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What is Yield Farming? What Are Its Benefits And Downsides?

For the longest time, yield farming has also been popularly known as staking. But in actuality, it is a slightly less popular method of profiting from cryptocurrencies, and for the longest time, its popularity has been overshadowed by more popular methods like trading.

The purpose of today’s article is to shed some light on yield farming so you can really understand what it is. We will also discuss its benefits and downsides.

What is Yield Farming?

In the DeFi world, “yield farming” is one of the most complex topics. To put it simply, yield farming is the practice of staking or lending crypto assets in order to generate high returns or rewards in the form of additional cryptocurrency. This innovative yet risky and volatile application of  decentralized finance has skyrocketed in popularity recently thanks to further innovations like liquidity mining. Yield farming is currently the biggest growth driver of the still-nascent  DeFi sector, helping  it  to  balloon  from a market cap of $500 million to $10 billion in 2020.

To do yield farming, we used Smart Contracts. Which are programs that run on the blockchain. In Yield Farming, every user is a liquidity provider, and they lend their crypto to a liquidity pool, which is just a smart contract. This Smart Contract now makes use of the underlying protocols of the DeFi platform, which usually provides rewards from the fee they charge whenever a user exchanges tokens on their platform. The reward is usually an ERC-20 token. As a Liquidity Provider, you can now use those rewards to stake in some other liquidity pool and so on.

How does Yield Farming work?

The first thing in yield farming is adding funds to a liquidity pool, which are essentially smart contracts that contain funds. These pools power a marketplace where users can exchange, borrow, or lend tokens. Once you’ve added your funds to a pool, you’ve officially become a liquidity provider.

In return for locking up your funds in the pool, you’ll be rewarded with fees generated from the underlying DeFi platform. Note that investing in ETH itself, for example, does not count as yield farming. Instead, lending out ETH on a decentralized non-custodial money market protocol like Aave, then receiving a reward, is yield farming. Reward tokens themselves can also be deposited in liquidity pools, and it’s common practice for people to shift their funds between different protocols to chase higher yields.

It’s complex stuff. Yield farmers are often very experienced with the Ethereum network and its technicalities and will move their funds around to different DeFi platforms in order to get the best returns. In other words, it’s not an easy money trick. Those providing liquidity are also rewarded based on the amount of liquidity provided, so those reaping huge rewards have correspondingly huge amounts of capital behind them.

Choosing the Right Protocol

Choosing the right protocol is absolutely essential in Yield Farming. Although there are multiple factors that describe the health of a DeFi protocol, TVL or Total Value Locked is by far the most popular factor that can help you in choosing the right protocol.

As the name suggests, TVL tells you about the total value of Crypto deposited in a DeFi Protocol. The higher the TVL, the better the protocol’s health. When a protocol has high TVL, it means it has high liquidity. Higher liquidity means that a lot of people have invested in that protocol which implies that the protocol is trustable.

Choosing the Right Protocol

The expansion of the DeFi sector has resulted in the expansion of yield farming opportunities. Here is a list of some of the most popular platforms currently used for yield farming:

Compound: Compound is a borrowing and lending platform where rewards for liquidity are compounded over time. 

AAVE:  AAVE is a decentralized borrowing and lending platform. Interest rates are adjusted by an algorithm based on supply and demand.

Maker DAO: This is a credit platform where users can deposit cryptocurrency in return for the US dollar-pegged stable coin DAI. Users then earn interest, which is added to their DAI holdings.

Curve Finance: Curve Finance is a decentralized exchange focused on the trading of stablecoins: By focusing on stable coins, Curve Finance is able to offer lower fees and lower slippage.

Uniswap: Uniswap is a decentralized exchange that allows users to deposit funds into liquidity pools. The liquidity pools are then used to facilitate trades.

Synthetix: Synthetix is a trading platform for synthetic assets backed by the native SNX token. Users can deposit native SNX tokens or ETH in return for rewards.

Yearn Finance: Yearn Finance is a decentralized aggregator for finding the optimum yield across multiple DeFi platforms.

The Benefits of Yield Farming

Yield Farming comes with a ton of benefits and if done properly, it can be a good low-risk low-yield investment.

Great Source of Passive Income

Though Yield Farming is a fairly complex topic, once you get a hang of it it becomes really simple. One can use different liquidity pools to maximize rewards and use them as a passive source of income.  

Cross-Chain Compatibility

With the help of blockchain wormholes and bridges, we can now interoperate between different blockchains and protocols. This makes it easier for us users to work with different DeFi protocols and combine them to maximize our profits. 

Plenty of Options

We have tens and thousands of DeFi protocols, from different providers. Some of the most famous ones are PancakeSwap, UniSwap, Aave, and SushiSwap. This gives us a huge array of options to choose from, we can also try combining different protocols to maximize our profits.

The Downsides of Yield Farming

Just like trading, yield farming has its own set of risks and downsides. We’ve mentioned a few below.

Needs A Huge Capital

For Yield Farming to actually be profitable, you need a huge capital to start with. This is a big downside to Yield Farming as the people who usually profit from these DeFi protocols are whale investors. 

Buggy Smart Contracts

Smart Contract is code, and code has a tendency to have bugs. This can be especially problematic within Yield Farming because it deals with investments. A lot of teams working in the DeFi sector have low funding, and it isn’t difficult to produce buggy code. Often this code can lead to huge losses.

Risk of Complete Liquidation

As we already know by now, Smart contracts can be buggy. The problem can get much bigger if the bug is fatal. It can result in complete liquidation or in simple words, a 100% loss.

Conclusion!!

There has been a rise in risky protocols that issue so-called meme tokens with names based on animals & fruit, offering APY returns in the thousands. It is advised for everyone to tread carefully with these protocols. As their code is largely unaudited and returns are subject to sudden liquidation due to price volatility. Many of these liquidity pools are convoluted scams that result in “rug pulling,” . Where the developers withdraw all liquidity from the pool and abscond with funds.

As blockchain is immutable by nature. Most of the time, DeFi losses are permanent and cannot be undone. It is therefore advised that users really familiarize themselves with the risks of yield farming and conduct their own research. Yield farming can be simple or complex, but it provides cryptocurrency investors with a way to earn a little passive income from otherwise idle investments.

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