too much demand on the network, causing congestion issues. Price corrections may cause some farmers to be unable to sell their assets, which may have a knock-on effect on general trust in yield farming.

For the time being, yield farming is a high-risk, high-reward technique that may be worthwhile to pursue if the appropriate research and risk assessments are conducted in advance.

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