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If in the past, in the field of cryptocurrencies, investors wanted to find a way to increase profits or increase the number of coins held by trading, now there is a new way to help investors quickly increase that amount of coins. It is Yield Farming.
So what is Yield Farming? How does it work?
The following article will help you better understand this term and help you make money with this method in the safest way.
What Is DeFi?
Let’s take a look at the term DeFi Yield Farming. Before getting into more details about Yield Farming, we’ll take apart the term DeFi.
DeFi generally refers to Decentralized finance. Decentralized finance can better be defined by defining its opposite, which is Centralized finance. It’s something that we’re all used to today. Centralized finance means that there is a powerful company or institution at the center of the whole financial transaction. For example, you want a loan from the bank, and you go to the bank. If the people at the bank don’t like your credit, they don’t like your color or where you’re from, you may not get that loan.
One problem about Centralized finance is that there is a centralized organization controlling access to capital and you have to interpret all the rules written and check whether or not you fit those interpretations. In contrast, Decentralized finance is all self-executing programs that exist on the Ethereum blockchain. There is no centralized place where your transactions can be controlled. You can go and get your lending decisions based upon not anyone’s interpretation but whether or not you meet the rules that have been set
up by programs.
This new way of finance is aimed to carry out financial activities such as lending, borrowing, investing in platforms that are decentralized open-source and do not
rely on big institutions.
What Is Yield Farming?
One of the things that exist in the DeFi framework is a type of program called a smart contract, which is pivotal to the function of the whole system. A type of
smart contract is called a liquidity pool from which people can execute Yield Farming.
Yield Farming is the procedure of taking an initial investment to gain an annual interest and you can grow that investment without having to add new money. More simply, it means locking up cryptocurrencies and achieving rewards.
How Does Yield Farming Work?
To better understand this concept we will need to know about the Automated Market Maker (AMM) model. We can mention the popular AMMs like LaunchZone, Uniswap or Pancakeswap. Like centralized exchanges, AMM has many different trading pairs but especially there are no buy or sell orders and traders do not need to look for buyers. Instead of that, a smart contract will work with the role of the creator of the exchange transaction.
Therefore, although there is no need for intermediaries, someone must still create the market and provide liquidity. Those are liquidity providers (LPs). When you want to exchange Usdt for BSCX, you will exchange it with the Liquidity Pool. USD is transferred to the Pool and BSCX will be from the pool to your wallet. When someone else wants to exchange BSCX for Usdt the process is similar.
To understand how such high returns are plausible, you need to understand TVL and liquidity pools, which are the three core elements of yield farming.
Total Value Locked (TVL)
TVL is the total liquidity in liquidity pools, making it a useful metric for measuring the health of DeFi and the yield farming market in general. It is also an effective metric for comparing the “market share” of different DeFi protocols. A pretty good destination for watching TVL is Defi Pulse.
Here you can check which platform has the highest amount of ETH or other cryptocurrencies locked
in DeFi. Accordingly, it can give you an overview of the current yield farming status.
Of course, the more value locked, the more yield farming continues to grow. It is worth noting that TVL can be measured in ETH, USD, or even BTC. Each will give you a different view of the state of the DeFi money market.
Liquidity Pools
These pools allow anyone to stake their assets into them to earn a passive income through interest. The interest is generated from the trading fees imposed upon users who tap into these pools to make exchanges. It is distributed to every liquidity provider based on what percentage of the total pool they provide.
How Is Yield Farming’s Profit Calculated?
Normally, the profit from Yield Farming will be calculated on an annual basis, like the interest rate on a 1-year savings deposit. There are two units of profit measurements that you often see are APY (Annual Percentage Yield) and APR (Annual Percentage Rate). APY takes into account compound interest while APR does not. If so, is there any way to calculate profit from Yield Farming in the short term?
It is quite difficult to estimate the profit from Yield Farming because it is a highly competitive campaign and many innovations as projects try to attract investors to provide liquidity into their protocol. As a result, profit levels can change very quickly and are difficult to accurately calculate in the short term.
Imagine this, when a user provides liquidity for a project, the protocol will use the built-in algorithm to automatically calculate a certain amount of reward. The more people enter Farming, the lower the reward each person receives, resulting in a lower profit from Yield Farming compared to the original.
As a result, after one year, your actual return may not be the same as the APY or APR at the time you provided the liquidity to the protocol, not taking into account the price movement of the original asset.
Risks Of Yield Farming
Everything above may sound amazing, but Yield Farming is fraught with risks. Like anything in this world, the potential for high rewards always comes along with a comparable chance of you losing money. In the case of yield farming, one of the biggest risks comes from smart contract failure. Because the entire field of DeFi is young and still growing, problems can occur. There’s generally always a chance that a smart contract could either fail or have some exploitable imperfection that could lead to a loss of funds.
Moreover, the impermanent loss is another risk you need to be careful of. That term means that you’re always selling off the better-performing coin in exchange for the lesser performing one. However, don’t worry too much if you invest in a good project. In this case, the impermanent loss can still be countered by transaction fees and the part of the token that can be farmed.
Final Thoughts
Yield Farming brings high profits in a short time. This is something that no one can deny about its attractiveness. However, yield farming still has risks such as asset liquidation, hacking because of fragile smart contracts. Therefore, you should be cautious when sending money to DeFi protocols to farm.
There are many opportunities to find a high return rate compared to traditional finance. Despite that, we still have to remember that it is still a very new industry, so it’s full of risks. We hope this article has provided much useful information for you about DeFi and Yield Farming.
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