Even with the latest downturn within the crypto markets, the whole worth of belongings locked in decentralized finance (DeFi) protocols presently sits at over $42 billion. For the uninitiated, decentralized finance is a rising assortment of monetary instruments and protocols permitting customers to commerce, borrow, and lend cash on the blockchain with out the necessity for third-party approval.
Perhaps the most important catalyst for DeFi’s development has been the rise in reputation of yield farming, a fairly dangerous ROI-optimizing technique that gives considerably larger returns than conventional investing. Due to its high-risk, high-reward nature and the overall choice towards hypothesis in crypto, yield farming has rapidly turn out to be one of the vital favored use instances of decentralized finance.
What is yield farming?
Yield farming is the method of staking and lending cryptocurrency by means of decentralized finance protocols to optimize returns. While technically yield farming can happen utilizing a single DeFi platform, most critical yield farmers constantly shift their cryptocurrency between quite a few mortgage platforms to benefit from their returns. By leaping backwards and forwards between platforms, customers are in a position to earn and optimize platform-native rewards and generate larger yield.
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It’s additionally price noting that whereas this sort of buying and selling is dangerous, utilizing a decentralized trade might help merchants keep away from what has turn out to be a present string of meltdowns at centralized exchanges, most notably the likes of FTX. In reality, some decentralized exchanges have seen a surge in exercise as customers flee centralized exchanges, together with Uniswap, which in mid-November noticed a surge in new exercise on its trade:
New customers of Uniswap’s Web App reached a 2022 excessive. Self-custody and transparency are in demand and customers are flocking to what they know and belief. Let’s hold constructing. pic.twitter.com/IwPqTmx58JNovember 14, 2022
How does yield farming work?
Yield farming includes the lending, borrowing, and staking of tokens into decentralized purposes like decentralized exchanges (DEXs) or open-sourced liquidity protocols. Each of those dApps is powered by sensible contracts which permit for the autonomous execution of transactions with none central financial institution or intermediaries.
Popular and trusted protocols embody Curve, Aave, Balancer, Compound, and Uniswap. Meanwhile, liquidity aggregators like Yearn, present lending aggregation seamlessly shifting swimming pools of customers’ funds throughout totally different protocols to maximise revenue and yield.
While most DeFi protocols had been initially primarily based on the Ethereum blockchain, excessive transaction charges, known as gasoline charges, have compelled protocols to change to different blockchains or sidechains like Polygon and Solana.
Types of yield farming
Providing liquidity: Liquidity suppliers provide the mandatory buying and selling liquidity that powers decentralized exchanges. To be a liquidity supplier (LP) of a dual-asset liquidity pool, say BTC/ETH, you need to provide an equal worth of each belongings.
In trade for offering liquidity to liquidity swimming pools, LPs earn a small share of every transaction. In addition, LPs obtain LP tokens, separate exchangeable and stakeable belongings that represents the proportion of a LP’s contribution stake relative to the complete pool.
For instance, in case you present $100 price of crypto belongings to a complete pool price $1,000 USD, you personal 10% of the pool. To characterize this possession, you’re rewarded with LP tokens which can be in a position to be claimed for 10% of the pool’s belongings at any time.
Lending: By locking tokens up into self-executing sensible contracts, yield farmers can instantly lend their tokens to a different particular person in trade for receiving the curiosity paid on the mortgage.
Borrowing: Yield farmers can put up one cryptocurrency as collateral to obtain a mortgage in one other token. Then, customers can deposit the borrowed cash right into a DEX or liquidity protocol to farm further yield, whereas nonetheless sustaining their preliminary holding.
POS staking: On proof-of-stake blockchains, customers can lock up their tokens to supply further safety to the community, in trade for curiosity.
LP staking: Staking the LP tokens acquired when offering liquidity to a DEX permits customers to earn yield twice, as they’re paid for supplying liquidity in LP tokens which they will then stake to earn extra yield.
Native token staking: Protocols like Curve and Aave incentivize farmers to make use of their networks with native tokens like CRV and AAVE. These tokens reward customers with advantages comparable to charge financial savings and governance voting energy round future platform-related choices. These tokens are moreover in a position to be staked in-platform in trade for added yield.
Risks of Yield Farming
As with most crypto investments that include enormous upside potential, yield farming is a really dangerous recreation and isn’t for the faint of coronary heart. It requires critical analysis, data, and danger urge for food, particularly in turbulent markets like these. Make certain you perceive the place the yield is coming from, as some less-known protocols can function just like Ponzi schemes, paying promised returns to current buyers utilizing new buyers’ funds.
As a rule of thumb: If you possibly can’t establish precisely the place the yield is coming from, your cash is another person’s yield.
Below, we define a few of the particular and big-picture dangers yield farmers face, together with just a few good reminders of the dangers inherent within the cryptocurrency sector basically.
Exit scams: Exit scams, sometimes called rug pulls, happen when the developer of a decentralized utility or protocol abandons the mission with out returning any customers’ funds. Lack of analysis into the place you’re lending and staking your tokens for yield can depart you empty handed and with no recourse. Unfortunately, this occurs very often in DeFi, so it’s at all times necessary to do your analysis and keep vigilant of warning indicators. Beware of recent protocols providing unreasonably excessive yields.
Platform hacks: Smart-contract hacks are the second largest danger in DeFi. While the standard and safety of sensible contracts has improved over time by means of third-party audits and an inflow of proficient builders, sensible contrack hacks are nonetheless fairly widespread. Once a wise contract is hacked, it’s usually unimaginable to get better funds.
Regulatory danger: Cryptocurrency regulation remains to be very a lot a Wild West, with the SEC starting to tighten the presently obscure definition of digital asset “securities.” While a lot of the premise of DeFi is centered round autonomy and a scarcity of central authority, extra stringent authorities regulation might have a critical impression on the expansion of the ecosystem. (There may very well be tax implications for cryptocurrency investments as properly.)
Volatility: In crypto market downturns or instances of utmost volatility, yield farming turns into even riskier than ordinary. Large value swings can result in heavy slippage, impermanent loss, and even sensible contract liquidation.
Impermanent loss happens when the worth of holding a cryptocurrency in your pockets is larger than that of being a dual-asset liquidity supplier. Depending on how the worth of an asset adjustments over time, particularly throughout instances of excessive volatility, it’s possible you’ll be higher off holding the asset outright as a substitute of getting used it to supply liquidity to a liquidity pool.
The backside line
As with all cryptocurrency investing, yield farming is inherently dangerous. But when executed responsibly and correctly, it can lead to spectacular returns. As a reminder, by no means make investments greater than you possibly can afford to lose and don’t let FOMO get the perfect of you. There will at all times be a brand new protocol promising sky-high annual share yields. Trust your intestine, and if it’s too good to be true it most likely is.