Yield farming – what do you need to know?

Yield farming, one of the hottest trends in the world of decentralized finance, has taken the whole ecosystem by storm since last year. It offers investors rewards for locking their cryptocurrencies in the DeFi market.

What is yield farming?

At its core is a yield farming process that allows cryptocurrency holders to earn rewards from their possession. At yield farming, the investor deposits cryptocurrency units in a loan protocol to earn interest on trading fees. Some users are also rewarded with additional revenue from the protocol management token.

Yield farming works similarly to bank loans. When the bank lends you money, you repay the loan with interest. Yield farming does the same, but this time the banks are cryptocurrency holders. Yield farming uses “idle cryptocurrencies” that would otherwise be idle on a stock exchange or hot wallet to provide liquidity in DeFi protocols such as Uniswap in exchange for revenue.

Liquidity pools, liquidity providers and AMM

Yield farming works with a liquidity provider and a liquidity pool (an intelligent contract filled with cash) that powers the DeFi market. A liquidity provider is an investor who invests in a smart contract. A liquidity pool is a smart contract filled with cash. Yield farming works on the basis of the automatic market maker (AMM) model.

This model is popular on decentralized exchanges. AMM eliminates the conventional order book, which contains all “buy” and “sell” orders on the crypt exchange. Instead of specifying the price at which an asset is to be traded, AMM uses liquid contracts to create liquidity pools. These pools execute trades based on predetermined algorithms.

The AMM model relies heavily on liquidity providers (LPs) to invest in liquidity pools. These pools are the basis of most DeFi marketplaces, where users borrow, lend to others and exchange tokens. DeFi users pay trading fees to marketplaces, and the marketplace shares these fees with LPs based on their share of the pool’s liquidity.

Calculation of income from management

Estimated earnings are calculated on the basis of an annual model. It shows the possible earnings for one year.

The most common metrics include annual percentage rate of return (APY) and annual percentage rate of charge (APRC). The main difference between them is that the APR does not take into account compound interest, which includes the repayment of profits in order to increase revenues.

Nevertheless, most calculation models are just estimates. It is difficult to calculate returns accurately because it is a dynamic market. The yield farming strategy can bring high yields for some time, but farmers can always accept it en masse, which will lead to a decrease in profitability. The market is relatively volatile and risky for both borrowers and creditors.

Risk yield farming

Despite the apparent potential profit, yield farming has its risks. Is part of them:

Risks of smart contracts

Smart contracts are paperless digital codes that contain an agreement between the parties on predefined rules that are self-executing. Smart contracts eliminate intermediaries, are cheaper and more secure for transactions. However, they are vulnerable to attacks and code errors.

Risk of volatile loss

Yield farming requires liquidity providers to supply funds to pools to earn revenues and fees for trading on decentralized exchanges (DEX). This offers LP market-neutral returns, but it can be risky during sharp market movements. This risk is possible because AMMs do not update token prices in line with market movements and do not take effect immediately.

Liquidation risks

As in the traditional financial space, DeFi platforms use their customers’ deposits to ensure the liquidity of their markets. However, a problem could arise when the value of the collateral falls below the cost of the loan. For example, if you take out an ETH loan secured by BTC, an increase in the price of ETH would lead to the liquidation of the loan because the value of the collateral (BTC) would be lower than the value of the loan in ETH.

Capital-intensive and complicated process

Yield farming is a capital-intensive operation. Most of the cost concerns relate to the issue of gas charges in the ETH network. This is a problem for smaller participants rather than richer users who have access to more capital. Smaller participants might find that they cannot withdraw their earnings due to high gas fees.

Conclusion

Yield farming uses investors’ resources to create liquidity in the market in exchange for returns. It has considerable growth potential, but it is not without flaws. If you want to get started, first do a detailed analysis of your options and resources. Do not take this article as investment advice.