Over the last few years, yield farming in decentralized finance has gained popularity worldwide. If you are a crypto investor, you must have heard this term. In this article, let us briefly discuss the concept of decentralized finance, yield farming, and how it works.
What is Defi and Yield Farming?
Decentralized finance or Defi refers to a system where investors can transact with financial products on a decentralized blockchain network. There is no need for mediators like banks or brokers to execute the transactions. Investors without government-issued ID, brokerage or bank account, address proof, or social security card can invest in Defi.
What is yield farming?
Yield farming provides liquidity to Defi. They provide liquidity in return for the yield. In this process, the crypto holders deposit their cryptos into a lending protocol in return for interest. Some protocol’s governance tokens also reward the additional yields.
Working on yield is like bank loans. Like a bank, the loan borrower repays the loan and interest, and the bank earns interest.
Instead of banks, the crypto holder is the lender and earns returns from lending idle protocols with yield farming. Idle cryptos in an exchange or hot wallet create liquidity in Defi protocols.
We will see phrases like liquid providers, liquidity pools, and automated market maker models associated with yield farming.
1. A liquidity provider is a crypto holder with idle cryptos who deposits them in the smart contract. The Defi market is empowered with a smart contract and cash liquidity pool.
2. An automated market maker (AMM) is used to execute yield farming. On decentralized exchanges, this model is gaining popularity. Traditional order books on the crypto exchanges contain all buy and sell orders.
An AMM generates a liquidity pool with smart contracts instead of determining the price of assets available for trade. Predetermined algorithms execute the trades in these pools.
For most crypto exchanges, these liquidity pools play a crucial role as it helps the investors to lend, borrow, and swap tokens. Borrowers get liquidity to funds locked in cryptocurrencies.
AMM serves the contract for matching participants. Borrowers get the funds for predetermined interest rates between the transacting parties.
Popular Defi-related stablecoins are DAI, BUSD, USDC, USDT, etc.
How are the yield farming returns calculated?
Annualized model is used for calculating the estimated yield returns. It denotes the estimated earnings for locking up cryptos for a year. Popular metrics for calculating the yield are annual percentage rate (APR) and annual percentage yield (APY). The fundamental difference between these two methods is that APR does not use compound interest, including plowing back profits to increase profits. It isn’t easy to calculate the returns as it is a dynamic market. Market experts based calculation models on the estimates. Farmers always consider fluctuations in the profitability as on some days; they may earn huge returns while on some sessions, they might incur a loss. The market risk is for both lenders and borrowers.
Let us take the example of a popular yield farming optimizer protocol: Yearn Finance
yEarn or Yield finance gained popularity last year because it gave the highest yields on top altcoins, ETH deposits, and stablecoins. The user token converts yTokens (yUSDT, yDAI, yUSDC). The smart contract protocol searches into Defi protocols with the highest yield for farming and executes the transaction. But, before deciding to yield farming, it is always advisable to understand the associated risks.
Risks in yield farming.
1. Smart contract risk: Smart contracts are written in paperless digital codes and contain predetermined contract terms between parties. These contracts execute the trade automatically.
But bugs and vectors can attack smart contracts in the code. Because of such attacks, popular Defi protocols, Akropolis, and Uniswap users have incurred losses because of smart contract scams.
2. Liquidation Risks: As the crypto market is dynamic, the risk might arise when the value of collateral deposits drops below the loan amount.
If you take the loan against the collateralized ETH, and the value of ETH drops, this stage would liquidate the value of the collateral.
3. Impermanent loss risk: In the case of yield farming, liquidity providers put funds into pools for earning profits from decentralized exchanges (DEXs). In this process, liquidity providers risk loss during sharp market moves.
If AMM does not update token prices on a real-time basis with movements in the market, then LPs would cover the difference. They might incur a loss if a price drops. LPs could not earn profits if the price rose as they locked their funds in the pool.
Final Thoughts: If you do not have experience in crypto transactions and overall market trends, you shouldn’t do yield farming. In one downward swoop, you might lose your entire earnings. It is a fast-paced and volatile process. If you have further queries, please comment on the box below. Team Blockchain Shiksha would be happy to help you.
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