Yield farming is an exciting way of accumulating rewards using cryptocurrency holdings. Often referred to as liquidity mining, it means locking up cryptocurrencies and getting rewards in return. Investors stand a chance to earn rewards by lending their cryptocurrency to others through smart contracts, and in return, investors earn dividends in the form of cryptocurrency.
It works with users called liquidity providers (LP) that add funds to liquidity pools and consequently earn passive income on their deposit through trading fees based on the percentage of the liquidity pool that they provide. One of the pioneers of decentralized exchanges that introduced the system was the Ethereum-based trading system bancor. These decentralized exchanges that leverage on liquidity pools are the same that make use of automated market maker-based systems. On such trading platforms, the traditional order book is replaced by pre-funded on-chain liquidity pools for both the trading pair’s assets. It was later popularised after Uniswap got involved.
Boost from the DeFi craze early 2020
A sudden strong interest in yield farming was propelled by the launch of the COMP token. While it didn’t invent yield farming, the COMP launch gave this type of token distribution model a boost in popularity. Since then, other DeFi projects have come up with innovative approaches to attract liquidity to their ecosystems.
A reliable and valuable index used to measure the DeFi yield farming scene’s overall health is the Total Value Locked (TVL). It measures how much cryptocurrency is locked in DeFi lending and other popular money marketplaces. The more value is locked in the system; the more yield farming may be taking place. TVL can be measured in ETH, USD, or even BTC. Each of these currencies give you a different outlook for the state of the DeFi money markets.
Understanding liquidity pools
Becoming a yield farmer involves adding funds to a liquidity pool, and these pools power a robust marketplace where users can exchange, borrow, or lend tokens. As soon as an individual or user adds funds to a pool, they officially become liquidity providers.
The returns on yield farming are calculated annually as it forecasts the returns that investors might expect over the course of a year. The Annual Percentage Yield (APY) and Annual Percentage Rate (APR) are popular metrics used to measure or calculate returns on funds added to a pool. The difference between The Annual Percentage Yield (APY) and Annual Percentage Rate (APR) is that the impact of compounding is not taken into consideration by APR. In contrast, the APY does ( compounding means reinvesting profits directly to yield more returns). The market of yield farming is fast-paced and highly competitive as such, the rewards also tend to fluctuate rapidly.
There is always a risk!
Smart contract risk, liquidation risk, impermanent loss, composability risk, scam risks are a few examples of those threats that yield farmers should be aware of before adding their funds into pools. In the case of smart contract risk, yield farming requires supplying assets to smart contracts for an extended period of time. If fraudsters or hackers successfully attack those smart contracts, funds may be compromised.
A good way to stop smart contract risk is to look out for information from audits of reputable companies. This way, individuals will adequately understand if the concerns raised by the auditors were addressed or not. To effectively manage smart contract risk, yield farmers should endeavor to select projects that take security seriously.
On the other hand, liquidation risk is the slight possibility of zero balance. Fortunately, yield farming makes it easier for investors to manage liquidity transparently. Liquidation risk happens when the price of an investor’s collateral price has dropped beyond the price of their loan, which causes a liquidation penalty to their collateral. Liquidity risk can be mitigated by forecasting cash flow regularly, monitoring and optimizing net working capital, and managing existing credit facilities. Also, Impermanent loss refers to the temporary loss of funds experienced by liquidity providers because of volatility in a trading pair. This further explains how much more money someone would have had if they held onto their assets instead of providing liquidity.
Impermanent loss explained
In order to mitigate impermanent loss, investors should consider providing liquidity to stablecoin pairs, Avoid risky and volatile cryptocurrency pairs, Provide liquidity to pools with unevenly weighted cryptocurrencies, Provide liquidity to incentivized pools and participating in liquidity mining programs, and finally, by not removing liquidity till the exchange rate returns to the initial rate.
Composability and scam risk can be mitigated through seeking of adequate information from experts as regards risk management and use of trusted platforms.
To invest successfully in yield farming, investors need to select reputable platforms with proven track records of outstanding service delivery. Such platforms include compound finance, Synthetix, MakerDao, Aave, Curve finance, Uniswap, Balancer, and Yearn.finance.
Yield Farming has the potential to generate good returns, and farmers should also be aware of potential risks and take proactive measures to mitigate them.