Understanding yield farming

Understanding yield farming

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YIELD farming, also referred to as liquidity mining, is a way to generate rewards with cryptocurrency holdings. In simple terms, it means locking up cryptocurrencies and getting rewards, writes Eburu Dearie Oghenenyerhovwo.

In some sense, yield farming can be paralleled with staking. However, there’s a lot of complexity going on in the background. In many cases, it works with users called liquidity providers (LP) that add funds to liquidity pools.

What is a liquidity pool?

It’s basically a smart contract that contains funds. In return for providing liquidity to the pool, LPs get a reward. That reward may come from fees generated by the underlying DeFi platform, or some other source.

Some liquidity pools pay their rewards in multiple tokens. Those reward tokens then may be deposited to other liquidity pools to earn rewards there, and so on. You can already see how incredibly complex strategies can emerge quite quickly. But the basic idea is that a liquidity provider deposits funds into a liquidity pool and earns rewards in return.

Yield farming is a way to make more crypto with your crypto. It involves you lending your funds to others through the magic of computer programs called smart contracts. In return for your service, you earn fees in the form of crypto.

Yield farming is the Wild West of Decentralized Finance (DeFi), where farmers compete to get a chance to farm the best crops logically.

Yield farming is closely related to a model called automated market maker (AMM). It typically involves liquidity providers (LPs) and liquidity pools. Let’s see how it works…

Liquidity providers deposit funds into a liquidity pool. This pool powers a marketplace where users can lend, borrow, or exchange tokens. The usage of these platforms incurs fees, which are then paid out to liquidity providers according to their share of the liquidity pool. This is the foundation of how an AMM works.

New technology

However, the implementations can be vastly different, not to mention that this is a new technology. It’s beyond doubt that we’re going to see new approaches that improve upon the current implementations.

On top of fees, another incentive to add funds to a liquidity pool could be the distribution of a new token. For example, there may not be a way to buy a token on the open market, only in small amounts. On the other hand, it may be accumulated by providing liquidity to a specific pool.

The rules of distribution will all depend on the unique implementation of the protocol. The bottom line is that liquidity providers get a return based on the amount of liquidity they are providing to the pool.

What is DeFi?

The Decentralized Finance (DeFi) movement has been at the forefront of innovation in the blockchain space. What makes dApp unique is because, they are permissionless, meaning that anyone (or anything, like a smart contract) with an Internet connection and a supported wallet can interact with them. In addition, they typically don’t require trust in any custodians or middlemen.

Decentralized finance based on blockchain (“DeFi“), also called open finance, is a fledgling technology with potential. DeFi operates via decentralized, permisionless (without any central authority) applications, called dApps, built on a blockchain network, most commonly Ethereum. Visionaries see this as an open-source alternative to every financial service we use today. Picture savings, loans, and trades, to insurance and even more, as all globally accessible.

What makes DeFi even more interesting is the movement of institutional investors and traditional finance professions to DeFi as a way to break free from what the industry considers an outdated and insular financial system.

In theory, it is possible to adopt every financial service currently offered by financial institutions to the crypto-sphere through DeFi. This will thus replace (even if only partly) centralized financial infrastructures and shift power to individual users and investors.

The current financial system allows for the exchange of value easily through debit and credit cards, and the exchange of currencies for goods and services through digital banking. It also allows individuals to store wealth, save money, and earn interest on those savings. Lastly, banks and other lenders provide individuals and businesses access to capital (through loans).

DApps can provide a variety of services. Some dApps enable lending and borrowing, with minimum loans of just $25 and maximums of $2M (Nexo, Salt Lending, Bankers, and Oasis). Others enable margin trading, where customers can use borrowed funds from a broker to trade a financial asset that forms the collateral for the loan from the broker (Margin DDEX, NUO, and dYdX). There are also completely decentralized exchanges that operate with no central authority (IDEX, Ox, Bisq, and Bancor).

Yield farming isn’t simple. The most profitable yield farming strategies are highly complex and only recommended for advanced users. In addition, yield farming is generally more suited to those that have a lot of capital to deploy.

Yield farming isn’t as easy as it seems, and if you don’t understand what you’re doing, you’ll likely lose money.

Obvious risk

One obvious risk of yield farming comes in the shape of smart contracts. Due to the nature of DeFi, many protocols are built and developed by small teams with limited budgets. This can increase the risk of smart contract bugs.

Even in the case of bigger protocols that are audited by reputable auditing firms, vulnerabilities and bugs are discovered all the time. Due to the immutable nature of blockchain, this can lead to loss of user funds. You need to take this into account when locking your funds in a smart contract.

In addition, one of the biggest advantages of DeFi is also one of its greatest risks. It’s the idea of composability. As stated earlier, DeFi protocols are permissionless and can seamlessly integrate with each other. This means that the entire DeFi ecosystem is heavily reliant on each of its building blocks. This is what we refer to when we say that these applications are composable, they can easily work together.

Why is this a risk? Well, if just one of the building blocks doesn’t work as intended, the whole ecosystem may suffer. This is what poses one of the greatest risks to yield farmers and liquidity pools. You not only have to trust the protocol you deposit your funds to but all the others it may be reliant upon.

Further reading…

OZTG Coin and Ozeety blockchain proof of stake with yield farming is bigger than DeFi