Yield Farming: Powering Your Crypto Holdings

Summary

• Yield Farming is earning through liquidity pools.
• Users move between different pools to generate high returns.
• There are high returns as well as high risks associated.
• Popular liquidity pools are Venus, Curve, Synthetic, etc.

Introduction

Everyone wishes to earn good returns on their investments or a passive income to support their financial situation. Cryptocurrencies have a plethora of opportunities as long as your expectations are realistic.

The world of Decentralized Finance (DeFi) has brought innovative ways for users to earn. Initially, people gained from cryptocurrency value appreciation which is still there but the gains have drastically reduced. Then came the concept of staking with proof of stake blockchains. Due to its huge popularity and everyone staking their coins, even these gains have dropped significantly.

With this article, we shall explore, why a new trend called Yield Farming has emerged and why it is much more profitable than the previous ones.

What Is Yield Farming?

Liquidity is the ease through which one asset can be traded. More liquidity means instant buy and sells for that asset. So to generate liquidity, some pools are created. 

Many liquidity providers found that there exists a difference between the returns of various pools and started moving their funds rapidly across pools. Thus started the concept of Yield Farming.

Yield Farming is a strategy to maximize crypto earnings by offering your crypto holdings to generate liquidity for various pools. It has also been often referred to as Liquidity Mining, however, yield farming involves rapidly shifting your assets across different platforms which is not a practice in liquidity mining.

How Does Yield Farming Work?

Yield farming works in a very simple way. You get paid to provide funds for cryptocurrency pools.

But why does anyone need such a pool?

The concept of Yield Farming was made popular by Decentralized Exchanges. For cryptocurrency buying and selling to take place, an exchange needs some initial funds in various cryptocurrencies so users can exchange their crypto and money.

In the traditional world, when exchanges need this liquidity, they contact hedge fund managers and pay a fee. DeFi has democratized this process. Pools are created before launching an exchange. These pools are made up of different cryptocurrencies such as Bitcoin, Ether, Matic, USDT, etc. Those people who provide these initial funds for the pools are rewarded with cryptocurrencies as fees. As soon as users notice better yields in another protocol/platform they switch. This entire procedure is called Yield Farming. 

Yield Farmers get paid initially in Platform Native Tokens (ex. AAVE) and provide tokens and coins such as Bitcoin, Ethereum, USDT, etc. Yields can be higher than in staking and simple liquidity mining. For example, SUN protocol offers 42% APY for SUN-TRX(Tron) swap. 

Note: APY is Annualized Percentage Yield, it is a measure of how much you can gain per year in that swap.

Popular Liquidity Pools

There are many liquidity providers for yield farming. Here are a few of the most popular ones.

• Curve – It supports swaps that are based on Ethereum. It has size of  $1.8 Billion.
• Synthetic – This protocol is also based on Ethereum and has a size of approximately $2 Billion.
• Venus – This protocol is based on the Binance Smart Chain. As per coinmarketcap, this protocol has the largest size by value of approximately $2.4 Billion.

Yield Farming Vs. Staking

Yield farming is different from staking in many respects. 

In staking, the tokens are staked to become validators. In yield farming, the sole motto is to generate higher and higher profits.

Further, staking has a lock-in period whereas, in yield farming, users switch very frequently between protocols.

Advantages Of Yield Farming

Yield farming has many advantages associated with it. Some of them are:

• High APY: Similar to its name, yield farming has the highest yields in cryptocurrencies. If you have reasonable expectations, you can make good gains. Just be aware of yields that promise unnatural returns such as in thousands of percentages.

Invest in those which are at least audited such as Venus(audited by Certik).

Risks In Yield Farming

There is a simple concept in the financial world. The higher the risk, the higher are the returns and vice-versa. 

Yield Farming has higher returns for many protocols but as the return increases for a swap, so does the risk. Primarily, there are the following risks involved:

• Illiquidity Risk: This risk arises when the fund itself has a very low customer base and is unable to return the funds to users who put in the initial liquidity.
• Smart Contract Bugs: Bugs can be the result of either human error or an inbuilt loophole in the system. A bug in Balancer Protocol led to the loss of $500 Thousand.
• Instability due to Failed Dollar Peg: Most platforms or protocols which are used for yield farming, use dollar-pegged stable coins such as USDT, DAI, etc. There is a big possibility of not having sufficient reserves with the stablecoin issuer. Major stablecoins are however not vulnerable to this but lesser-known stablecoins are.

Conclusion

Yield farming is a powerful tool in the hands of a wise investor. It can generate good returns over time. However, there are high risks associated with them. If an investor(yield farmer) takes sufficient precaution and exercises due diligence, they can get phenomenal returns. Since there are no lock-in periods like in staking, yield farmers can move their funds to different protocols and take benefit of the highest risk-adjusted returns.