Yield farming is the process of using decentralized finance (DeFi) to generate the highest return possible.
DeFi platforms allow users to borrow and lend tokens, which in turn pay them a commission for their services.
Yield farming has become increasingly popular as a way to generate passive income in the world of decentralized finance (DeFi).
dApps allow users to lend, borrow, or stake coins, and in return, they earn yield – similar to interest payments from a bank.
How does yield farming work?
Yield farming is facilitated by decentralized exchanges (DEXs) which connect traders with other traders or providers offering financial services such as those offered by dApps.
Once connected, users are able to add coins or tokens to their wallets and start earning yield through the automated smart contracts that are built into the system.
Additionally, yield farmers can reap the rewards not only from leveraging price movements but also from participating in liquidity pools and receiving transaction fees for helping facilitate trades between buyers and sellers.
Types of yield farming
There are 4 ways you can earn from yield farming.
1. Liquidity Provider
Users deposit two coins (E.g. FRAX-USDC) to a DEX to provide trading liquidity in an exchange.
Exchanges charge a small fee to swap the two tokens and a part of the swap fees is paid to the liquidity providers. This fee can sometimes be paid in new liquidity pool (LP) tokens.
Token holders can lend crypto to borrowers through a smart contract and earn yield from interest paid on the loan.
Users can use one token as collateral and receive a loan of another token in a dApp.
Users can then farm yield with the borrowed tokens. This way, the farmer keeps their initial token (collateralized), which may increase in value over time, while also earning yield on their borrowed tokens.
Staking tokens is similar to locking your tokens with the exchange or dApps.
Users can also stake LP tokens earned from supplying a DEX with liquidity. Thus, they can earn yield twice - once for supplying liquidity in LP tokens and again for staking their LP tokens to earn even more yield.
You can find an exhaustive list of all the pools where you can lend or stake tokens or provide liquidity along with the APY they offer.
Beware that the highest APY pools might also have higher risks so you should be doing your research before investing with any of the pools.
What are the risks of Yield Farming?
While yield farming seems like an easy way to make passive money, it has a ton of risks that you should understand first.
To farm yields, your tokens are often locked in for a determined period of time. And if the market turns red during that time you could potentially be at risk of significant losses. Yield Farming has the same risks as any trader or investor holding those digital assets.
Long-term investors should take particular caution when participating in yield farm platforms, as these investments can be quite risky with the chance of large drawdowns.
Earning yields by taking exposure to smaller caps has a lot more risks involved than staking more established tokens like Ethereum.
2. Impermanent Loss
Impermanent loss occurs when someone uses a liquidity pool, swapping one type of token for another at a given ratio.
For example, if a user is trading ETH for HBAR and buys HBAR from this liquidity pool, they are essentially depositing ETH into the pool and taking out an equivalent amount of HBAR. This begins to shift the ratio of tokens inside the pool by creating more ETH and less HBAR; raising the value of HBAR while lowering the value of ETH. Those who provide funds to the liquidity pool will have less of the token that increased in value due to this imbalance.
The concept of impermanent loss is important for investors as it helps them understand how their investments could change over time based on other trades being made within a given decentralized finance system.
As trades continue to be made, prices may begin to adjust accordingly as liquidity increases or decreases; indicating that investors must be vigilant with their trade decisions so as not to face large losses due to impermanent losses occurring in their DeFi portfolio.
Understanding how these concepts play out will prove invaluable when traders make decisions about which pools they wish to participate in.
Rug pulls have become increasingly common in the modern cryptocurrency market. Essentially, this type of scam involves a project creating and promoting a new token to draw buyers in with the promise of potential future profitability. Unfortunately, once the creators have raised their desired amount of funds they suddenly vanish without warning or explanation, leaving investors vulnerable and out of pocket.
4. Liquidity pools drying up
Since liquidity is supplied by various users worldwide in an LP, people can pull their tokens out of the pool. This situation can lead to low liquidity which causes higher slippage when this happens. Slippage means that less than expected funds are received by users when selling tokens into the pool.
5. Shifting market conditions
Payouts in a Liquidity pool can change from one day to another. And a high payout LP might reduce their yield which can lead to users always looking for newer strategies and pools. Needless to say, all this requires time and constantly keeping in touch with the yield opportunities available in different pools.
Thus, yield farming is not a passive approach to investing and there's no one-size-fits-all strategy to yield farming.
Yield-farming protocols to know about
Here are a few of the top yield farming protocols:
There are many others and each of these protocols has its own unique set of rules and regulations designed to ensure the fairness of the protocol. Investors must research any potential platform before entering into it in order to reduce the risk associated with yield farming.
Yield Farming is a risky strategy to make money. It is not a passive income strategy where you can expect to earn money without any effort.
However, if you understand the market situations well and are ready to put time and effort into moving your funds in and out of various LPS and not get rug-pulled, this can be a highly profitable strategy.
It’s easy to get distracted with high-yield promises of protocols so make sure you know what you’re doing and do a proper due dilligence.
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