What Is DeFi Yield Farming and How Dose It Work?

The evolutionary process is inescapable in all industries. With so much buzz surrounding rising trends, the world observes how the crypto space has reshaped every aspect of economic development. The introduction of DeFi technology is one of the most innovative developments in blockchain. Compared to traditional finance, it has driven innovation and flexibility within the financial industry. Yield farming is one of these emerging trends in the crypto world that has captured the attention of many cryptocurrency enthusiasts. While investigating specific cryptocurrency investments and seeking to generate a substantial profit, DeFi yield farming is the superior option.

According to credible sources, there are currently 1.9 billion dollars locked up in DeFi. Compound’s COMP governance coin primarily motivates cryptocurrency owners to add more value to their work in DeFi applications by introducing a new yield-generating pasture.

What Is Yield Agriculture? Extensive Explanation

Utilizing DeFi to maximize returns is yield farming. On a dedicated DeFi platform, the platform users, in exchange for their services, can borrow or earn cryptocurrency.

To increase their productivity, yield farmers can employ more strategic plans. For instance, yield farmers can continuously use different loan platforms to transfer their cryptocurrencies to maximize their profits.

Fast Facts:

How Does Yield Farming Work?

By placing coins or tokens in a dApp, yield farming enables investors to generate yield. dApps include apps like crypto wallets, DEXs, decentralized social media, and other applications.

Yield farmers use DEXs to lend, borrow, or stake coins to earn interest and muse on price fluctuations. Smart contracts, that are contracts written in code to ensure smooth transaction, automates financial agreements between two or more parties.

Here are some standard terms you may encounter while working in this industry:

Liquidity: The ease with which a digital asset can be converted into fiat currency without affecting its market price.

Liquidity Pool: A Yield Farming Smart Contract’s Liquidity Pool is a collection of funds locked in a smart contract. They are intended to facilitate decentralized commerce and lending.

Liquidity Provider (a.k.a. market maker): A liquidity provider (also known as a market maker) is an organization or individual that quotes the buy and sell price of a tradable asset to profit from the bid-ask spread or turn.

Automated Market Maker: Automated market makers are models that enable the trading of assets without permission by employing liquidity pools instead of conventional market approaches. It is closely related to yield automation farming.

Now that we understand the fundamentals let’s examine the big picture.

Stage 1: In the initial stage, smart contracts are liquidity pools. There, providers deposit their funds. Stablecoins, a brand-new class of cryptocurrencies that aims to provide stable prices and is backed by a reserve asset, are locked by these contracts, becoming accessible under specific restrictions and yield farming platforms.

Stage 2: In the second phase, users can trade, lend, or borrow yield farming coins. Participants pay specific fees. Market makers receive an investment return proportional to the amount of capital contributed.

Stage 3: Market makers are rewarded for their willingness to lock up funds in the pool at this stage. Protocols and deposits determine the rewards users receive.

Stage 4: Providers reinvest and reallocate their rewards to increase their returns. That is, they continue to store coins in liquidity pools. This is how liquidity providers diversify and raise capital with their investment portfolios. It is possible to maximize profits by selecting effective strategies.

Types of Yield Agriculture:

Liquidity Provider: Users who deposit two coins to a DEX to provide liquidity for trading. Exchanges charge the fee to swap two tokens and pay to liquidity providers. Sometimes, this fee can be paid in new liquidity pool (LP) tokens.

Lending: Lending is the process where token holders can lend the cryptocurrency to borrowers through a smart contract and earn interest on the loan.

Borrowing: Farmers are able to use one token as collateral while receiving another token as a loan. The borrowed coins can then be used to cultivate yield. Thus, the farmer retains their initial holding, which may increase in value over time, while earning interest on their borrowed coins.

Staking: There are two types of staking in the DeFi universe. On proof-of-stake blockchains, users are compensated with interest for pledging their tokens to the network to provide security. The second step is to stake LP tokens earned by providing liquidity to a DEX. This allows users to yield twice, as they are compensated in LP tokens for providing liquidity, which they can then stake to earn additional yield.

What Characteristics of DeFi Make it More Suitable for Yield Farming?

DeFi is powered by code that runs on blockchain’s decentralized infrastructure, unlike the traditional financial system, which operates on a centralized infrastructure governed by central authorities and intermediaries. The immutable smart contracts aid Defi smart contract development providers in launching and using programmable financial protocols and platforms.

The concept of yield farming arose due to the decentralization of finance. Because DeFi is decentralized, no centralized entities provide seed capital. Therefore, lenders and liquidity providers provide all cryptocurrencies to DeFi platforms. These DeFi platforms are software-based brokers who facilitate financial transactions for a small fee.

DeFi utilizes the significant characteristics of blockchain to unlock liquidity, improve financial security, and support standard economic systems. The critical attributes of DeFi that make it suitable for yield farming are outlined below.

Immutability

Since DeFi is based on blockchain technology, all data is immutable. The tamper-proof information increases the security and auditability of financial transactions.

Programmability

Smart contracts that are highly programmable automate the execution and creation of digital assets.

Interoperability

Combination and integration are integral to DeFi protocols and applications. DeFi enables developers to build on existing protocols, customize interfaces, and integrate third-party applications. Consequently, DeFi protocols are also referred to as “money legos.”

Transparency

DeFi is based on blockchain technology; all transactions, data, and codes are highly transparent. This level of transparency and authenticity surrounding transaction data fosters confidence and makes network activity accessible to all users. The source code for DeFi protocols is available for anyone to view, comprehend, and audit.

Permissionless

DeFi enables unrestricted and open access. Anyone with a crypto wallet can access DeFi applications regardless of location or the required funds.

Self-Custody

Participants in the DeFi market can retain custody and control of their assets and data. Through the use of web 3 wallets such as Metamask, they can interact with permissionless financial applications and protocols.

How can Returns be Calculated in DeFi Yield Farming?

The following metrics play an essential role in calculating returns for liquidity providers.

Total Value Locked (TVL)

TVL is a parameterized measure of crypto locked in DeFi lending and other markets. Tracking the total value of cryptocurrencies locked in smart contracts across diverse platforms provides a comprehensive performance overview. It aids the participants in comparing the market share of various DeFi platforms and protocols. TVL is an efficient method for collecting liquidity in liquidity pools and demonstrates a quantifiable approach to the overall size of the DeFi and yield farming market.

Yield Percentage Annual (APY)

It is the annual rate of return imposed on borrowers and subsequently paid to providers.

Annual Rate of Percentage (APR)

The annual return rate is imposed on capital borrowers but paid to capital providers.

The returns in DeFi Yield agriculture are estimated annually. Annual Percentage Rate (APR) and Annual Percentage Yield are crucial parameters for calculating returns in yield agriculture (APY).

APR and APY differ in the compounding effect. Compounding refers to reinvesting profits to obtain the highest possible returns. APY takes into account the impact of compounding, whereas APR does not.

As APR and APY are derived from legacy markets, DeFi must determine its metrics to calculate yield farming returns. Simple staking procedures provide up to ten percent of annual returns, whereas yield farmers can adopt complex trading strategies that provide over fifty percent yearly returns.

Popular Yield Farming Practices

Curve Financial Markets

The curve is the largest DeFi platform in terms of TVL (total value locked) on the platform, with nearly $19 billion. With its market-making algorithm, the Curve Finance platform utilizes locked funds, which is advantageous for both parties that are swappers and liquidity providers.

Curve provides a list of stablecoin pools with competitive APRs tied to fiat currency. The curve maintains high APRs ranging from one point nine percent (1.9%) to thirty two percent (32%). As long as the tokens keep their peg, stablecoin pools are highly secure. It is possible to avoid the impermanent loss because their prices will not vary significantly relative to one another. Curve carries the risk of temporary impermanent loss and failure of smart contract, as do all DEXs.

The curve platform has its token, CRV, used for Curve DAO governance.

Aave

Aave is another prominent stablecoin yield farming platform, with over $14 billion in locked-up value and a market cap of over $3.4 billion.

Additionally, Aave has its native token, AAVE. This token incentivizes network usage by providing benefits such as fee reductions and governance voting rights.

It is common for liquidity pools to work together on yield farming. The Gemini dollar has an annual percentage yield on deposits of 6.98 percent and an annual percentage yield on borrowing of 9.69 percent, making it the most profitable stablecoin available on Aave.

Uniswap

Uniswap is a DEX system that enables token exchanges devoid of trust. Liquidity providers invest the equivalent of two tokens to establish a market. Traders are subsequently able to conduct transactions against the liquidity pool. In exchange for providing liquidity, liquidity providers collect transaction fees from trades executed within their collection.

Due to its frictionless nature, Uniswap has become one of the most popular platforms for trustless token swaps. This is beneficial for high-yield agricultural systems. UNI, the DAO governance token of Uniswap, is also its own.

PancakeSwap

PancakeSwap operates similarly to Uniswap, albeit on the Binance Smart Chain (BSC) network as opposed to Ethereum. It also contains a few additional gamification-oriented features. PancakeSwap provides:

PancakeSwap is susceptible to the same risks as Uniswap, including temporary loss due to significant price fluctuations and the failure of smart contracts. Numerous tokens in PancakeSwap pools have small market capitalizations, making them susceptible to temporary loss.

CAKE is PancakeSwap’s native token, which can be used on the platform and to vote on platform proposals.

Advantages of DeFi Yield Agricultural Development

Easy User Interface: Numerous yield farming tools with simple user interfaces are available to track investments. Their learning curve is low. Their straightforward user interface permits checking project availability and choosing a cryptocurrency deposit amount.

Easy Start: Again, this is a result of user-friendly software applications. Specialized instruments will perform all the work for you, so you do not need any prior technical knowledge. The high interoperability of DeFi services also allows for a quick start. A cryptocurrency wallet and Ethereum are two primary requirements; they are typically sufficient.

Profit Potential: Similar to cryptocurrencies, early investors in protocols have the opportunity to generate substantial returns. In other words, investors are attracted by a solid return on investment.

Interoperability: As can be seen, the decentralized finance industry is adaptable and interoperable. Some systems automatically move cryptocurrency from service to service to improve investment outcomes.

Questions Asked Frequently

Is yield agriculture profitable?

Yes. However, it depends on the amount of time and money you are willing to invest in yield farming. Specific high-risk strategies require a comprehensive understanding of DeFi platforms, protocols, and intricate investment chains to be effective.

If you’re looking for a way to generate passive income without making a significant investment, try placing some of your cryptocurrencies on a time-tested and reputable platform or liquidity pool and observing how much they earn. After establishing this foundation and gaining confidence, you can move on to other investments or even directly purchase tokens.

Is yield farming risky?

Before engaging in risk farming, investors must be aware of several associated risks. In DeFi yield farming, scams, hacks, and volatility losses are uncommon. The initial step for anyone using DeFi is to investigate the most reliable and thoroughly tested platforms.