What Is Yield Farming and How Does It Work?
Interest in yield farming, also known as liquidity mining, has fueled the fast expansion of decentralized finance (DeFi). Yield farming is the process of using a number of DeFi liquidity mining strategies to maximize profits on crypto assets. While it can be profitable, success needs a detailed grasp of DeFi standards. In most cases, yield farmers use complex and dynamic techniques to optimize profits, often shifting crypto assets across loan platforms.
As a result, learning the basics of yield farming might be overwhelming for newbies. Before entering this new industry, it's critical to be well-versed in best practices.
DEXs and Crypto Liquidity Pools are two types of decentralized exchanges.
Decentralized exchanges (DEXs) have become one of the most extensively utilized crypto protocols inside the DeFi ecosystem. DEXs use liquidity pools to support peer-to-peer (P2P) trading, unlike centralized exchange (CEX) order books. Many DEXs are able to maintain fair market values for the tokens they hold owing to liquidity pools, which use automated market maker (AMM) algorithms to keep token prices comparable to one another inside a pool. Different crypto liquidity pools may utilize somewhat different algorithms depending on the protocol. For example, to preserve price ratios, Uniswap liquidity pools employ a constant product formula, and several DEX platforms use models with varied degrees of resemblance.
Today's best DEXs employ AMM liquidity pools to decrease or eliminate the need for a centralized organization, and as a result, they require a consistent outside supply of liquidity to operate correctly. Liquidity providers (LPs) enter the picture at this point. Individuals that construct their own liquidity pool or, more commonly, deposit tokens into an existing one so that traders may acquire tokens on a DEX are known as liquidity providers.
Let's have a look at an example: An LP might deposit $100 USD worth of CAKE and $100 USD worth of BNB to the CAKE/BNB liquidity pool on the PancakeSwap platform.
The PancakeSwap LP would earn FLIP (PancakeSwap's Liquidity Provider token) as an incentive for providing this liquidity to the PancakeSwap DEX platform. Long-term investors gain a return on these tokens in the form of an annual percentage yield (APY). The average trading fees earned by the CAKE/BNB liquidity pool account for this return. In many DeFi yield farming systems, earning LP tokens is a necessary step.
DeFi Liquidity Mining Strategies for Yield Farming Crypto
Serving as an LP is frequently the first step in developing a yield farming strategy. Liquidity providers, on the other hand, are not true yield farmers until their LP tokens are staked in numerous protocols and/or pools.
Liquidity miners frequently deposit tokens in several liquidity pools and DEX systems.
Let's take a look at a different scenario. The following stages might be included in a simple yield farming crypto strategy:
On PancakeSwap, add CAKE and BNB to the CAKE/BNB liquidity pool.
CAKE-BNB FLIP tokens will be given to you.
CAKE-BNB FLIP tokens can be deposited into the associated CAKE crypto liquidity pool to increase returns.
This type of staking or farming possibility abounds in the DeFi liquidity mining market, with additional pools and protocols popping up every day. Those interested in yield farming cryptocurrency may invest their LP tokens in a variety of protocols and liquidity pools for as long as they choose — from a few days to many months.
The Ecosystem of Crypto Yield Farming
Because there are so many different crypto yield farming tactics, there isn't an one approach to get the best results. Furthermore, the fast rate of growth provides an ever-changing ecology, necessitating a continuous review of DeFi yield farming potential. The list below, while not inclusive, comprises some of the most important yield farming platforms.
Aave is a non-custodial, decentralized, open source crypto lending and borrowing mechanism. AAVE tokens may be used to construct money markets, borrow assets, and earn compound interest.
Compound: A money market protocol that uses algorithmically adjusted compound interest rates to promote crypto lending and borrowing. By using the system, users may also earn COMP governance tokens.
Curve Finance is a decentralized exchange protocol that allows users to swap stablecoins and other decentralized protocols. To maintain low costs and little slippage, the Curve protocol employs a proprietary market-making algorithm.
Uniswap is a DEX and AMM that allows practically any ERC-20 token pair to be exchanged.
PancakeSwap is a Binance Smart Chain (BSC) DEX and AMM that allows users to trade BEP-20 tokens.
On BSC, the Venus Protocol is an algorithmic money-market platform that connects lending and credit systems.
Balancer is an automated trading and portfolio manager with a liquidity mechanism based on flexible staking.
Yearn.finance is a decentralized, automated aggregation protocol for finding successful crypto yield farming services using user-generated algorithms.
Crypto staking vs. Yield Farming
Despite the fact that yield farming and crypto staking are two distinct processes, some people wrongly use the terms interchangeably. Yield farming, also known as liquidity mining, is a means of earning money from bitcoin assets. Staking, on the other hand, is primarily used as part of a Proof-of-Stake (PoS) blockchain network's consensus mechanism – a process for which stakers are rewarded. While serving as a staker yields a profit, it is often substantially lower than the profit generated by DeFi yield farming procedures. In general, staking yields pay paid once a year, with payouts ranging from 5% to 15%. Yield cultivation rates in crypto liquidity pools, on the other hand, may reach 100% and pay out on a regular basis, allowing for withdrawals at any time.
While crypto yield farming is usually more rewarding than staking, it is also more dangerous. When yield farming on Ethereum, for example, the network gas prices necessary to receive rewards might limit APY rate revenues. Furthermore, if the market becomes volatile in either way, temporary losses might occur, reducing earnings dramatically. When the value of tokens kept in an algorithmically balanced liquidity pool depreciates in comparison to assets on the open market, this is known as depreciation. Finally, because liquidity pools rely on smart contracts, there's a potential that hackers may discover and exploit flaws in the programming.
Crypto Yield Farming with Leverage
The use of borrowed money to support an investment is known as leverage. Yield farming bitcoin with leverage can multiply the rewards offered by DeFi protocols, just as leveraged trading may amplify returns and dangers across traditional asset classes and crypto alike. The main advantage of leveraged yield farming is that farmers may borrow more than the collateral they put up, allowing them to increase their returns even more. For instance, if yield farming with "X" gives "Y," then yield farming with "10X" yields "10Y." It's important to remember that if price objectives are missed, losses are exacerbated in the same way. Leveraged trading and crypto yield farming are best left to the most seasoned investors.
Leveraged yield farming platforms are a new but rapidly growing sector of DeFi, and protocols use a variety of methodologies to bring together protocols, lenders, yield farmers, and liquidity providers to create opportunities to borrow and farm tokens in a variety of liquidity pools and rewards-generating markets.
The following are some of the most well-known leveraged yield farming crypto platforms today:
Finance for Alpacas (BSC): On the BSC, it is marketed as the largest loan mechanism for enabling leveraged yield farming. The protocol strives to provide lenders with safe and predictable returns while providing yield farmers with undercollateralized loans.
Tulip (Solana) is the first yield-aggregation platform based on the Solana platform. The technology uses the Solana blockchain's cheap cost and great efficiency to provide auto-compounding vault techniques.
Even more intricate DeFi yield farming procedures will emerge in the future. Leveraged yield farming has already launched some of the first under-collateralized loans in the crypto business, which are controlled by smart contracts. This feature aims to address a number of DeFi flaws, including capital efficiency and the availability of deeper capital markets. Crypto yield farming, in addition to these systemic improvements, is assisting in the development of more mature DeFi protocols and increasing their earning potential, hence stimulating growth across the whole ecosystem.