What Is Yield Farming in DeFi and How Does It Work? Learn DeFi

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What Is Yield Farming in DeFi and How Does It Work? Learn DeFi

Learn DeFi The activity of staking or lending crypto assets to create high returns or rewards in the form of extra cryptocurrency is known as yield

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Learn DeFi

The activity of staking or lending crypto assets to create high returns or rewards in the form of extra cryptocurrency is known as yield farming. It’s no secret that decentralized finance (DeFi) has become increasingly popular in recent years because of developments like liquidity mining, but it’s not without its risks. Currently, yield farming is driving the fastest growth in the still-nascent DeFi sector, which expanded from a $500 million market valuation to $10 billion in 2020. There is a high demand for DeFi developers in the market now. The DeFi sector has expanded so widely, everyone is looking for a DeFi expert to sort their doubts.

What is yield farming and why is it important? Learn DeFi

It’s a technique that allows bitcoin holders to earn rewards on their holdings, and it’s really simple. To generate interest from trading fees, a cryptocurrency investor uses yield farming, which involves depositing units of a cryptocurrency into a lending scheme. The protocol’s governance token also rewards some users with additional payouts.

When it comes to the way yield farming works, it’s very similar to how bank loans function. When you borrow money from a bank, you have to pay interest on the loan. As with yield farming, the banks are now crypto holders like you. DeFi systems such as Uniswap rely on “idle cryptos” that would otherwise be sitting idle on an exchange or hot wallet to offer liquidity.

What are liquidity pools, liquidity providers, and the automated market maker model?

Yield farming relies on a liquidity provider and a liquidity pool (a smart contract filled with cash) to run a DeFi market, according to a report from the Financial Times. A liquidity provider is a person who deposits money into a smart contract as a kind of payment. Smart contracts are used to fill the liquidity pool, which is made up of currency. Automatic market makers (AMM) are used in yield farming. 

On decentralized exchanges, this technique is very common. As a result of AMM, there is no longer a need for a traditional order book, which includes all “buy” and “sell” orders on a crypto exchange. An AMM builds liquidity pools using smart contracts instead of announcing the price at which an asset will trade. These pools perform trades based on specified algorithms, which are developed in advance.

The AMM approach is primarily reliant on liquidity providers (LPs), who deposit monies into liquidity pools to create liquidity pools. Users borrow, lend, and swap tokens on most DeFi marketplaces using these pools. Market participants pay trading costs to the marketplace, which splits the fees with LPs according to their share of liquidity.

Think about Compound. Liquidity is provided by the protocol for anyone who wishes to borrow money in cryptocurrency. Smart contracts on the Ethereum blockchain are used by the Compound Finance system to do this. Liquidity pools are funded by LPs. For market participants, these contracts work as a matchmaker.

Upon agreement on a rate of interest, the borrower receives the funds.

Making a profit from farming

On an annualized model, yield returns are estimated. It’s possible to gain a lot of money by storing your cryptos for one year.

APR and annual percentage yield (APY) are two of the most prevalent measurements (APR). The primary difference is that APR does not take into account compound interest, which entails reinvesting your income to boost your return on investment (ROI).

Nevertheless, the majority of calculating models are just guesses. As a result of the market’s volatility, it’s impossible to precisely quantify yield farming’s profits. A high-yield farming approach may be profitable for a period, but farmers may adopt it in large numbers, resulting in a decline in profitability. Borrowers and lenders alike face an unpredictable and dangerous market.

Is it a good idea to undertake yield-based farming? 

There are downsides to yield farming despite its evident benefits (Learn DeFi) . To name a few

Smart contract dangers

Unlike traditional contracts, smart contracts do not require the paper to be signed. Instead, they are digital codes with specified rules that automatically execute. Smart contracts reduce the need for middlemen and make transactions cheaper and safer. A few vulnerabilities exist in the code which makes them more prone to attack vectors and faults in the code. Scams targeting users of major DeFi protocols (Learn DeFi) such as Uniswap and Akropolis have resulted in losses.

Impermanent loss risk

Profit farming is a method of earning yields and trading fees from decentralized exchanges that involves liquidity providers to transfer assets into pools (DEXs). Market-neutral returns are offered, however, it could be risky during large market swings because of the volatility.

Since AMMs do not update token prices in accordance with market fluctuations, this risk exists. In other words, if the price of an asset decline by 60% on a centralized exchange, the change won’t appear immediately on a decentralized exchange (DDE).

Due to the tight price spread, a knowledgeable arbitrage trader might sell their token at a premium on a yield farming site. Inevitably, LPs will have to make up the difference and suffer losses if the price falls in the long run. Since their capital is tied up in the pool, they are unable to profit from price increases. For example, Curve’s WBTC and renBTC pairs are examples of protocols that exchange assets with low price slippages.

Liquidation risks

To supply liquidity to their markets, DeFi platforms use deposits from their consumers, just like traditional finance. When the collateral value falls below the loan’s price, however, a problem may occur. You can liquidate your loan in the event of an ETH price increase if you have collateralized it with BTC. The collateral (BTC) would be worth less than your ETH loan.

Wrapping up

Investors’ money is used to provide liquidity in the market in exchange for rewards, which is called yield farming. It has a lot of growth potential, but it’s not perfect.

The Ethereum blockchain is the most known example of this. At the time of writing, DeFi Llama estimated the DeFi space to be valued at more than $121.5 billion. Most DeFi networks rely on the Ethereum blockchain, which has had scaling concerns in the past, according to a report by CoinDesk. As a result of the network congestion, gas prices have risen. Learn DeFi to understand more about the wonder called yield farming. If used correctly, it can mint profits for you.

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