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What is Yield Farming?

Read 5 min
Floating boxes in an open space
— Yield farming allows cryptocurrency holders to earn money from their cryptocurrency by lending it to others through smart contracts.

— With decentralized finance as the basis, yield farming means individuals can both borrow and lend without the need for a profit-hungry middleman eating into the majority of the interest earned.

— While it has the potential to be extremely lucrative, it has its risks and there are many different strategies to approaching yield farming, so make sure you go in armed with information.

What is yield farming? if you’re making your first DeFi steps, we’ve got your back!

Wouldn’t it be nice if there was a way for cryptocurrency holders to earn more crypto by lending their crypto? Well, with an exciting concept called yield farming, there is! Yup, you can earn cryptocurrency with your crypto holdings while helping others get loans. Winner-winner, crypto’s paying for your dinner. 

How does it work? Do I need any special tools? Digital ploughs? Online horses?

No, no horses necessary in this. But we’re glad you’re asking the important questions. Let’s take a look at the field and find out what yield farming is!

What exactly is yield farming?

Simply put, yield farming is a way for you to make extra cryptocurrency by lending your crypto assets directly to others using smart contracts. In return for the loan, you earn interest in the form of cryptocurrency. Passive income, hello!

You know when you store your money at the bank in a saving’s account, the bank then lends that money out to others who take out loans. As a compensation, you can accumulate some interest in your savings. The main problem with this, though, is that the bank takes a massive chunk out of that cake and leaves you scraps in return. And when you take inflation into account, often you end up losing purchasing power because banks don’t offer interest rates high enough to cover the difference. 

Yield farming takes the middleman out of the lending process which means that you get the majority of that cake instead. It’s a far more tasty deal that highlights the benefits of the decentralized system and the opening up of the financial industry. And thanks to that decentralized system, you reserve full ownership of your cryptocurrency.

This means that you can move your assets freely without needing to get permission from your banking authority and without limits on your savings accounts.

How does yield farming work?

This is where things get a little more complicated. There are many different ways to approach yield farming with different strategies and implementations. So, in a broad sense, this is what happens:

The first part of the process in yield farming involves putting funds into something called a liquidity pool (which is basically a smart contract that contains funds). This pool acts as a marketplace where users can borrow and lend tokens. So if you’re lending and you add funds to the liquidity pool, you become a “Liquidity Provider” (congrats, it’s a great title!).

From there, Liquidity Providers get rewards for adding to the pool. The interest rates for the reward vary depending on the liquidity available on a protocol. So at a fundamental level, the rates are driven by supply and demand. This means that providing liquidity when it’s scarce yields a higher interest rate than when it’s abundant.

Before you tell us the choice is an obvious one – there’s a bit of a caveat: The protocols with more liquidity (we call it TVL – “total value locked in”) tend to be more secure and legitimate. So, although higher interest rates seem the most enticing on paper (for example, seeing an 800% interest rate is hard to turn down), there’s more risk involved.

The counter to this caveat is that you can still get tidy returns on protocols with higher liquidity and lower interest rates. For example, earning up to 11% interest on stable coins through protocols like Aave, is still a much better deal than what you might get from your bank.

The perks and quirks of yield farming 

The perks 

A fairly obvious benefit of yield farming is the reward you get for your loan. It’s also great because you know that you are involved in part of a process that is opening up the financial industry beyond the traditional system as we know it.

Another important perk is that the blockchain boasts transparency like nothing else found in traditional finance, meaning you aren’t going to suffer hidden fees or any bias towards a certain player (like a banker). Blockchain’s immutable nature also means that the contract can’t be changed afterwards – so everyone involved can trust that no nasty “surprises” will pop up.

The quirks

On the other side of the coin, though, is that yield farming is a complicated business. While anyone can participate in borrowing and lending, it can be tricky if you are only just stepping into the world of crypto.

It’s also a high-risk high-reward practice. With volatility, smart contract risks, hacks and scam possibilities, there are threats in the field that are worth considering. 

It’s also worthwhile noting that because the middleman is cut out, so is the customer service. So with tech taking the driver’s seat, you need to put your trust in the developing technology.

The solution

To navigate the quirks, there are a few ways to pick the best direction:

  • Do your own research (DYOR) on protocols that interest you. Find out important information like:
    • Who is behind the protocol and whether they have a trust-worthy, legitimate background, 
    • Whether the smart contracts have been audited, 
    • What the community has to say about the network, and 
    • Whether there’s a “lock up period”  (which means less volatility but it also reduces freedom). 
  • Check what the total value locked in (TVL) is. The higher, the better. It represents that more investors have confidence in the protocol.
  • To succeed, avoid greed! While a higher annual percentage yield (APY) is enticing, it is riskier. Remember, the average (and more secure) APY is still a better bigger slice of cake than you’ll be able to get from the legacy system.

Is yield farming sustainable? What does the future look like?

For now, while it might be a bit of a volatile train, it’s one with an incredible amount of potential. With institutions starting to jump on board and test protocols, it wouldn’t be surprising if the rate of adoption increases significantly. And with decentralized insurance (like Nexus Mutual and Opium Insurance) in place to cover smart contract risks, we’re looking at just the tippiest tip of the iceberg of where this financial revolution can go – with security leading the way. 

So in the meantime – if you choose to step into yield farming – just be sure to protect yourself with knowledge and we wish you high yields and happy farming!

Knowledge is power

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