19 October 2020
Yield Farming enables its user in a Decentralized Finance - DeFi market to earn a variable amount of interest through the means of crypto investment. It is a concept wherein the user stakes, locks up or puts its crypto assets to work and generates returns on its assets. In Layman’s term - Yield farming is a way to profit more crypto from the crypto that you hold and invest. It works best when there is a significant-good sum amount of capital involved to generate significant profits. Yield farming is also often called liquidity mining.
The Mechanics of Yield Farming
The users - the liquidity providers add funds to the liquidity pool to earn rewards.
A liquidity pool is a smart contract that consists of a marketplace involving funds where users can borrow, lend or exchange tokens. The one using the platform is incurred with a fee which thus is later paid out to the liquidity providers as rewards.
The liquidity providers are the people that provide funds or liquidity to the pool to earn rewards. The reward comes from the fees that are generated by the source as mentioned while the reward is based on the fee generated and as per the share of the provider.
Hence, yield farming is about liquidity providers that earn rewards based on the sum liquidity they provide in the pool.
The mechanics of yield farming on DeFi depends upon the terms of the individual DeFi app and to earn in return the token of the project. The early the user adopts a new project the better the chances of receiving benefits from the token rewards while also enabling appreciation in the value and if sold at the right time - the user can finally earn its significant gain! Also, the gains can then be reinvested for other DeFi projects and there we have more of farms to yield. Farmers also keep moving their cryptos around amongst variant lending marketplace to maximize their returns in terms of profits.
Such as lending ETH on Aave - an open-source and non-custodial protocol in the money market for the users to earn interest on deposits and borrow assets - more than the price appreciation of ETH is yield farming.
Aave and Compound are of the top known and a primary DeFi’s borrowing and lending protocols, combining an account of - $390 million of borrowing and $1.1 million of lending.
It is preferable to earn returns in DeFi by lending capital in the money market. It is suited for the lender to deposit stablecoin as it increases the marginal returns, while for the borrowers the stable rate is comparatively higher than the variable rates.
Aave offers better rates as it enables the borrowers to choose a stable rate of interest instead of the variable rate.
Compound enables its users with an incentive by the issuance of its native token named COMP, also both the ends - borrowers and lenders - earns a determined amount of COMP.
Also Read, 7 Top DeFi Apps In 2020 For Making Money
Liquidity Pool in Yield Farming on DeFi
The liquidity providers who contribute to the pool earn a reward (through a fee) for facilitating the process when someone trades through liquidity pool.
Uniswap and Balancer offer rewards for adding its assets to pool to the liquidity providers with fees.
Uniswap offers a configured liquidity pools of 50-50 ratio amongst two assets.
Balancer offers liquidity pool through the custom allocation of about up to eight assets.
However sometimes when reaping the benefits of profits the investor also has to consider the loss that may occur such as the loss that is created when the asset speedily appreciates by the liquidity.
Curve Finance provides trading amongst assets that are pegged to the same value and since all the assets are the same sum of amount in worth it thus attempts to eliminate the impermanent loss.
Hence, Uniswap and Balancer facilitate resulting in higher fee gain while Curve Finance attempts to eliminate the impermanent loss.
Like Compound has COMP incentive for users to utilize the protocol.
Synthetix was the first to introduce the sETH - ETH pool offering the liquidity providers an incentive named SNX rewards. It has two liquidity incentives - sBTC pool and sUSD pool on Curve that offers the liquidity providers the reward in SNX.
Security and Collateral
DeFi money market facilitates security for the lender by following the collateralization method.
Collateral is a concept wherein the borrower would need to deposit an asset or collateral to cover their loan or deposit collateral that is more than the loan’s value (also termed as over-collateralization). So when needed, it ensures that the collateral can be liquidated to repay the lenders.
If the collateral falls below the protocol’s required threshold then the collateral could be liquidated in the open market.
Thus the borrower needs to thoroughly understand the collateral ratio of the platform before proceeding.
Choosing the Farm
The risk-averse users that want to earn a yield on their investment could invest in - stablecoins, money markets or Curve Finance liquidity, as it is the suitable choice for the low-risk interest.
While the users who have good sum amount of crypto holdings and want to take the risk while making it productively work can use liquidity pools like Balancer and Uniswap.
However, there are many other platform and protocols that facilitate yield farming such as Aave, Compound Finance, Synthetix, MakerDAO, Uniswap, Balancer, Curve Finance and many more.
As Spencer Noon of DTC Capital said,
“Yield farmers are extremely creative. They find ways to ‘stack’ yields and even earn multiple governance tokens at once.”
The more profit you want to reap - the more complex yield farming gets. It is important while investing with yield farming to be diligent and thorough. Thus, Yield Farming on DeFi differs from person to person and the capital and risk they want to put on to.