Introduction
With the increase in popularity of Defi (decentralized finance) which is based on trustless, intermediate-free transactions. Defi is the biggest beneficiary of the blockchain movement. With different protocols and tokens appearing nearly every day, Defi is becoming more financially rewarding too. One such rewarding new concept is Yield Farming.
Yield Farming is a protocol(smart contract) that lets you earn more cryptos from your crypto holdings. It involves locking your cryptos with the protocol, which lends to others and earns interest over it. Before discussing Yield Farming and how it works in more detail, let's discuss what is Yield?
Yield
In simple terms,
Yield is defined as interest earned over-invested amount.
Typically Yield is estimated annually in terms of Annual Percentage Rate(APR). Example: Consider the case of a bond, where you invested INR 5000 and earn an interest of INR 500 over it in a year. So, the APR of the bond becomes 10%(500*100/5000).
Yield Farming
Yield Farming is a permissionless liquidity protocol, where liquidity providers(LPs) or crypto-holders add cryptos to the liquidity pool to generate rewards from their holdings. Typically, ERC-20 tokens based on Ethereum are used for farming.
What is a liquidity pool? It's a smart contract where all the funds provided by the LPs are stored. In return for liquidity, they are rewarded with tokens(In the case of Compound, you are also rewarded with COMP governance token).
Yield Farming is a good source of passive income for those LPs, who invest in cryptos for the long term (famously known as HODL).
How Yield Farming Works?
Yield farming is closely related to the automatic market maker. Typically involving the liquidity pool and LPs. Liquidity pool powers the marketplace where users can lend, exchange or borrow assets.
This happens with the fees, which in turn are used to reward the LPs and in some cases, an additional token to incentivize LPs for participation based on their share in the pool. The funds deposited in the pool are generally in stable coins though it's not a general case.
What is an automatic market maker(AMM)? AMM is a decentralized exchange(DEX) protocol that relies on a mathematical formula to price the assets instead of using an order book for price discovery.
For eg.: Uniswap AMM works like X*Y = K, where X is the amount of token present for one token and Y is for another. Such that K remains constant meaning total liquidity always remains the same. Based on that if suppose the quantity of X’s token drops, the price will rise of X’s token.
How to take a loan?
Generally, If you want to take a loan, you need to put something as collateral, which acts as insurance against the loan. So how much collateral do borrowers need to put? Well, that depends on the protocol which defines something called collateralization ratio.
Collateralization Ratio means a percentage of collateral value to the loan borrowed. If the value of the collateral falls below the threshold defined by the protocol, then the protocol will start liquidating assets in the open market.
Collateralization Ratio = Collateral Value/Loan Value
Some protocol also has the concept of over-collateralization, which means borrower needs to add more value than they want to borrow. Typically, to reduce the volatility of markets during violent times.
Generally, the collateralization ratio is greater than 100%, which means the borrower must have more collateral value than the loan value. Which hedge protocol during turbulent market times.
Quality of the Yield Farm
With Defi's popularity, Yield Farm is becoming an attractive destination for Hodler’s to park their holdings and earn extra cryptos. But it comes with the risks. There are so many risks that typically yield farm is facing majorly due to liquidity.
Liquidity should be a major parameter to check the quality of the farm before investing. Total Value Locked (TVL) a parameter to check liquidity, represents how many cryptos are locked in the lending and farm ecosystem.
TVL is also a great indicator to check the market share of different protocols. Defi Pulse is a good place to look for TVL and will give you a general idea about the state of yield farms.
Risks
Any investment in general which gives medium to high returns is associated with risks. A few of the most common risks across different protocols are:
- Liquidity Risk: LPs can’t buy or sell at any desired price or the order takes too long to execute due to lesser volume or participation activities.
- Risk of Impermanent Loss: In a pool, you put tokens in pairs of equivalent values; if you add one ETH in an ETH/USDC pair and 1ETH is 2000 USDC, you must add 1ETH and 2000 USDC. So, loss in the value of your tokens in the open market compared to when you put them in the liquidity pool due to price fluctuations. Such losses are impermanent as the prices of tokens catch up at different platforms due to arbitrage opportunities. But it can pose a severe risk, as prices of different tokens change drastically.
- Defi Smart Contract Risk: Yield farming is a smart contract code that is written by a developer or team of developers. Any bug/s present in the code can lead to a potential hack leads to a loss in funds or can make the value of your rewards zero.
- Risk of Scam and Unfairness: Yield farming is largely controlled by its founders or early-stage investors, who have the majority stake in the pool. Any sell-off(pump and dump scheme) from their side can lead to illiquidity and the price needs to be paid by small investors due to the wide bid-ask spread.
Platforms
Now you have the basic knowledge of yield farming, so that means you are all set for starting and earning money? No, not that fast. Each protocol has its own set of rules and regulations, which you must know before putting in all your money.
There is no single golden strategy that will make money for you, on the contrary, a strategy that worked for you in the past might not work in the future, due to the rapid pace of changes in protocols and other holders using a similar strategy, thus reducing rewards.
So you must beware before deploying any strategy and adopt proper risk management tactics to safeguard your account. With that in mind, there are so many platforms that facilitate lending and borrowing activity. A few popular ones are:
Conclusion
Yield Farming is becoming more popular and widely used as a passive income way for Hodler’s. No doubt the value created by the yield farm is great for the economy and society. Being trustless, permissionless, and intermediate-free Defi is a great application of blockchain and has the potential to reach an under-served section of society.