Crypto Yield Farming

What is Yield Farming?

"The amount lent out is paid back with interest when typical loans are made through banks," explains Daniel R. Hill, CFP, AIF, president of Hill Wealth Strategies. "The premise is the same with yield farming: bitcoin that would otherwise be sitting in an account is instead lent out to produce returns."

Yield farmers have earned returns in the form of annual percentage yields (APY) that can approach triple digits since the practice began in 2020. However, this potential profit comes with a significant level of danger, as the protocols and currencies acquired are prone to tremendous volatility and rug pulls, in which creators abandon a project and steal investors' assets.

How does Yield Farming work?

Yield farming, also known as liquidity farming, allows an investor to stake their coins by depositing them into a lending protocol using a decentralized app, or dApp. Other investors can then borrow the coins through the dApp to use for speculation, hoping to profit from big swings in the coin's market price that they foresee.

However, because this is a novel technology, the implementations can be substantially diverse. There's no doubt that new ways will emerge that will improve on current implementations.

Aside from fees, the distribution of a new token could provide a further incentive to add funds to a liquidity pool. For example, a token may only be available for purchase in tiny amounts on the open market. It can be accumulated, on the other hand, by supplying liquidity to a certain pool.

The distribution rules will be determined by the protocol's unique implementation. In the end, liquidity providers are compensated based on the quantity of liquidity they offer to the pool.

Stablecoins tied to the US dollar are regularly deposited monies, while this is not a prerequisite. DAI, USDT, USDC, BUSD, and other stablecoins are among the most commonly utilized in DeFi. Some protocols will create tokens to represent the coins you've deposited in the system. If you deposit DAI into Compound, for example, you'll obtain cDAI, or Compound DAI. You will receive cETH if you deposit ETH into Compound.

As you may expect, there are numerous layers of complexity to this. You could transfer your cDAI to a system that creates a third token to represent your cDAI and your DAI. The list goes on and on. These chains can get extremely complicated and difficult to understand.

What are the risks of Yield Farming?

Farming for yield isn't easy. The most profitable yield farming tactics are quite complex and should only be attempted by experienced farmers. Furthermore, yield farming is best suited to individuals with a large sum of money to invest.

Yield farming isn't as simple as it appears, and you'll most certainly lose money if you don't know what you're doing. We've just gone over how to liquidate your collateral. But what other dangers should you be aware of?

Smart contracts are an obvious risk of yield farming. Many protocols are established and developed by small teams with limited budgets due to the nature of DeFi. This raises the possibility of smart contract bugs.

Vulnerabilities and flaws are discovered all the time, even in larger protocols that are certified by respectable auditing organizations. This can result in the loss of user funds due to the unchangeable nature of blockchain. When locking your funds in a smart contract, you must keep this in mind.

Furthermore, one of DeFi's greatest benefits is also one of its greatest threats. It's the concept of reusability. Let's have a look at how it affects yield farming.

DeFi protocols, as previously stated, are permissionless and may effortlessly connect with one another. This means that each of the DeFi ecosystem's building parts is extremely reliant on the others. When we state that these programs are composable, we mean that they can simply function together.

What makes this a danger? If even one of the building components fails to function properly, the entire ecosystem may suffer. This is one of the most significant threats to yield farmers and liquidity pools. You must trust not only the protocol into which you put your funds, but also any others on which it is relying.