First of all, what is DeFi
Decentralized finance, also known as DeFi, is a global financial platform that’s accessible on public blockchains such as Ethereum. This system eliminates banks’ control over money, financial products, or financial services. They are permissive, which means that anyone can access them (or any other object, such as a smart contract) via an Internet connection and supported wallet. They don’t usually require trust in custodians and middlemen. They are therefore trustless.
What is Yield Farming?
Yield farming allows you to earn interest on your cryptocurrency in the same way that savings accounts earn interest. Similar to depositing money at a bank, a yield farm involves locking your cryptocurrency for a time, known as “staking”, in exchange for interest, or other rewards such as more cryptocurrency.
Traditional loans are issued by banks and paid back with interest. Yield farming is the same concept: cryptocurrency is lent to generate returns instead of sitting in an account.
How does Yield Farming Work?
Liquidity providers (LPs) are users who provide cryptocurrencies to the DeFi platform. These liquidity providers (LPs) provide tokens or coins to a liquidity pool, a smart contract-based, decentralized application (dApp), that holds all funds. The liquidity pool is activated once the LPs have locked tokens in a liquidity fund. They will be paid a fee or interest from the underlying DeFi platform.
It is essentially a way to make an income by lending tokens via a decentralized app (dApp). Smart contracts are used to lend without any intermediary or middleman.
The liquidity pool is the engine that powers a marketplace where anyone can borrow or lend tokens. Users pay fees for the use of the marketplace. These fees can be used to pay liquidity providers to stake their tokens in the pool.
The Ethereum platform is the most popular place to do yield farming. This is why rewards are a type of ERC-20 token.
Lenders can use the tokens however they like, but most lenders are speculators who seek arbitrage opportunities in cashing in on token fluctuations.
How is yield farming return calculated?
The expected yield returns are often annualized. The expected returns are calculated over the course of a year.
Annual percentage rate (APR), and annual percentage yield are two commonly used measurements. APR doesn’t account for compounding, which is the act of reinvesting gains in order to generate higher returns. APY does.
Remember that these measurements are only projections and estimates. It is difficult to predict even short-term benefits with precision. Why? Yield farming is highly competitive and fast-paced, with constantly changing incentives.
A yield farming strategy that works for a long time will be embraced by other farmers, eventually resulting in significant returns.
DeFi will need to calculate its profit calculations because APR and APY have become obsolete market metrics. Due to DeFi’s rapid pace, weekly or daily expected returns might make more sense.
What are the risks associated with yield farming?
- Volatility: refers to the extent to which an investment’s value fluctuates. Volatility is an investment that sees a large price swing in a short time. While your tokens are locked up, their price of them could plummet or rise.
- Fraud: Yield farmer may put their coins in fraudulent schemes or projects that take all of their coins. According to CipherTrace, fraud and misappropriation are the main causes of $1.9 billion worth of crypto crimes in 2020.
- Rug pulls: This is a type of exit scam in which a cryptocurrency developer raises funds and then abandons the project, without returning investors’ money. CipherTrace’s report mentioned that rug pulls and other exit schemes were responsible for nearly 99% of major fraud in the second half. This is a problem that yield farmers are especially vulnerable to.
- Risk of smart contract: Smart contracts used in yield-farming can be vulnerable to hacking or have bugs, which could put your cryptocurrency at risk. Yield farming is most vulnerable to smart contracts. Smart contracts can be more secure thanks to better code vetting and third-party audits.
- Impermanent loss: Your cryptocurrency’s value could fluctuate while it is being staked. This can lead to temporary unrealized gains and losses. These gains and losses are permanent when you withdraw your coins. If the loss is greater than the interest earned, you may be better off keeping your coins open for trading.
- Regulatory risk: Many regulatory questions remain around cryptocurrency. SEC has declared that certain digital assets are securities, and therefore fall under its control. It can regulate them. BlockFi, the largest crypto lending site, has already been stopped by state regulators.
Examples of Yield farming Dex
Aave is one of the most popular stablecoin yield-farming platforms. It has a market value of more than $3.4 billion and is worth over $14 billion.
Aave has its native token, AAVE. This token provides benefits like fee savings and voting power, which incentivizes users of Aave to use the network.
When it comes to yield farms, it is not uncommon to see liquidity pools working together. The highest-earning stablecoin on Aave is the Gemini dollar. It has a deposit yield of 6.98% and a borrowing yield of 9.69%.
Curve has nearly $19 billion in total value locked and is the largest DeFi platform. Curve Finance platform uses its own auto market-making (AMM) algorithm to make more use of locked funds than other DeFi platforms. This is a benefit for swappers as well as liquidity suppliers.
Curve offers a wide range of stablecoin pools that have good APRs and are tied to fiat money. Curve maintains its high APRs, which range from 1.9% for liquid tokens to 32% for the larger ones. Stablecoin pools can be trusted as long as they don’t lose the tokens. Because their costs won’t change drastically, the impermanent loss can be avoided. Like all DEXs Curve is susceptible to temporary loss or smart contract failure.
Curve also owns its token, CRV. This token is used to govern the Curve DAO.