What Is Yield Farming in DeFi?
Yield farming is the latest craze in crypto and is the key reason behind the DeFi explosion going on right now, So what exactly is it? Well, yield farming entails lending crypto to earn more crypto. It is a break from the past where to make money in crypto, you either had to HODL or trade on price movements speculation. Essentially, a yield farmer will look for DeFi pools that offer the highest lending rates and lend with the aim of maximizing their crypto holding as much as possible.
Sounds too complicated? If you are a newbie in the DeFi space, you are probably wondering what is yield and how farming relates to crypto, right? To understand farming, you need to relate it to a bank account.
When you open a bank account and save money, you expect a return on your savings since the bank uses your money to earn through lending. The interest the bank pays is your yield. It is the same with DeFi yield farming. The only difference is that unlike conventional banking economics, DeFi is trustless. When farming cryptocurrency, you overcollaterize, meaning that the platform does not need to do KYC. Your wallet represents you instead of your name.
What is yield finance?
To make sense of yield finance, you need to understand the meaning of yield and why there is a lot of hype around it. Ideally, the concept of lending crypto to earn interest is not new. However, its most recent explosion can be attributed to the launch of a project called Compound and the compound token. The interesting aspect of the compound token is that it allows holders of the token to take part in the project’s governance.
Essentially, this means that token holders can vote on everything, including the lending rates. It also opened the way for another innovative way to make money called liquidity farming, as investors try to earn new tokens and take part in governance. With the increased popularity of Comp, other DeFi projects have taken up the idea of distributing governance tokens, creating a whole ecosystem of yield farming and liquidity mining protocols.
It is also noteworthy that DeFi tokens are ERC-20 tokens. This means that as one multiplies their tokens through lending and liquidity mining, they are also farming Ethereum. That’s because they will have a higher amount of ETH upon conversion. It is a much cheaper way to grow an ETH portfolio as compared to conventional ETH mining.
How fast is yield farming growing?
One way to measure the prospects of the DeFi space and yield farming is to look at the amount of Ethereum (ETH) locked up in DeFi projects, also known as the total locked value. Going by DeFiPulse data, the amount of Ethereum locked in DeFi projects has been on the rise over the last one year. In September 2019, the total locked value stood at around $480 million. The number has been growing steadily over the year and peaked at $12.3 billion in Mid-September 2020. It has since fluctuated slightly and currently stands at $9.47 billion.
The mechanics of yield farming and the risks involved
When researching yield finance and how to make money off it, the focus should be on understanding the logic behind it and the risks involved. Yield farming is a form of automated market-making and entails the use of liquidity pools and liquidity providers.
Essentially, a liquidity provider (crypto farmer) deposits funds into a pool, which in turn lends the tokens, or exchanges them for a fee. The fees generated by these pools are then distributed to the liquidity providers based on their contribution to the pool. The returns that investors earn are calculated annually using metrics like annual percentage rate and the annual percentage yield.
Since DeFi lending is overcollateralized, there is a near-zero risk of default. However, there is a risk in the tech itself. Yield farming uses complex smart contracts that could lead to the loss of funds in case of exploitable vulnerabilities.