As new financial instruments become available, we are witnessing a trend in which users are directly involved in protocol development. Whether it’s something as simple as borrowing/crediting on the Compound platform, or something more complex, such as participating in liquidation auctions on Maker, it’s clear that DeFi is opening up exciting new opportunities for passive income.
Yield farming is a movement whose members strive to squeeze out the maximum profit from their investments through DeFi protocols. The name can be explained very easily — the crypto farmers “grow” their income from “previously seeded” investments. Usually this concept includes the issuance of your assets in the form of loans bypassing all intermediaries, but using a special program (smart contract) as a mediator. In return, you will begin to earn income in the form of cryptocurrency.
Introduction to a new crypto trend
DeFi is a thriving ecosystem of applications and protocols aimed at updating the existing financial infrastructure. DeFi projects build their technology on top of the first level protocols such as Ethereum, Cosmos and Polkadot, with the vast majority of current DeFi developments building on Ethereum due to its extensive capabilities.
In a broad sense, DeFi can be seen as creating an alternative financial infrastructure to an outdated system (e.g. banks, insurance companies, stock exchanges, etc.) from scratch. The idea is to get rid of the trust placed in existing institutions by creating decentralized and more inclusive versions of the financial system in networks without authorization.
DeFi platforms range from decentralized exchanges (DEX, e.g. Uniswap) to synthetic assets (e.g. Synthetix), liquidity pools, insurance products (e.g. Opyn), payments, loan/credit protocols (e.g. Compound), stablecoins, etc. These platforms function similarly to existing financial services, but in most cases replace the institution (e.g. exchange) with a series of smart contracts operating in a network such as Ethereum.
For example, the decentralized version of the exchange on Ethereum is Uniswap. Uniswap protocol is based on an automatic market maker (AMM), which is essentially a bot that quotes prices between two trading assets. The idea at first glance may seem complicated, but at a high level it is quite simple. DEX, such as Uniswap, simply replaces the exchange’s order book with a smart contract that sets prices between each member of the liquidity pool of different assets.
In contrast, centralized exchanges, such as Binance, can process transactions using a centralized order book much faster than their DEX counterparts. For many traders, the performance limitations of DEX are prohibitively high, so they prefer centralized exchanges.
The immediate problem that occurs with many DeFi platforms (such as DEX) is liquidity. DeFi protocol developers understood that financial instruments and trading would be the first major technological bait in the crypto market, while attracting liquidity remained a challenge. However, the developers found a solution to this problem by applying a method known as liquidity mining, also known as “yield farming”.
How does yield farming work?
A yield farming is a conversational name for liquidity mining processes, a method for distributing tokens and rewarding users for providing liquidity to the DeFi platform. At a high level, the liquidity mining can be seen as a reward-based marketing move that over time dilutes the token ownership of early investors in the hope of widespread token and platform distribution. Users are rewarded for providing liquidity to the protocol at an early stage. DeFi protocols are often defined as successful or not by the total amount of locked funds (TVL) in a protocol.
Investors use different strategies to make a profit:
- Interest earning through borrowed funds and rewards. To do this, the farmer needs to register with the DeFi project, which grants loans. For example, in Compound. His funds are transferred to another user who has applied for a loan on special terms — with subsequent payment of interest. Fees received — the income of the crypto farmer from participation in the project. In addition, startup tokens are distributed among Compound users. By selling them, or saving them for the future (waiting for an increase in the price of coins), you can also get additional profits.
- Liquidity mining. Users are rewarded for working with a specific protocol. As a rule, the startup distributes a certain amount of cryptocurrency to the participants on a daily basis. The influx of clients increases the demand for the startup and its products and, as a result, the project token becomes more expensive. The first liquidity mining was presented by the Balancer project team. Its users were paid BAL tokens.
- Providing swaps — exchange of tokens of one protocol for coins of another. An important component of yield farming — continuous market research, in order to find alternative strategies. As soon as a community member finds a new, more profitable option for investment, he reallocates funds. The swap principle is useful here, by means of which less profitable tokens are transformed into other — more economically attractive. Among crypto farmers, this procedure is commonly referred to as asset rotation.
There are other, more complex strategies of yield farming. Many community members simultaneously use different ways of earning money on DeFi protocols.
The work of crypto farmers can be compared with investments in traditional banks. Clients of classic financial institutions place money in deposits and earn interest on their deposits. Most choose investment strategies, including those based on the level of profitability. As soon as a bank with more favorable conditions or attractive deposit interest appears on the horizon, many people transfer funds to a new financial institution.
An important difference between the work of crypto farmers and investing in traditional banks is an increased level of profitability, which balances with high investment risks.
How is the yield calculated?
As a rule, the yield of farming is calculated in the form of interest per annum, as in the banking system. Thus, if the yield is declared as 8%, it means that on your contribution you will receive 8/12 or 0.6% monthly.
The most common metrics that you can find on the protocol sites are APR (Annual Percentage Rate) and APY (Annual Percentage Yield). The difference between them is that APR does not include the effect of growth, in which the income you receive immediately reported back to the pool, and APY includes.
You should also keep in mind that the described metrics are approximate and have been calculated using simple forecasting. Even for a short period of time it is very difficult to calculate the yield. Why? The fact is that the DeFi industry is still very young and the size of the awards is variable. As soon as a revolutionary new protocol is on the horizon (which may end up being nothing) many farmers take their money out of current pools and carry it into new pools, thus shaking up the market.
The risks of yield farming
Yield farming is a rather complicated process. The most profitable strategies are long chain schemes and are recommended only for advanced users. In addition, farming is usually more suitable for users with more capital, the so-called “whales”.
The first and main risk is the use of borrowed funds taken from a smart contract. If the market fluctuation is strong enough, your collateral can be liquidated and you will lose your locked coins.
The second risk is working with smart contracts. You give your money to the management algorithm, which theoretically may contain errors. Due to the very nature of DeFi, projects are usually developed by small teams with limited budgets. This increases the risk of bugs in smart contracts.In a blockchain transactions are irreversible, which means that in case of an error on your part or in case of some bug, your funds may be lost forever.
DeFi protocols work like LEGO — all protocols rely on each other and work in a bunch. This is also a risk, because if a big bug in one of the popular projects comes up, it can have a house of cards effect.
Platforms for yield farming
Compound — an algorithmic platform for loans and credits. Any user who has an Ethereum wallet can provide their funds to the pool of liquidity Compound and begin to receive income immediately after deposit. Rates are calculated algorithmically based on the ratio of supply/demand.
Maker — a decentralized lending platform that supports the issuance of DAI token secured by ETH, BAT, USDC, WBTC. DAI — stablecoin, which rate is 1:1 to the U.S. dollar. Farmers often use released DAI to implement their strategies.
Synthetix — synthetic asset protocol. It allows you to lock tokens on a smart contract SNX or ETH and release against their pledge special “synthetic” trading assets — for example, digitized silver, gold or barrel of oil.
Aave — a decentralized loan and credit protocol, which is very actively used by profitable farmers. The lender (liquidity providers) receives aToken’s in return for their funds. These tokens immediately begin to generate income when issued.
Uniswap is a decentralized exchange protocol, essentially a decentralized exchange (DEX). Liquidity providers can create new markets for exchange between any ERC-20 tokens by providing two equal estimated portions of tokens to a smart contract. Traders can exchange tokens at any time — the second party is the liquidity pool. In return for the provision of funds, suppliers receive a percentage of trading fees.
Curve — a decentralized exchange protocol, made for the exchange of tokens. In contrast to Uniswap Curve generates a much smaller shift in the cost of exchange when the supply/demand ratio changes.
Yield farming may seem incomprehensible because of the abundance of specific terms and application of complex strategies. In fact, however, the purpose of the movement can be described in just one phrase — to achieve maximum returns using DeFi protocols. To other conclusions:
- Income farming is risky. No one can guarantee that the project in which the user has invested will continue to work tomorrow. It is important to pay attention to the security level of the investment. To do this, you should study the technical documentation of the project;
- Communication between community members is an important part of yield farming. They share with each other information about current projects and income opportunities through them;
- To earn income from yield farming, you need to understand the market for decentralized finance, how digital assets work and how to interact with them.
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