Intro
I started learning about DeFi a year ago and I am still a novice in the space. I’ve made my share of mistakes(haha...who hasn’t??) and I would like to share with you what I have learnt so far. This article briefly explains the concept of DeFi and throws more light on one of the biggest projects in DeFi, Yield farming, and outlines how you can also start farming on the blockchain, the risks associated and the immense benefits it has. If you are interested in Yield Farming, you should definitely give this article a read and find out more about it before jumping in. Let’s start with the basics in DeFi, shall we?
What is DeFi?
Decentralized Finance(DeFi) is a system that allows users to engage in financial transactions such as trading, investing, borrowing and lending without going through custodians(Centralized institutions). It eliminates the control centralized institutions such as banks and other financial institutions have over money and other financial products. DeFi as a system comprises various products such as yield farming, margin trading, staking etc. Yield farming was the hottest topic in “DeFi Summer '' 2020. Now let’s delve more into it.
Yield Farming
Yield farming basically is a way of earning incentives or more crypto from your crypto. The incentives can be a fraction of transaction fees, interest from lenders or a governance token. Farmers usually move their crypto around all the time looking for platforms with high Annual Percentage Yields(APYs). APY is the real rate of return on the funds users have provided for liquidity. The total amount of crypto locked in a yield farm’s underlying liquidity pool or stake pool is called Total Value Locked(TVL). Yield farmers use the TVL as a measure of how healthy a particular Yield farm protocol is. TVL can be tracked on DeFi Pulse to see the platforms with the highest amount of crypto staked. The Ethereum blockchain has the highest activity of yield farming. Users farm on the Ethereum blockchain using ERC-20 tokens.
How does Yield Farming work?
Yield farming can be done in two main ways. These are: Liquidity pool farms(LP) and Staking farms. Since farmers usually move their funds around all the time, they have to be strategic about it. They are usually very discreet about their strategies in order not to render them ineffective. That said, let's look at how LPs and staking farms work.
Liquidity pool farms require users otherwise known as liquidity providers to deposit their crypto in liquidity pools. A liquidity pool is basically a smart contract that contains funds. The liquidity users provide are in turn used to power Decentralized exchanges(DEXs) and marketplaces where users can lend, borrow or trade tokens. The fees from the platform are then paid out to the liquidity providers or they receive a distribution of a new token. Mostly, users get a return depending on the amount they provided as liquidity but the rules of distribution generally depends on the implementation of the protocol. Some LPs pay their rewards in multiple tokens. Rewards are paid out to liquidity providers as long as they have their crypto deposited in the pool. Users can withdraw their funds from the pool at any time.
In a staking farm, the funds users deposit are locked in a decentralized vault over a period of time. During that time, users can earn interest on the funds they deposited. Staking farms in contrast to LPs require users to deposit a single kind of asset and cannot be withdrawn until the specified period of time is over.
Users can also participate in yield farming in other ways which include: arbitrage mining, insurance mining and trade mining.
Getting started
There are many platforms where users can participate in yield farming to earn rewards. These are a few popular yield farming protocols:
The AAVE Protocol : TVL at time of writing - $10.93 billion
Aave is an open source and non-custodial liquidity protocol for earning interest on deposits and borrowing assets. Interest on any supplied crypto assets adjusts automatically and algorithmically based on supply and demand in the protocol. The Aave Protocol is decentralized and controlled by Aave Governance, which comprises over 70,000 AAVE token holders who have the ability to make proposals to change, amend or upgrade the Aave Protocol and to vote on such proposals.
Compound: TVL at time of writing - $8.29 billion
Compound is an algorithmic, autonomous interest rate protocol built for developers, to unlock a universe of open financial applications. Compound is built on the ethereum blockchain and allows users to earn interest or borrow assets against collateral. The Compound protocol sets aside 10% of interest paid as reserves; the rest goes to suppliers. Compound initially launched on mainnet in September 2018 and upgraded to v2 in May 2019. The protocol now supports BAT, DAI, SAI, ETH, REP, USDC, WBTC, and ZRX.
Yearn.Finance: TVL at time of writing - $3.8 billion
Yearn.Finance is a suite of products in DeFi that provides yield generation, lending aggregation, and more on the blockchain. When you deposit your tokens to yearn.finance, they are converted to yTokens, which are periodically rebalanced to choose the most profitable lending services. YFI, yearn.finance's governance token, is distributed only to users who provide liquidity with certain yTokens.
What are the advantages and risks?
Yield farming offers higher profits than almost any other centralized investment options, from real estate to stocks and bonds. Farmers can also immensely increase their returns with liquidity pool farming where they’ll receive tokens from the institutions borrowing their funds, in addition to the high interest on the liquidity they provided.
With all the perks of yield farming comes some disadvantages you might want to consider before jumping in. Here are some risks associated with yield farming:
High ETH gas fees
Ethereum gas fees have become a cause for concern over the past years for yield farmers. This discourages users with smaller funds. The gas fees increase immensely when a lot of users invest immensely in a yield farming protocol. This causes a FUD, making investors with small funds locked in or low risk tolerance to withdraw their assets often resulting in them losing money.
Impermanent loss
This is one of the biggest risks of yield farming. Impermanent loss occurs when users provide liquidity to a liquidity pool, and the price of the deposited assets changes compared to when they were deposited. Sometimes profits from farming yields cover the losses but this does not always happen. Cryptocurrencies are very volatile so a user risks impermanent loss any time the market falls. However impermanent loss is greatly seen when the price of cryptocurrencies fall drastically.
Hacks and fraud
The yield farming space is not immune to hackers and fraudsters. Individuals with the necessary skills can create a yield farming app to lure unsuspecting investors. Users usually fall to these schemes as a result of the high rewards associated with new platforms. Always make sure to do background checks on whatever platform you’re about to invest on so as to not fall victim to fraudsters and hackers. You can research suspicious platforms on Twitter, Reddit and DeFi Pulse
Outro
The world is advancing and investors are looking for smarter, safer and more efficient ways to invest their money. More people are going to go decentralized as we approach mass adoption. Currently, the TVL in DeFi sits around $92 billion . As the years go by, I see this number increasing very steadily and yield farming or DeFi in general becoming a trillion dollar industry.
I always recommend that investors research heavily on whatever protocols or platforms they want to invest in. You should also not invest more than you can afford to lose. This article is for educational purposes only and should not be regarded as financial advice.
Thank you for taking the time to read. I just started writing and would appreciate some suggestions on how to improve as a writer. A thumbs up would be highly appreciated too. Feel free to reach out to me on Twitter :)