https://nasacademy.com/blog/article/earn-free-crypto-on-your-existing-crypto-holdings-yield-farming-101
For many Crypto Investors, the knowledge of Crypto is limited to crypto trading but there are many opportunities to earn substantial profit besides trading.
An extended part of the Crypto world is DeFi which is based on Blockchain technology. DeFi, decentralized finance, is an alternate financial system. DeFi assists in Peer-to-peer financial transactions between users without the interference of an intermediary or any third party. There are many Financial Services provided on the DeFi platforms with the help of Smart Contracts. One such part of the DeFi platform is Yield Farming.
Now you must wonder what is yield farming? Is it like the game Farmville? Not even close.
Yield farming and its innovation of liquid mining are gaining popularity and have been a phenomenal growth driver for the emergent DeFi ecosystem. Yield Farming is an Investment strategy that allows you to earn interest on your cryptocurrency. In a traditional sense, you earn interest on fiat currencies from your savings account. Crypto can be earned by lending or borrowing your existing cryptocurrency and in return for fulfillment of the services, interest is earned.
Just like how you deposit your fiat currencies in a bank account for a certain period to earn interest, the same way you lock in your cryptocurrencies, known as Staking, for a certain period of time on a cryptocurrency exchange platform and in return earn more cryptocurrency as a reward.
Instead of keeping your assets idle, why not stake them and earn additional crypto as interest. Thus utilizing the crypto even while you HODL. It is an excellent strategy for long-term holders to earn more cryptos on the basis of already held cryptos in their exchange wallets.
Mark Cuban, the Shark Tank star said that he entered the world of DeFi through yield farming and he is seeing an annualized return of over 200% by being a liquidity provider on DeFi exchanges.
But it’s not always profitable for the investors. It can be a risky and volatile investment and we will discuss why, shortly. For now, let’s begin with what is yield farming.
In yield farming cryptocurrencies are locked up in smart contracts i.e., liquidity pools to receive rewards in return. Also known as liquidity mining, yield farming allows farmers to earn rewards from their existing cryptocurrencies.
With the introduction of the liquidity mining program concentrated on the governance token ‘COMP’ launched by lending protocol Compound Finance, which gave the owners of the COMP token voting rights over proposed changes on the platform. The hype created by the COMP token pushed Compound in the DeFi ecosystem amongst top positions. This resulted in the growth and mass adoption of yield farming applications and protocols.
To earn more yield farmers employ different tactics and don’t disclose such tactics as the more people will know about them the less effective it will become. Yield farmers are constantly moving their cryptos across different marketplaces to exploit different opportunities to earn rewards across the DeFi ecosystem, applications, and marketplace.
As most of the dAapps are based on the Ethereum Platform, the rewards earned are in ERC-20 tokens.
Yield Farming heavily relies on the Liquidity provider and the liquidity pools (LP) that create a DeFi marketplace for borrowing, lending, and swapping tokens.
Liquidity providers deposit their crypto assets in smart contracts that are programmed to offer a liquidity pool. Yield Farming is based on the automated market maker (AMM) model.
AMM makes the conventional order book, containing all buy/sell options on cryptocurrency exchanges, redundant. Liquidity pools are created by AMM using smart contracts and with the help of the predetermined algorithm, the pools execute trades.
Users of the DeFi marketplace pay trading fees for availing services available in the marketplace, such fees are shared with the liquidity providers as per their contribution in the liquidity pool, and additionally, liquidity providers are also given LP tokens as rewards which they can stake.
DAI, USDT, USDC, BUSD, and others are the most common stablecoins used in the DeFi ecosystem.
Normally, returns on yield farming are calculated annually i.e., the rate of return expected over an entire year.
Returns are either calculated as Annual Percentage Rate (APR) or Annual Percentage Yield (APY) difference being APY takes into consideration the effect of compounding and APR doesn’t. Compounding means reinvesting of income earned on the underlying deposit to incur more gains. The concept of APR and APY come from the traditional financial markets.
Since yield farming is extremely competitive and constantly changing, the rewards fluctuate constantly. Therefore these return rates are usually projections and not the actual rate of return.
Let’s discuss the different types of yield farming to better understand its mechanism.
Understanding the types of yield farming will give us a piece of in-depth knowledge about yield farming. The gist of yield farming is depositing cryptocurrency in smart contracts. Types of farming largely depend on the type of smart contract involved. Basically, there are two approaches to yield farming namely Liquidity Pool Farms and Staking Farms.
Liquidity providers i.e., users that deposit two trading cryptocurrency pairs in the liquidity pool, smart contracts programmed to offer liquidity on Decentralized exchanges, or decentralized finance applications. In return for depositing in LPs, LP tokens are rewarded to liquidity providers by DeFi Apps.
DeFi apps also provide the option of locking in or staking LP tokens that are generated as a reward.
In stake farming, crypto assets are deposited in smart contracts programmed to offer a staking pool. Unlike Liquidity pools, staking pools only deal with a single cryptocurrency asset. It acts as a decentralized vault for a specific asset. Stake farms provide security of crypto assets and allow users to earn crypto more easily.
No LPs are earned on staking, only a single passive income is earned.
Yield farms that incentivize arbitrage traders i.e., traders who gain from differences in the price of the same commodity in different marketplaces.
Yield farms in which users deposit crypto assets in decentralized insurance funds and earn rewards for the same are insurance mining farms. Insurance mining farms are considered highly risky.
Trade mining falls on the same line as Arbitrage mining the only difference being simple trades are carried for earning token rewards.
Let’s move on to the concept of Total Value Locked in Yield Farming
It is like an index to measure the health of the overall health of DeFi and Yield Farming Market. Total Value Locked means how much crypto assets are locked in the DeFi lending marketplace i.e., how much crypto has been deposited in the liquid or staking pool. It also helps in comparing the market share of different protocols.
The more value is locked in the DeFi lending marketplace the more yield farming is being done.
Let’s further discuss how safe yield farming is and the risks associated with it.
Even though the rate of return earned through yield farming is much higher than that offered by traditional and legacy financial systems. Yield farming is less secure than them. Let’s see why?
Let’s go through a list of risks associated with yield farming.
There are a lot of ongoing fraud projects in the Crypto marketplace, users can inadvertently invest in fraudulent or scam protocols and lose all of the coins deposited in the pools.
The crypto space is extremely volatile, there are extreme ups and downs in the marketplace in short periods which can cause the price of the tokens to drastically increase or decrease while they are locked in the pool.
Since the DeFi ecosystem is a nascent space, the smart contracts are not extremely secure as they can be hacked or have bugs incorporated within the smart contracts. But with third-party audits, the smart contracts will become more secure over time.
Rug pulls are exit scams where developers collect tokens from investors for a project and then desert the project, without returning the tokens or funds to the investors.
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