Yield farming refers to a popular practice in the decentralized finance (DeFi) space, which involves users making money and earning rewards by providing liquidity to liquidity pools on blockchain platforms.
Basically, it is a method of earning income on your idle capital just like the interest you earn when you deposit money in a bank MINUS the centralized entity taking a cut.
How does this happen? Cryptocurrency holders can earn passive income by lending or staking their funds to various DeFi protocols.
In other words, when you lend other people your cryptocurrency in a liquidity pool (aka the proverbial farm) on a DeFi protocol you stand to gain an annual percentage yield (APY).
Let me explain this honest work.
How does Yield Farming work?
First, you have to deposit your tokens into a decentralized account or in other words ‘give your money to the pool’.
Next, users borrow these tokens and pay interest on their crypto loans. Finally, some of the proceeds go to the liquidity providers. And YOU can get a return on your investment!
And this continues. Whenever someone borrows money from this pool, they pay a fee, and part of that fee gets deposited into your account. And this differs from giving your money to a CENTRALIZED company where you are not completely in control of your assets.
Why? When you give them your crypto, they have to approve your transaction PLUS a waiting period before which you aren’t allowed to withdraw your money!
Not to mention the high-interest rates…
Is Yield Farming safe?
Well, to say that there are no risks would be a total lie. However, lending protocols deal with this by utilizing a method called ‘over-collateralization’.
Here, the borrower has to put a number of assets or amount of money ON ACCOUNT before borrowing.
For example, if the borrower has 1000$ worth of Ethereum, they put that directly on the decentralized lending platform.
The said platform will then allow this person to borrow a percentage of that money (about 70%) in any form they want.
By this, the lender is confident of the borrower’s ability to pay back their assets. Since originally the decentralized platform has their money/assets on the account.
Most Common Types of Yield Farming
Liquidity providers (LPs) contribute crypto assets to a decentralized exchange and receive a percentage of exchange fees from trades. LPs must deposit equal amounts of two crypto assets into a trading pair. Check out our article on crypto trading pairs for more!
Proof-of-Stake protocol in a blockchain: People lend some amount of the blockchain’s native crypto asset (For example ETH on the Ethereum blockchain…) to the network in order to secure it. In exchange for this vital service, they receive a percentage of the blockchain’s new token issuance.
Limited-time opportunity staking: Some projects allow people to “stake” LP tokens by depositing them into a staking smart contract. As a result, LPs earn yield twice, first for providing liquidity in a pool and second for staking LP tokens on the decentralized exchange.
DeFi allows people to borrow crypto assets from a pool of lenders. The lenders receive yield from the interest borrowers pay. Check out our article on crypto lending for more!
Risks of Yield Farming
If you wish to travel the extra mile, you can take the rewards you receive and reinvest them in other liquidity pools to maximize returns. This process is referred to as “compounding” and can be quite complex, as farmers seek the most profitable opportunities across different DeFi protocols.
All in all, yield farming can be a great way to reap passive income from your otherwise frozen assets. However, with reward comes risk, so be careful before you lock your money in any liquidity pool.
Do your thorough research, and stay tuned for more!