Yield farming is one of the trending topics in decentralized finance. It is highly likely that you may have heard of it and it concerns you. So, what exactly is yield farming? In simple words, it is about maximizing the rate of return on capital. It does that by leveraging multiple DeFi protocols. Yield farms constantly switch over different strategies to secure the highest yield. The highly profitable strategies involve some of the DeFi protocols such as Synthetix, Curve, Balancer, Uniswap, Compound, etc. If the current strategy doesn’t work as intended, yield farmers switch over to the next available strategy. In effect, they move funds to other protocols or swap cryptocurrencies for more yields. This process of switching over is commonly dubbed as crop rotation.
Comparisons with Traditional Banking
If you prefer to compare to traditional banking, consider people trying to spot the best savings account. They go for the highest annualized percentage yield (APY). It is the easiest way to measure and compare the rate of return on investment. It suits the market where multiple financial products are involved. It is always a better way to express returns of multiple yield farming strategies. Usually, the traditional savings accounts in the west have a minimum of 0.1% APY. Anything in the upside of 3% is unheard of, in this age and era. This is where Yield farming scores big with insane return rates of up to 100% APY. Obviously, you need to understand how it is done and what the catch is.
There are three major quotients of Yield farming - liquidity mining, leverage and risks.
Liquidity Mining: Liquidity mining is the process of distributing coins or tokens to users in a protocol. Synthetix pioneered the process by rewarding SNX tokens for users who added liquidity via SETH or ETH on Uniswap. Additional incentives for users include token benefits besides the total yield. Moreover, just to add up liquidity, Compound offered rewards to borrowers of assets in the protocol.
Leverage: Besides liquidity mining, another factor that makes insane APY possible is leverage. It is the strategy of utilizing borrowed assets to exponentially increase the potential returns on your money. All your investment works as just collateral in ultra-margin trading. Sometimes, you can use borrowed assets as collateral to borrow more assets. Nevertheless, the higher the leverage, the higher are the risks. In fact, the risks you are willing to take are part of yield farming.
Risks: Besides leverage associated risks, you have the dangerous possibilities of smart contract bugs, platform changes and other systematic risks. For instance, Ethereum went on a spree of losing its value more than once. In addition, you have other DeFi associated risks including targeted attacks on liquidity pools. Overall, Yield farming is a high risk, high reward game.
You need to learn about different yield farming strategies. We will cover such topics in future posts. Regardless, yield farming is slowly but surely becoming a science in blockchain space. In addition, its popularity has constantly been on the rise in recent times.