Yield farming is a system that generates revenue out of deposited crypto assets. In simpler terms, it is similar to eking interest from the money deposited in your account. More specifically, it produces rewards for people who use these preserved tokens. And in a way, they also become a medium that brings liquidity and is typically used by projects.
Understand Yield Farming
While it sounds easy to apply, Yield Farming has its complexities. There are protocols that you need to follow while engaging in this process. The most prominent ones are Uniswap, Curve Finance, and Aave. However, you must know that this practice has its fair share of risks. It gives way to issues like price volatility, smart contract hacks, rug pulls, and more.
The entities deploying yield farming secure the assets in decentralized apps. They could be wallets, decentralized exchanges, and other similar mechanisms. The farmers use these instruments to stake, borrow, or lend coins. These actions bear interest as well as price fluctuations. The underlying process is supported by smart contracts that automate and arbitrate financial agreements between dealing parties.
Types of Yield Farming You Should Know
- Staking- Staking works in two different ways in the Defi ecosystem. The first and more prominent way is to use proof-of-stake blockchains. Under this arrangement, the user pledges their tokens to the network, and in return, they receive interest. The second way is to stake Liquidity Pool (LP) tokens that they earn from a decentralized exchange with liquidity. It has the added advantage of earning the yield twice. Once when they’re paid for supplying LP tokens and again when they stake the same tokens.
- Borrowing- This is quite like taking a loan on a mortgage. Users submit one token as collateral and receive another in return. They can use those borrowed coins to get yields. It gives them a chance to earn double rewards. The original tokens’ raised value(if that happens) and the yield on borrowed coins.
- Lending- The token holders can lend their crypto to others and yield interest. The whole system works on a smart contract.
- Liquidity Provider- In this system, the users deposit two coins to a decentralized exchange. The exchange takes a small fee to swap the two and pay the interest using the Liquidity Pool tokens.
Calculating Yield Farming Returns: An Overview
The returns are calculated on an annual basis. They are done based on Annual Percentage Yield (APY) or Annual Percentage Rate (APR). The APY takes compounding into account to generate higher returns, but the APR does not. However, you must remember that the interest amount will depend on market conditions.
Since yield farming is all about generating interest, it is used by entities and individuals to yield substantial results. But to make this happen, one needs to get a grip on investment chains, protocols, and Defi platforms. And you should also keep in mind it is exposed to some risks above. Thus, you must use reliable mediums to make the most of yield farming.