In farming, the amount of crop you grow from your seeds is called the ‘yield’.
But now the term ‘Yield Farming’ is one of the hottest terms in the crypto world? Does it mean the same or different? Let’s dive in to understand.
Farming or Yield Farming to be exact is an act of putting your crypto assets to work to generate more crypto. This can be done by leveraging different Decentralized Finance (DeFi) products and protocols to earn a yield or say a return on your invested asset.
DeFi has opened up a whole range of opportunities for people like you and me to actively participate and earn.
People who put their crypto at work are not investors, traders, or miners, they are known as farmers. These are the people who have found lucrative lending and borrowing opportunities in the DeFi space, some of which are able to generate a 100% yield.
Yes, you read it correctly, a one hundred percent yield which is impossible to earn with our traditional banking systems.
In this article, we will cover what exactly yield farming or liquidity mining is, will take you through different DeFi protocols and platforms that are used for yield farming, and will share some potential risks of opting for yield farming.
So, Let’s get started.
- What is Yield Farming?
- Where Can You Farm?
- How Are Yield Farming Returns Calculated?
- The Risks in Yield Farming
- The Future of Yield Farming
- FAQs
So, What is Yield Farming?
Yield farming or liquidity mining is hunting yield into the DeFi space. Basically, it means to allocate crypto to lending, borrowing, and liquidity pool opportunities and using interoperable protocols to enhance that yield.
Financial Services into the DeFi ecosystem is provided through a number of dApps. Most of the DeFi apps are related to Wallets, lending, borrowing, spot trading, margin trading, market-making, and interest-earning.
As an example, Compound Finance is the most widely used dApp for farming yields.
Yield farming is mostly done using ERC20 tokens on Ethereum and the rewards are also in the same form. There are several protocols available in the DeFi ecosystem that are based on Ethereum and that allows people around the globe to lock their crypto and to earn interests on it. Yield farmers continuously move their funds around different protocols in search of high yields.
Farmers in yield farming have a specified set of strategies to grow their crops. Each strategy has its own rules and risks. Before locking up your crypto into the DeFi space it’s worth learning what are the most popular platforms that yield farmers use and what are the strategies they use to maximize their crop?
Where Can You Farm: Yield Farming Platforms and Protocols
Liquidity mining, another term for yield farming is the method of allocating tokens and rewarding users who provide liquidity to the DeFi platform. Farmers use different DeFi protocols and platforms to earn rewards. These protocols are majorly categorized into five different categories.
Now, take a look at the picture below:
As you can see the total value locked into the DeFi ecosystem is pretty large i.e, $11 billion as of September 2020. Scrolling down to the website you will notice that all the DeFi protocols are classified under 5 different categories according to their function namely, Lending, DEXEs (Decentralized Exchanges), derivatives, payments, and assets.
Now let’s have a look at some of the widely used protocols from the above categories.
Lending and Borrowing in Yield Farming
DeFi lending platforms allow everyone to earn interests and borrow loans in a trustless manner. A liquidity provider can immediately start earning interests on his supplied stable coins or cryptocurrencies.
Compound Finance, Aave, and Maker DAO are the three most widely used open-source platforms for lending and borrowing cryptocurrencies. However, we have many in the pipeline.
1. Compound Finance
For current statistics visit https://defipulse.com/compound
The above graph represents the total value locked into Compound (in USD) is $809.1 million.
Compound is an algorithmic platform based on Ethereum that allows users to earn interests and borrow assets by putting up collateral. Anyone who has an Ethereum wallet can provide the funds to the Compound’s liquidity pool and can immediately start earning interests on it. In compound finance, users can borrow up to 50-75% of their collateral value that is referred to as ‘cTokens’.
2. Aave
For current statistics visit https://defipulse.com/aave
The above graph represents the total value locked into Aave (in USD) is $1.55 billion.
Aave is one of the heavily used protocols by the yield farmers to maximize their DeFi crop. Like Compound Finance,
Aave is an open-source, decentralized lending and borrowing protocol based on Ethereum. The supplied collateral here is termed as ‘aTokens’ and users can start earning interests and compound interests immediately after supplying liquidity to the Aave pool.
3. Maker DAO
For current statistics visit https://defipulse.com/maker
The above graph represents the total value locked into Maker DAO (in USD) is $1.97 billion.
Maker DAO is a decentralized lending platform that issues DAI token in the ratio of 1:1 to the US dollar. Dai – a stablecoin can be generated as a debt against the supplied collateral such as ETH, BAT, and USDC. Yield farmers use issued Dai to implement their complex strategies for farming yield.
Liquidity Pool Exchanges in Yield Farming
A decentralized exchange (DeFi) is a marketplace where trades occur directly between users through an automated process. Decentralized exchanges are broadly classified into two: order book exchanges (like Binance) and liquidity pool exchanges (like Uniswap, Balancer, and Curve).
Order book Exchanges
Order book exchanges use an order book to record the interests of buyers and sellers in a particular token. In an order book exchange, the exchange’s matching engine will only execute the trade when an opposite order of the same token and at the same price is available.
Liquidity pool Exchanges
Liquidity pool exchanges work on the phenomenon of automated market maker (AMM). An AMM is the exchange’s matching engine in the form of a smart contract that automatically matches the trader’s buy and sell orders.
Investors just need to deposit their funds to the pool to provide Liquidity and the rest is taken care of by the smart contract. Liquidity pool exchanges eliminate the need of trader-2-trader matching by maintaining the liquidity in the pool.
Returns from liquidity pool exchanges are based on three factors: Prices of the asset when supplied and withdrawn, trading volumes, and liquidity in the pool.
Now, let’s have a look at some heavily used liquidity pool exchanges.
1. Uniswap
For current statistics visit https://defipulse.com/uniswap
The above graph represents the total value locked into Uniswap (in USD) is $2 billion.
Unlike Binance, Uniswap is a fully Decentralized Exchange (DEXs) protocol that allows users to exchange tokens. Built on the top of the Ethereum, Uniswap uses liquidity pools to swap between ETH and any ERC20 token.
In order to exchange tokens, liquidity providers have to create new markets by supplying two equal proportions of tokens to the smart contract. As a return for supplying liquidity to the Uniswap pool, liquidity providers can earn fees from the trades that happen in the pool.
2. Balancer
For current statistics visit https://defipulse.com/balancer
The above graph represents the total value locked into Balancer (in USD) is $488.1 million.
Like Uniswap, Balancer is a Decentralized Exchange liquidity protocol for exchanging tokens. The only key difference here is that it does not require 50/50 allocation of tokens to create custom Balancer pools for the exchange of tokens. Similar to Uniswap, traders can earn fees from the trades that happen in the liquidity pool.
3. Curve
For current statistics visit https://defipulse.com/curve-finance
The above graph represents the total value locked into Curve Finance (in USD) is $1.35 billion.
The Curve is a decentralized exchange liquidity pool designed specifically for stable coin trading like Dai. Unlike Uniswap where token-to-token trades are expensive, curve allows users to trade in stable coins with low slippage and at a very low fee.
Derivatives
Derivatives are the financial contracts that derive their value from an underlying asset. An asset can be anything in value. In the case of cryptocurrency, it is BTC, ETH, or other cryptocurrencies.
There are multiple protocols in the DeFi ecosystem that fall under this category. Synthetix is one of them.
Synthetix
For current statistics visit https://defipulse.com/synthetix
The above graph represents the total value locked into Synthetix (in USD) is $624.1 million.
Synthetix is a decentralized, synthetic asset exchange. It allows the creation of synthetic assets. In the crypto space, Synthetix allows users to hold assets in the form of digitalized gold, silver, etc.
How Are Yield Farming Returns Calculated?
In a highly competitive and volatile market like yield farming, calculation of returns and rewards can be a bit tricky. It is nearly impossible to estimate the exact value of return even for short terms. Yield farming ROI can be calculated in terms of Annual Percentage Yield (APY) and Annual Percentage Rate (APR).
Annual Percentage Rate (APR): APR refers to the annual rate of return charged on borrowers, but paid to capital investors.
Annual Percentage Yield (APY): APR refers to the yearly rate of return charged on capital borrowers and paid to capital providers.
Looks the same? Well, APR is not different from APY apart from the fact that APR interest earned on the capital cannot be added to the original principal capital to earn more interest however, this can be done in APY.
The Risks in Yield Farming
There is no gain without pain. You cannot generate more returns without accepting additional risks. In the case of yield farming, one of the biggest risks comes from smart contract vulnerabilities.
Hackers study these smart contracts deeply and if they spot an opportunity to tap they will jump at it. Another big risk involved in yield farming is High Liquidation risk. This happens when the value of locked collateral falls below a specific value as required by the protocol. This happens because of market swings. In this case, your collateral will be liquidated on the market to cover the debt.
Last but not least is smart contract bugs. Sometimes it is possible that smart contracts have bugs in it. There are numerous occasions when bugs have occurred and users can lose their funds by having them stuck in the smart contracts. Now, this could be scary. But Defi has made its own way out for these risks as well.
There are several DeFi insurance-related projects like Nexus+Mutual, ETHERISC, and CDx going on. These projects can be the next big thing into the DeFi space as it gives confidence to people for using DeFi products and services.
Even though yield farming can be profitable but it can be risky at the same time. So, it is advisable to consider the risks and challenges associated with it before stepping in and one should only use the capital that he can afford to lose.
The Future of Yield Farming
Yield farming is a completely new thing and it is far from being a fully efficient market. There are plenty of opportunities revolving around it. It is impossible to predict how big it can be in the years to come and what new it will bring to the finance sector.
Yield farming has the potential to attract more users to the DeFi space to use its products and protocols.
According to DeFi Pulse, there is $11 billion in crypto assets locked in DeFi as of September 2020. That gives an idea of how big Yield Farming can be in the years to come.
FAQs
1. What is DeFi?
DeFi short for Decentralized Finance takes components from traditional finance and decentralizes them by removing the requirement of middlemen and replacing them with Smart Contracts.
DeFi is all about building a more complex financial ecosystem on the top of the Blockchain that allows us to borrow loans in an over collateralized manner and supply money to earn interests, all this by making the use of Digital Smart Contracts. A straightforward example of a DeFi system is decentralizing loans and earning interests.
The awesome thing about DeFi is that anyone around the world can be a part of the DeFi ecosystem even without getting their KYC done.
2. What are Tokens?
Tokens or Crypto assets are special kinds of virtual currency that are used to raise funds for crowd sales. It represents the ownership of an underlying real-world asset.
In simple terms, a token is a cryptocurrency that is built on the top of an existing blockchain like Ethereum.
In the crypto world, Token can be of two types: security token and utility token.
3. What are Smart Contracts?
A Smart Contract is a digital contract between two people (say a buyer and a seller) that executes automatically when predetermined terms and conditions are met. Digital Smart Contracts allows you to exchange anything in value in a very transparent way by removing the need of any middle man.
The transactions that happen in a Smart Contract are recorded on a public Blockchain. This means that the ownership of assets cannot be disputed and at the same time you need not trust any middlemen for the ongoing transaction.
4. Is there DeFi for Growing Bitcoin?
As we know, a large part of the DeFi ecosystem is based on the Ethereum blockchain rather than that of Bitcoin. It’s become really frustrating for BTC owners to participate and use DeFi products and protocols unless they sell their crypto assets or buy others.
This problem can be overcome by the use of WBTC. WBTC or Wrapped Bitcoin is an ERC-20 token that is backed in the ratio of 1:1 to the Bitcoin.
WBTC allows BTC owners to use DeFi products and protocols like anyone else without selling their Bitcoins.
Investors can go through the “wrapping” and “unwrapping” process by the use of several exchanges or through a merchant with some fees associated with it.
Users can mint WBTC like other cryptocurrencies at the same DeFi platforms.
When Bitcoin is wrapped, the equal amount of WBTC is made public – with proof that Bitcoin, the asset beneath is in secure custody.
Now, farmers can use WBTC on different lending platforms to borrow assets by keeping their WBTC as collateral. This in turn allows BTC owners to mint Bitcoin on DeFi platforms.
5. What Does the Term Over-Collateralized Mean?
Taking loans in Defi is not the same as taking loans from your local banker. If you want to take a loan in the DeFi ecosystem, you need to put up collateral (In DeFi, it’s Crypto) to cover your loan.
You also need to make sure the value of your collateral should not fall below a threshold required by the protocol. If that happens your collateral will be liquidated on the open market.
This type of loan is known as over collateralized loan. It means that you will always receive a loan of a lesser value than the supplied collateral and if you miss your repayments your collateral will be liquidated to recoup the value of the loan.
Thus it becomes important to keep an eye on the supplied collateral value. You should add more collateral if the value of your supplied collateral is falling below the required threshold and if you want to keep yourself into the game.
The Final Note
Undoubtedly, yield farming is the next big thing that happened in the crypto space after the ICO boom of 2017.
Rather than seeking just the high returns it may provide, one should first understand the risks associated with it. Yield farming strategies are highly complex and are only recommended for experienced users.
Before stepping in into the world of DeFi, make sure that you are comfortable with bearing losses and have the zeal to cover those losses.
