What Is Yield Farming? How Does It Work?
On Nov 23, 2020
After the emergence of Bitcoin and Blockchain technology, new concepts have been added to the market over the years. One of them is Yield Farming. So what is yield farming that has been talked about a lot recently?
Yield farming is one of the most popular investment strategies in the decentralized finance (DeFi) sector. It allows investors to receive interest for lending out their tokens. For a better understanding of it, we recommend you that first check out our blog, “What is DeFi?” DeFi stands for “decentralized finance,” which is one of the fastest-growing cryptocurrency trends. To put it briefly, DeFi is a financial instrument in the form of services and applications built on the Ethereum (ETH) blockchain. The fundamental purpose of decentralized finance is to become an alternative to the traditional banking sector. That is to open up access to decentralized lending and new investment platforms for a large number of individuals. And let them receive revenue from crypto assets, as well as save on transfers, loans, and deposit fees.
The working logic of the popular DeFi projects such as Compound (COMP), Aave (LEND), and Maker (MKR) is based on the Yield Farming system. The most common platforms for yield farming investors are Uniswap, Compound Finance, Maker DAO, Synthetix, Aave, SushiSwap, Curve Finance, Balancer, Yearn. Finance.
What Is Yield Farming?
Now let us back to our main topic. Yield Farming is a way of earning rewards from cryptocurrency capital investments. In this process, investors can get much more besides cryptocurrencies they already own.
Generally speaking, the initial purpose of this concept is to facilitate transactions on the blockchain network. Yield farming works with the staking process. Investors stake, or in other words, lock the cryptocurrencies they hold in return for some amount of reward. Digital funds held in a crypto wallet bring returns to their investors through the locking process.
How Does It Work?
The system is so simple. Investing and earning interest. But, considering the risks they will take, investors should always be careful about their decisions. The investor with a large amount of crypto adds the money he/she owns to the pool of the service provider. If they do not touch this money for a long time, they earn a certain amount of interest in return. Once the money has been added to the pool, it is locked. There is no access to these funds for a certain period. Here the investor takes a significant risk. If the deposited coin falls in value, the investor cannot withdraw his money. Therefore, yield farming is an investment strategy that requires a lot of attention and precise calculation. And given the risks it entails, it appeals to investors of large amounts of cryptocurrencies, which we often call whales.
Yield Farming and Staking Difference
Although yield farming is similar to staking, each one is a different concept. In the staking, users only earn income by promising to keep their crypto money in the wallet for a certain period. But with Yield Farming, happens differently. In this innovative model, users are not considered to be farming by keeping their coins in the stock market or wallet. Investors must deposit the coins into the DeFi pool and buy the pool’s tokens to yield farming. Unlike staking, yield farmers often move their digital assets from one credit market to another to find the highest yield. Yield farming investors use very complex strategies. They always move their cryptocurrencies between different lending markets to maximize their returns.
What Are the Risks of Yield Farming?
Naturally, as with any investment, there are risks with yield farming too. For making substantial profits, yield farmers have to put in a large initial capital. It is important to know that the most successful farming strategies are complex. Taking into account the volatile nature of cryptocurrencies, the risk is higher for those who do not fully read and understand the terms of how all fundamental protocols work.
One of the obvious risks of the system is smart contracts. Due to the nature of DeFi, smart contracts are mostly created and developed by teams with limited budgets holding significant amounts of their tokens. This can increase the risk of smart contract errors. It is crucial to take into account when locking money into a smart contract that errors can always occur, even in the case of protocols controlled by audit firms.
Most DeFi apps are based on the Ethereum blockchain. But, the network’s lack of scalability presents some challenges for yield farmers. As yield farming becomes more popular each day, more transactions are clogging up the Ethereum network. As the system loads more, confirmation times slow, and transaction fees increase. For now, the upcoming Ethereum 2.0 update is expected to address the scalability issue of the current network.
In summary, yield farming is an investment that will make you earn more money than you have. Considering market volatility and other possible risks should be carefully considered before investing.
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Disclaimer: All information provided in the content is for informational purposes only and should not perceive as investment, financial, or trading advice. Any investment decision you make should be a personal choice based on financial knowledge, experience, and market research.