Decentralised finance (known as DeFi), is an emerging financial technology that aims to eliminate intermediaries in financial transactions and where multiple avenues of income have opened up for investors.
Yield Farming is a DeFi investment strategy that involves “lending” or “dumping” your coins or tokens to earn rewards in the form of transaction fees or interest.
This is somewhat similar to earning interest from a bank account; technically you are lending money to the bank.
Yield Farming involves moving money across different markets. There is also an element of Yield Farming where the strategy becomes less effective and this is when more people know about it. As the number of users in farming grows, the percentage of commission earned goes down.
Yield Farming is currently the most important growth engine in the DeFi sector and in the InnovaMinex blog we are going to explain the key concepts for those who are starting out in the world of cryptocurrencies.
How does Yield Farming work?
Users who provide their cryptocurrencies to run the DeFi platform are known as liquidity providers (LPs).
These LPs provide coins or tokens to a liquidity pool (here we explain what a liquidity pool is): a decentralised application (dApp) based on a smart contract that contains all the funds.
Once LPs lock tokens into a liquidity pool, they are awarded a fee or interest generated by the underlying DeFi platform on which the liquidity pool is located.
Simply put, it is an income opportunity by lending your tokens through a decentralised application (dApp).
Lending is done through smart contracts without intermediaries.
The liquidity pool powers a marketplace where anyone can lend or borrow tokens.
The use of these markets incurs user fees, and the fees are used to pay liquidity providers to stake their own tokens in the pool. Most of the Yield Farming takes place on the Ethereum platform.
That’s why the rewards are a type of ERC-20 token. While lenders can use the tokens as they wish, most lenders are currently looking for arbitrage opportunities by taking advantage of token fluctuations in the market.
How did Yield Farming become popular?
The boom in the practice of Yield Farming can be attributed to the launch of the COMP token, a governance token in the Compound Finance ecosystem.
Governance tokens allow holders to participate in the governance of a DeFi protocol. Governance tokens will often be distributed algorithmically with liquidity incentives to launch a decentralised blockchain. This gives farming individuals an incentive to provide liquidity in a pool.
Some of the popular Yield Farming platforms are Aave, Compound, Uniswap, Sushiswap, Curve Finance.
How are Yield Farming returns calculated?
The estimated yield of Yield Farming is calculated in terms of annual percentage yield (you will see it with the acronym APY).
This is the rate of return that the user earns during a year. Compound interest is also taken into account in the APY calculation.
What are the risks of Yield Farming?
Hackers can be adept at finding vulnerabilities and exploits in software code to steal funds. And you should also be aware of the volatility of tokens – the price of a token can increase or decrease when it is locked in the liquidity pool.
The most important thing if you are thinking of doing Yield Farming is that you have all the information and do it with all the knowledge to minimise the risks and increase your profits.
