Defi Yield Farming: What Is It and How Does It Work?
“What is yield farming?” is a commonly asked question nowadays. In this guide, readers will find comprehensive information on that.
What Is Yield Farming?
So, what is yield farming? Experts define this term as one of the existing investment strategies in decentralized finances (DeFi). It allows everyone who has internet access to hit the crypto market and earn money.
How Did It Develop?
Today, it is possible to lend cryptocurrency coins or tokens to earn some income without even leaving your home. Just a few decades ago, a regular user couldn’t enter the global financial market. Now, many people know what DeFi yield farming is, but back then, the finances were mainly held by financial institutions, such as banks, and controlled by governments and other relevant organizations.
It all started with Bitcoin, which, in essence, was the very first DeFi app. BTC made it possible to own some asset and transfer it to any part of the world. People could exchange funds without involving third parties. This allowed for a high speed of transactions and low fees. In essence, people do not need to know each other or trust each other to conduct direct payments. BTC has no regulating authority, so no one can change its rules.
Thanks to Ethereum, it became possible to use smart contracts, which allowed accessing the crypto market for multiple purposes beyond transferring and storing crypto coins. A smart contract is a program or a protocol developed to automatically execute, control, or record relevant actions and events under the terms of an agreement.
This was when people first started questioning, What is yield farming? It is all about lending or staking crypto funds to get a reward. So, it is related to investment activities using crypto assets. It may come in the form of interest, transaction fees, and other types of rewards. It is similar to the interest taken by banks from borrowers for lending them some money.
Yield farming became possible thanks to decentralized finance. Since there are no third parties involved, such as intermediaries or governments, people can purchase crypto assets, lend them to others, and earn a profit for that. Lending money is an effective contribution to liquidity.
It is important to have a good understanding of what DeFi is. It is an open and global financial system working as a solid alternative to the traditional financial industry. This system cannot be controlled by third parties, and it is accessible to everyone. Users can purchase, store, and trade their finances as they want.
So, here is the answer to the question “What DeFi yield farming is?” — it is a way to earn money based on the existing decentralized financial system.
Those involved in this type of activity are called yield farmers. Their number is growing day by day.
Total Value Locked (TVL): What Is It?
When it comes to cryptocurrencies, total value locked (TVL) means the amount of all assets deposited in DeFi protocols to earn interest, new coins, fixed income, and other types of rewards. Since the system has no control, cryptocurrency users build this network themselves. At the moment, TVL has reached a sum of $169 billion globally.
It is calculated in a pretty simple way. For example, an investor deposits $1,000 via the DeFi platform to validate transactions. Then he lends out $1,000 to earn interest. Then, the same investor deposits $1,000 to provide trading liquidity and earn commissions. If these are the only transactions in the market, then TVL will be $3,000.
How Does It Work?
Now that you know what yield farming is, let’s figure out how it works. Here are all the important moments explained.
There are two main things used by DeFi for the provision of services requiring no intermediaries:
In a traditional financial system, financial institutions such as banks serve as guarantors of payments. This is how they get lots of power over users’ money. Also, plenty of people all over the globe cannot open a bank account.
A smart contract in DeFi eliminates the need in any financial institution to conduct a transaction. A smart contract works like an Ethereum account. This is where the funds are stored and from where they can be sent to another account or received from other users. No one has the power to change a smart contract when it is active.
For example, a contract is designed to send a certain amount of money from one account to another on Mondays. This order will be executed until it is closed or the amount of funds are insufficient. It is impossible to change this contact by adding a different recipient. Such contracts are open publicly, so everyone can view them and evaluate their legality.
There are numerous ways to earn money using cryptocurrencies in the DeFi system. Knowing them is as important as answering the question “What is yield farming?”
For example, this is how crypto lending works:
Users can pick from multiple platforms to start earning money from yield farming in DeFi.
Crypto applications exist for various purposes. They allow users to access the crypto market and conduct a variety of actions, such as purchasing, storing, exchanging, and more.
The list of reliable platforms that can be used for this purpose is pretty extensive. Some of the options available for users include:
Usually, each platform provides a clear tutorial on how its services can be used.
Four main simple steps are involved in earning profit from yield farming:
Liquidity providers (LP) deposit funds into liquidity pools (smart contracts).
The liquidity pools distribute the funds for the users to exchange, lend, and borrow.
The users pay fees for the services of the DeFi platform. The LPs get their rewards.
LPs get profits distributed by the platform. The level of income for each LP depends on a variety of factors, such as the initial investment amount.
Then LP can reinvest their earnings, and everything will repeat all over again.
Is Defi Yield Farming Profitable?
Before starting to earn with DeFi yield farming, it is essential to learn how profitable this can be. This does not involve too difficult calculations.
How Returns Are Calculated
Now when the answer to the question “What is DeFi farming?” has been provided, let’s learn how to estimate possible returns.
In yield farming, there are three main types of income users can receive, including the following:
Transaction fees depend on protocols and pools. In 2021, the average transaction fee on the BTC network varied from $1.78 to $62. On Ethereum, it was between $1.59 and $70. All exchanges have this fee. Most of them have a fixed fee model. Another factor taken into account when determining the fee level is the volume of transactions. Those interested in earning from transactions should check the conditions applied on different exchanges, compare them, and pick the best option.
Token rewards are provided to ensure liquidity. They are distributed over a specific period of time, such as a week, month, year, etc. Such tokens are usually traded on decentralized exchanges, but they can also be found on centralized exchanges, such as Coinbase.
As for capital growth, it allows determining the potential profitability of any challenging yield farming investment.
When it comes to calculating returns for the providers of liquidity in yield farming, the following indicators are taken into account:
TVL indicates the cryptocurrency amount locked in the DeFi lending market or other sectors. It is used for estimating the overall condition of the system. So, the larger the market size, the higher the return on yield farming may be expected.
APY means the amount of interest paid annually. It allows determining what income it is possible to get from crypto yield farming. This metric is used by an investor to estimate possible earnings. In the calculation, compound interest is taken into account.
The formula is the following:
(1 + r/n )n – 1, where:
r = nominal rate
n = multiplier meaning the number of compounding periods
As for APR, this indicator also represents the annual rate of return. It shows borrowers how much they will pay for borrowing funds.
In DeFi Yield farming, the returns are calculated on an annual basis.
What Is Collateralization in DeFi?
Collateralization is another important notion in yield farming, implying valuable assets used to secure a loan. It means that a borrower provides something to protect the lender’s finances in case one fails to pay back the loan.
In traditional finance, different assets, such as automobiles or jewellery, can be used for this purpose. In decentralized finance, no traditional credit check is run, so no one has a credit score.
Usually, in DeFi lending, the size of collateral is greater than the size of the borrowed asset. No other insurance like in traditional finance is applied.
Popular Yield Farming Strategies
It is essential to pick the right yield farming strategy. Here are four strategies to check out:
Is Defi Farming Safe?
Defi farming is associated with some risks. However, some approaches can be utilized to decrease or avoid them.
The things to look at include:
Eventually, it is possible to use a less risky strategy in yield farming. Also, it is important to remember that every type of investment is associated with certain risks. Below, the readers will find helpful information on possible risks involved in yield farming.
Now when it is clear how yield farming works, let's learn what risks may be involved.
Volatility means the degree to which the price of an asset fluctuates. If the asset is considered highly volatile, investors can expect plenty of price movement within a short period of time. This means that the price may increase and decrease quickly and drastically. While this may result in a great profit, it is also associated with possible high losses.
It is possible to create a smart contract with a bug or a different issue accidentally. However, programmers may intentionally add certain features enabling them to take all the funds at any moment.
Yield farmers may invest their money in a fraudulent project without even knowing about that. The scammer will take all the money and disappear. In 2020, the losses caused by crypto crimes reached about $1.9 billion. So, checking the reliability of application creators is important. Also, it is essential to look for an open-source app checked by a reputable team. No funds should be sent to a protocol that has not undergone the proper third-party check.
Smart Contract Risk
Yield farming uses smart contracts, which are, simply put, codes. They are stored in Blockchain and executed under certain conditions. Unfortunately, they are imperfect and can contain bugs or vulnerabilities. All this puts your cryptocurrencies at risk.
Developers of the projects come through plenty of challenges when creating well-protected smart contracts. The main problems related to this activity are the high cost of executing the codes and issues with speed and scalability. Some issues may be improved with proper code vetting and third-party audits.
According to the information on how yield farming works, no bodies are currently regulating the DeFi market. However, lots of regulatory questions regarding cryptocurrencies arise all the time. A few lawsuits have been opened against crypto sites. Various types of regulations apply to the platforms, such as registration and licensing. It is difficult to predict which state regulators may announce their intention to implement some regulatory policies and when this might happen.
Pros & Cons of Crypto Yield Farming
It is essential to weigh the possible advantages and disadvantages of investment in crypto yield farming.
The advantages include:
As for the disadvantages, they are as follows:
DeFi is certainly the future of the financial world. It develops rapidly, regardless of some risks. The system is expected to grow further, and many of its imperfections may be improved over some time. More and more people are hitting the cryptocurrency market to satisfy their financial needs. There are lots of things to learn about this type of earning. Gaining the necessary knowledge and implementing it for obtaining real benefits would be a smart decision.
It will take some time to find the most effective ways for earning income and learn how to manage risks. One thing is certain — spending time and money on understanding how yield farming works is worth it.
Frequently Asked Questions
What Is Yield Farming?
It is not difficult to understand what yield farming is. It is all about lending or staking cryptocurrencies to get rewards. The profits from this activity depend on different factors.
How Yield Farming Works?
There are several steps involved in the yield farming process. Users need to find a liquidity pool to add some funds there. Then, the funds are distributed, and the LP gets rewards. The obtained rewards can be re-invested again.
Is DeFi Yield Farming Profitable?
Along with finding out what yield farming is, it is also important to learn how profitable it is. The level of potential profit depends on various factors. APY is used to estimate the earnings yield farmers can obtain. While this type of investment can be quite profitable, considering possible risks is also important.