What is yield farming about? What does it entail? Should you start taking part in it, or should you keep off? Welcome to today’s article, in which we shall explore this concept that most crypto enthusiasts are concerned about.
What is yield farming?
Yield farming also referred to as liquidity mining, exists as an approach to generate rewards with one’s crypto holdings. Simply put, yield farming means locking up one’s crypto assets to get returns and rewards.
In one way or another, yield farming can be likened to staking. There’re, however, many complexities in the background. The liquidity providers (LP) usually add funds to the liquidity funds.
Liquidity providers and liquidity pools
Liquidity pools are essentially smart contracts that have funds. When an LP provides liquidity to the liquidity pool, they get a reward. The reward received by the LP may come from fees collected by the DeFi platform on which the entire process happens, or from another source.
Some liquidity pools reward LPs using several tokens. The reward tokens may then get deposited in other liquidity pools that they can earn rewards. As you can see, the strategies involved in the process are quite complex. The basic idea, however, is that when an LP deposits funds into a certain liquidity pool, they get returns and rewards.
Yield farming typically happens with ERC-20 Tokens on Ethereum. The rewards sent to the LPs are a type ERC-20 tokens. This may change in the future with many activities going on in the Ethereum ecosystem.
Cross-chain bridges may end up saving the day by allowing other DeFi apps to eventually become blockchain agnostic. This basically means that these apps will have the capability to run on other blockchains, provided they support smart contracts.
Yield farmers usually their funds in the form of crypto assets quite often. They hope that as they hop from one protocol to the other one, that they will find one that will help them generate high yields. This means that DeFi platforms have an opportunity to offer economic incentives in a bid to attract extra capital on their platforms. As is the case with centralized exchanges, with liquidity, one can attract more liquidity.
The cause of the yield farming boom
In 2020, there was a sudden growth in the level of interest in yield farming. Experts in this industry attributed this sudden phenomenon to the successful launch of the COMP token.
COMP Token exists as the governance token issued by Compound Finance ecosystem. Governance tokens usually grant the governance tokens to their holders. How can then such tokens get distributed if the objective is to ensure that the network remains as decentralized as possible?
One common approach to establish a decentralized blockchain is through the distribution of the governance tokens algorithmically, by attaching liquidity incentives. The incentives attract the liquidity providers to join the DeFi platform to “farm” the new token. They usually achieve this by providing liquidity to this protocol.
As much as the launch of COMP did not invent yield farming, it did an impressive job at giving this token distribution model its popularity. Since the invention of COMP, several other DeFi projects have commenced and have established innovative schemes to bring in LPs to their ecosystems.
How Yield Farming works
As we have already seen, yield farming basically involves liquidity providers (LPs) and Liquidity Pools. The process starts with the LPs depositing funds into a given liquidity pool. This pool powers the marketplace in which the lending, borrowing, and exchange of tokens can occur. The users of this marketplace pay fees to use various services. The same fees are usually used to pay the liquidity providers based on the share of funds they offered to the liquidity pool. Evidently, yield farming resembles another popular model known as an automated market model (AMM). The implementation of the two models can however be significantly different. On top of that, yield farming is an entirely new technology.
In addition to the fees, the other incentive to LPs to add funds to the liquidity pools is, potentially, the distribution of new tokens. For instance, there may not be a defined way to purchase a certain token on the open market, apart from in small amounts. The token may, however, get accumulated by offering liquidity to a given liquidity pool.
All rules of token distribution in a given platform depend on how the uniqueness of the implementation of the underlying protocol. With most platforms, however, it’s safe to say that the return an LP gets is based on the amount of liquidity provided to a liquidity pool.
Stablecoins deposited to liquidity pools
The funds deposited to liquidity pools are mostly stablecoins whose value is attached to the USD (not a general requirement). Some of the very common stablecoins used in DeFis include:
Some protocols have the capability to mint new tokens that represent the of funds deposited in their system. If you for instance deposit ETH into the Compound DeFi, you will get cETH.
I know you can begin to begin the many complexities that can arise from this model. Some investors can, for instance, deposit their cETH to a platform that also works by minting a third token that should represent the cETH that represents the initially deposited ETH. This can go on and on, forming complex chains that are hard to follow.
How returns are calculated in yield farming
In most cases, investors calculate estimated yield farming returns on an annual basis. The figure obtained represents the returns one can expect over the course of that year.
The most common metrics used to determine the returns are:
- Annual Percentage Rate (APR)
- Annual Percentage Yield ( APY)
What’s the difference between the two metrics? APR does not usually consider the effects of compounding, whereas APY factors in these effects. Compounding refers to the reinvestment of profits in a bid to earn more returns. Note that APR and APY can be used interchangeably.
Also keep in mind that these are only estimates, and can change within no time (even in the short-term horizon). Yield farming is highly competitive and when many farmers jump on a profitable opportunity, its returns may diminish with time.
With time, DeFi will need to establish a new metric to calculate returns. The fast-paced environment makes it hard for investors to remain very confident about their returns unless on a weekly or daily scope.
That’s all for this article on what yield farming is all about. I hope that you now know a thing or two about this concept and that you can help your friends and family understand what it entails. Let me know if you have any more questions related to this topic. Also, do not forget to have a look at the about resource. It is value-packed and may help you get a turning point in your financial life.
I wish you well,
Eric, Investor and Team Member at Gold Retired!