Although the DeFi world is complicated, some users have figured out how to maximize their cryptocurrency’s earning.
Utilizing decentralized finance (DeFi) in order to optimize profits is known as yield farming. On a DeFi platform, users may lend or borrow cryptocurrency and get cryptocurrency in exchange.
Farmers that are interested in increasing their crop production might use more sophisticated strategies. For instance, yield farmers might continuously switch their cryptocurrency holdings between several lending platforms to maximize their profits.
How does yield farming work?
Yield farming allows investors to earn yield by depositing coins or tokens in a decentralized application, or dApp. Cryptographic wallets, DEXs, decentralized social media, and other applications are examples of dApps.
Decentralized exchanges (DEXs) are typically used by yield farmers to lend, borrow, or stake coins in order to earn interest and speculate on price fluctuations. Smart contracts, which are bits of code that automate financial agreements between two or more parties, enable yield farming throughout DeFi.
Types of yield farming:
- Liquidity provider: Users deposit two coins to a DEX to provide trading liquidity. To switch the two tokens, exchanges charge a nominal fee, which is given to liquidity providers. Sometimes, fresh liquidity pool (LP) tokens can be used to pay this cost.
- Lending: Coin or token owners can use a smart contract to lend cryptocurrency to borrowers, earning yield from the interest that is charged.
- Borrowing: Farmers may borrow another token by pledging one as security. The borrowed cash can then be used to increase farming productivity. In this manner, the farmer retains their initial investment, which may rise in value over time, and earns return on the coins they borrowed.
- Staking: In the universe of DeFi, there are two types of staking. The primary implementation is on blockchains using proof-of-stake, where a user receives interest in exchange for pledging their tokens to the network as security. The second is to stake LP tokens obtained by providing liquidity to a DEX. Because they are compensated for providing liquidity in LP tokens, which they may later invest to earn more interest, this enables users to earn yield twice.
Calculating agricultural yield returns
Typically, expected yield returns are annualized. A year’s worth of calculations go into calculating the potential profits.
Annual percentage yield (APR) and annual percentage rate (APR) are two frequently used measures (APY). APR does not take compounding—reinvesting profits to produce higher returns—into account, while APY does.
Remember that the two measures are only hypotheses and guesses. Even immediate benefits are challenging to predict with certainty. Why? A fast-paced, fiercely competitive sector with constantly shifting incentives is yield farming.
A farming approach that increases yields for a while will eventually stop producing large returns because other farmers will start using it.
APR and APY are outdated market indicators, therefore DeFi will need to develop its own method of calculating profit. Due to DeFi’s quick speed, weekly or even daily predicted returns could make more sense.
Risks of yield farming
A difficult practice known as “yield farming” puts both borrowers and lenders at danger of losing money. Users run a higher risk of momentary loss and price slippage during volatile markets. Here are a few concerns connected to farming for yield:
Rug pulls
Rug Pulls are a type of exit scam in which a cryptocurrency developer solicits money from investors for a project, abandons it, and keeps the investors’ money. According to a CipherTrace study report, rug pulls and other exit scams, to which yield farmers are particularly susceptible, accounted for roughly 99% of large fraud during the second half of 2020.
Regulatory risk
Regulation of cryptocurrencies is still shrouded in mystery. Some digital assets are now regulated by the Securities and Exchange Commission since it has determined that they are securities. Against centralized cryptocurrency lending platforms like BlockFi, Celsius, and others, state regulators have already issued cease and desist orders. If the SEC classifies DeFi loans and borrowing as securities, the ecosystems of lending and borrowing may suffer.
Though this is accurate, DeFi is intended to be independent of all centralized control, including governmental laws.
Volatility
The degree to which an investment’s price fluctuates in either direction is referred to as volatility. A volatile investment is one that has a significant price movement in a brief amount of time. Yield farmers take a significant risk when tokens are locked up because of the potential for value fluctuations, especially during bad markets in the cryptocurrency markets.
What exactly is temporary loss?
Liquidity providers may suffer temporary loss at times of significant volatility. This happens when the price of a token in a liquidity pool fluctuates, causing the ratio of tokens in the pool to shift in order to stabilize the pool’s overall value.
The majority of the risks connected to yield farming are caused by the smart contracts that support them. Better code screening and outside audits are helping to increase the security of these contracts, although attacks in DeFi are still frequent.
Before using any platform, DeFi users should do their due diligence and study.
Is farming for yield profitable?
Yes. However, it all relies on how much you’re ready to invest in yield farming in terms of both money and time. Even while certain high-risk strategies offer significant returns, they often work best when the user has a solid understanding of DeFi platforms, protocols, and complex investment chains.
Try putting some of your cryptocurrencies into a tried-and-true platform or liquidity pool to see how much it earns if you’re looking for a means to get passive income without making a significant financial commitment. Once you’ve established this base and gained confidence, you may go on to additional investments or even make direct token purchases.
Is farming for yield risky?
Investors should be aware of the hazards associated with risk farming before beginning. In the DeFi yield farming industry, scams, hacks, and losses from volatility are not unusual occurrences. Anyone interested in using DeFi should start by looking at the most reliable and tried systems.
