Introduction

One of the most innovative aspects of blockchain technology is Decentralized Finance (DeFi). What makes DeFi applications stand out? They are permissionless, meaning that anyone with an Internet connection and a supported wallet can interact with them. Also, they usually don’t require trusting custodians or middlemen. In other words, they don’t require trust. So, what sort of applications do these features make possible? One example is yield farming. Yield farmers earn rewards with cryptocurrency by staking their holdings in permissionless liquidity protocols.

Yield farming is a term used to describe the process of earning passive income through Ethereum’s decentralized ecosystem. Because of this, yield farming could potentially change how investors hold assets in the future. If you’re not utilizing your assets, why keep them idle?

How does yield farmer take care of their crops? What kind of yields can they expect? And where should you start if you’re thinking of becoming a yield farmer? We’ll explain them all in this article.

What is yield farming?

Yield farming, also known as liquidity mining, is a way to generate rewards by holding onto cryptocurrencies. In other words, it means locking up your coins and getting rewarded for doing so.

In some ways, yield farming can be compared to staking. However, there’s usually a lot more going on behind the scenes. In many cases, yield farmers work with users called liquidity providers (LPs) who add funds to liquidity pools.

A liquidity pool is a smart contract that contains funds. By supplying the pool with liquidity, LPs earn a commission. This fee may come from the decentralized finance platform itself or some other source. Additionally, some pools offer rewards that are paid out in multiple tokens.

Once you’ve deposited your tokens into a liquidity pool, you can then earn rewards which may be deposited into other liquidity pools. As you can see, strategies can quickly become quite complex. Though the basic idea is that providers deposit funds into a liquidity pool to receive rewards in return.

ERC-20 tokens are used on Ethereum for yield farming, and the rewards are also frequently an ERC-20 token. This might change later down the line though. Right now, a lot of this is going on in Ethereum’s ecosystem but with cross-chain bridges and other technological advancements, DeFi applications could become blockchain agnostic in the future. That would enable them to run on different blockchains that support smart contract capabilities as well.

Just like centralized exchanges, DeFi platforms provide economic incentives to attract yield farmers and their capital. These yield farmers move their assets around frequently in pursuit of higher returns, so the more attractive the platform is, the more likely it is that these users will be staying put.

How it all started

The recent spike in yield farming can be accredited to the COMP token – the governance token of Compound Finance. Essentially, Governance tokens grant voting rights to whoever holds them. However, if you want to maintain a decentralized network, how do you distribute these tokens? 

One way to start a decentralized blockchain is by distributing governance tokens algorithmically and providing liquidity incentives. This attracts liquidity providers, who can then “farm” the new token by providing liquidity to the protocol. The COMP launch popularized this type of token distribution model, and since then other DeFi projects have come up with innovative schemes to attract liquidity to their ecosystems.

The most accurate method to measure the current state of yield farming in DeFi is Total Value Locked (TVL). It takes into account how much cryptocurrency is locked up in different money markets for lending and other purposes. 

In a way, TVL displays the liquidity present in all liquidity pools. This makes it an essential metric not only for determining the health of DeFi as a whole but also for comparing the “market share” held by various DeFi protocols.

To understand the current state of yield farming, you can track TVL on Defi Pulse. This platform allows you to see which platforms have the most ETH or other crypto assets locked in DeFi. Generally, if more value is locked, then more yield farming is taking place. It’s important to know that TVL can be measured in ETH, USD, or BTC–each one providing a different perspective on DeFi money markets.

How does yield farming work?

Yield farming is similar to automated market makers (AMM). With this system, there are liquidity providers (LPs) and liquidity pools. Modifications have been made so that users can deposit funds into the pool to power a marketplace. There, people can borrow, lend, or exchange tokens as needed. The usage of these platforms requires fees which are then given back to the LPs in accordance with their share size of the total pool.

The implementations of new technology are always different, and this is no exception. It’s certain that we’ll see more effective approaches arise as time goes on. An additional benefit to adding funds to a liquidity pool could be the payout in a new token. 

For example, there might not be any way to buy the token except in small quantities. On the other hand, it may be possible to accumulate it by supplying liquidity to a designated pool. The return that liquidity providers receive is based on the amount of liquidity they add to the pool.

Generally, the funds deposited are in stablecoins pegged to the USD. However, this isn’t a rule set in stone. Some of the most popular stablecoins used presently in DeFi are DAI, USDT, USDC, BUSD, etc. 

Quite a few protocols will mint tokens that show your deposited coins within the system. As an example: if you deposit DAI into a Compound, cDAI (or Compound DAI) is what you’ll receive. If ETH is what you choose to deposit into the Compound instead; then cETH is awarded.

Complexity can arise from this in many ways. For example, you could deposit your cDAI to another protocol that mints the third token to represent your cDAI that represents your DAI. And so on, and so forth. Eventually, these chains can become difficult to understand and follow.

The risks of yield farming

Yield farming strategies can be highly profitable, but they are complex and should only be attempted by advanced users. In addition, yield farming generally requires a large amount of capital to get started (i.e., whales).

Yield farming isn’t as easy as it seems, and if you don’t understand what you’re doing, you could lose money. We just discussed how your collateral could be liquidated. But what other risks do you need to expose yourself to?

One of the primary risks associated with yield farming is the use of smart contracts. Because DeFi protocols are often built and developed by small teams with limited financial resources, this can create a higher risk for smart contract bugs. Even in cases where bigger protocols are audited by well-respected firms, vulnerabilities and bugs are discovered regularly.

Given that blockchain is immutable, this could lead to users permanently losing their investment. Always consider this when deciding whether or not to lock your assets in a smart contract. In addition, one of the largest advantages DeFi offers is also one of its primary dangers. It’s called composability. Now let’s explore how it affects yield farming.

Previously, we talked about how DeFi protocols are permissionless and can easily connect with one another. This ecosystem is then greatly determined by each of its foundation parts. We call this composable because the applications work well together.

One of the biggest risks facing yield farmers and liquidity pools is that if just one of the building blocks doesn’t work properly, the whole ecosystem may suffer. This means that you not only have to trust the protocol you deposit your funds into, but also any other protocols it may be reliant upon.

Wrapping up

The decentralized financial revolution doesn’t seem to be slowing down any time soon. With yield farming being the latest craze in the cryptocurrency space, it’s difficult to predict what other applications may spring up that build on these current components. 

However, trustless liquidity protocols and other DeFi products are definitely at the forefront of finance, cryptoeconomics, and computer science. There’s no doubt that DeFi money markets can help create a more open and accessible financial system for anyone with an Internet connection.