Yield Farming in DeFi: A Complete Guide

Yield farming (YF) in decentralized finance (DeFi) has become one of the hottest trends in 2021, giving investors an even greater chance to increase revenues.

A Guide to Yield Farming in DeFi

Credible sources claim that 1.9 billion dollars are currently locked in DeFi. Cryptocurrency owners are adding more and more value to work in DeFi applications, motivated mostly by an intro of a brand new yield-generating pasture, Compound’s COMP governance coin.

In today’s article, OpenGeeksLab has rolled out a yield farming guide. We will route you through what yield farming stands for, how it works, why the concept is so popular. What’s more, you will learn how to calculate returns, what yield farming protocol to choose, and what benefits YF delivers. Let’s dig deeper into the topic!

What Is Yield Farming? Detailed Definition

What is yield farming? Find out what this term stands for, its most common interpretations, and areas of implementation.

So, what is yield farming in DeFi? What are its areas of implementation? Briefly, yield farming is a practice in the DeFi cryptocurrency world. It is the term that defines the process that stands for obtaining the highest yield and a method to earn more cryptocurrency with your cryptocurrency. In addition, it’s a chance to obtain extra yields from the protocol’s governance token.

We have more answers to this question, “What is yield farming in decentralized finance (DeFi)?” Traditional investors view crypto yield farming as bonds and dividends. What’s in common? Yield on DeFi coins fluctuates depending on how various projects roll them out. Like dividend payouts, in case the price per asset grows, the yield paid on your cryptocurrency provides users with new tokens; they cost more money. Millions of modern traders are interested in using this reward system.

Some experts compare this term to bank loans. Each time the bank borrows money from a client, they pay back the loan with interest. Banks are cryptocurrency owners. YF applies “idle cryptocurrencies” that would have been wasted away in an exchange or hot wallet to provide liquidity in decentralized finance protocols.

How did this term gain its popularity? It happened because of protocols like Compound and Aave. The value of digital assets locked in DeFi smart contracts went up rapidly from $670 million to $13 billion in 2020.

Why Is Yield Farming Hot and Trendy Today?

What makes yield farming so hot right now and why does it make sense to dig deeper into this topic?

Most experts relate the yield farming boom to the start of the so-called COMP token. Past June 15 can be called a starting point. It is an ERC-20 asset that authorizes community governance of the Compound yield farming protocol. The owners of these tokens offer and vote on any modifications in the protocol. Governance coins pass all rights of ownership to asset holders. The question is how to make the network highly decentralized?

One way is distributing such tokens algorithmically, including liquidity incentives. It is rather attractive for market makers. It motivates them to create new tokens and provide liquidity. Since COMP was launched, many different DeFi platforms have offered brand new schemes to attract liquidity to a yield farming ecosystem.

Usage of the Ethereum blockchain is the most notorious when it comes to YF. The decentralized finance space is currently worth more than $121.5 billion. Earlier, ETH blockchain has suffered from certain scalability problems. That is why some experts like the “father” of Ethereum, Vitalik Buterin, claimed he would not dip his feet into YF until it stabilizes.

Yield farming token holders can use coins in many different ways. Tokens, as a rule, stand for ownership in something like a piece of a specific liquidity pool or access to some service. For instance, if we take Brave Browser, advertisements can be purchased just by using a basic attention token (BAT). Sometimes, you can use these tokens as funds within a set of applications. Online users can spend coins with each other in rather small amounts.

Those are all reasons why yield farming is in trend nowadays. Yield farming crypto is reportedly booming, and investors could see up to 50% returns last year. That is not a limit, and it’s never late to start investing in this field. As experts from Forbes fairly admit, all you need to benefit from YF development is the right timing and correct underlying instrument.

Principles of Yield Farming Work: Step-by-Step Instruction

How does yield farming work? Find out how it is usually applied and when.

How does yield farming work? Before we move on, check out how we can answer this question. First things first, imagine a market for both DAI and USDC. These coins are worth one dollar each every time. If you are to set up a USDC/DAI pool, first, contribute equal numbers of both tokens. In a pool with just two DAI and two USDC, the price would be one USDC for a single DAI.

Next, this pool would possess one USDC and three DAI. The pool would be out of whack. A user could earn 50 cents by investing in a single USDC getting 1.5 DAI. That is a 50% arbitrage revenue, as well as the issue with restricted liquidity. In case there were 500,000 DAI and USDC of the same amount, a trade of one DAI and one USDC would have a negligible effect on the relative fee. It makes liquidity useful.

Understanding how yield farming works also requires knowing what a smart contract is as they play a specific role. Smart contracts that act as tiny computer programs serve as a bridge between your cash and the funds of other users.

Any type of lending is about making money, and crypto lending is not an exception. A lender earns fees in the shape of coins for their services. Yield farming is among the top popular methods of generating rewards with cryptocurrency holdings.

How about its working scenario? DeFi yield farming takes after auto-market makers (AAM). That is one of the numerous DEX protocols, which comprises liquidity pools and providers. Here are some main terms that you may face while working in this field:

  • Liquidity. That is the ease with which a digital asset is converted into real funds without impacting the market price.
  • Liquidity pool. That is a collection of money locked in a yield farming smart contract. They are meant to facilitate decentralized trading and lending.
  • Liquidity provider (a.k.a. market maker). That is an organization or person that quotes a buy and a selling price of a tradable asset with an aim to earn a profit on a bid-ask spread or turn.
  • Automated market maker. Those are models that allow trading assets with no permission by applying liquidity pools instead of traditional market approaches. It closely relates to automated yield farming.

Now that we’ve figured out the basics, let’s dive into how the entire picture looks like.

  • Stage 1. At this point, smart contracts are liquidity pools. Providers deposit their money over there. Stablecoins, which refer to a brand new class of crypto that aims to offer stable prices and is backed by a reserve asset, are locked by these contracts, turning available under certain restrictions and yield farming platforms.
  • Stage 2. Here, users choose whether to trade, lend, or borrow yield farming coins. The participants pay some fees. Market makers receive a return on investment with respect to the amount of money contributed.
  • Stage 3. It is at this stage when market makers obtain rewards thanks to their willingness to lock up cash in the pool. Protocols and deposited amounts determine rewards that users obtain.
  • Stage 4. Providers reinvest and shift their rewards to increase their returns further. In other words, they keep on storing coins in liquidity pools. That is how liquidity providers diversify their investment portfolios and raise capital. Earning maximum profit is possible by choosing effective strategies.

Pool’s activity is another factor that defines how much a participant can earn. Those are preferably stablecoins pegged to USD in DAI, USDT, BUSD.

Now that you know how yield farming works, you may wonder how much you can get in return. Below, you can find how to calculate your returns in DeFi YF.

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Calculating Returns in DeFi Yield Farming: Formulas to Remember

Discover how the returns in DeFi yield farming are calculated using specific indicators and formulas.

You should estimate this metric every year using a yield farming calculator. It will show the returns that you may obtain over a specified period of time. Usually, two metrics, APY and APR are enough, but some use one more indicator, which is total value locked. So, here is how to calculate returns for LP.

  • Total Value Locked (TVL) is a measure of how much cryptocurrency is locked in DeFi lending and other money marketplaces. This indicator is useful for estimating the condition of the yield farming ecosystem. “Golden rule” sounds this way: the more value is locked, the more yield farming might be happening. Use USD, ETH, or BTC to assess this metric.
  • Annual Percentage Rate (APR) is the amount of interest you pay annually. APR ignores the compounding impact.
  • Annual Percentage Yield (APY) is an actual rate of return you earn on invested amounts. In this case, compounding interest matters.

You may wonder what compounding is. In simple terms, it stands for directly re-investing revenues to make even more money. Using APY and APR interchangeably is possible.

Still, estimating ROI in this field is almost as difficult as predicting outcomes of random table games like keno or bingo. Those calculations would never be 100% accurate. That is because YF is a rather competitive and rapidly-paced marketplace. Thus, the prizes can change unbelievably fast. In case one specific strategy is effective during a long period, many participants would implement it. As a result, it may prevent high returns.

Keep in mind that farming isn’t immune to capital losses. The farming transaction includes virtual transaction protocols between a couple of anonymous parties with no central enforcement body. If any system error takes place, the financial info risks being lost. In the case of blockchain blocks all shapes of system delegation, the records would be secure.

How Do Yield Farmers Obtain an ROI?

Tips for earning a solid return on investment for yield farmers.

ROI can be divided into three separate categories when it comes to a yield farming ecosystem. They involve:

  • Token prizes. Those are like incentives to propose liquidity. The coins are distributed within a certain period of time, from weeks to years. Users can trade such crypto on DEX along with exchange services like Binance or Coinbase. The purpose of using these tokens is to govern a system.
  • Transaction fee revenue. Imagine that the commission proposed during pool development by the participant displays variation between 0.003% and 15%. That is one specific pool’s rate. Others charge around 0.02%. Market makers receive all fees. Most probably, governance coin owners will obtain a part of the proceeds further.
  • Raise of capital. An increase in funds assists with computing revenues of any challenging yield farming chance. Once the relevant yield farming strategy includes REN, BTC, CRV, and SNX assets, they turn highly volatile and do not require correlation any longer. Adopting proper approaches that align equally well with stablecoins to prevent volatility is critical.

That is how you get a return on investment when dealing with YF. Let’s move to the best protocols that you can pick for yield farming.

Which Yield Farming Protocol to Choose

A brief overview of the most popular yield farming protocols currently used by many liquidity providers.

Now, you may ask how you can make money using this principle. Keep in mind that multiple YF strategies exist, and new ones pop up regularly. Using them all at a time is impossible. Remembering all of them by heart can be challenging as well.

To make things right, you should study every platform of your preference to discover which strategies it recommends. What’s more, learn how decentralized liquidity protocols work in general – it would be enough for your first time.

One thing any expert can tell you for sure is that you’d better avoid blindly depositing cash on the first website you find. On top of that, be aware of the risk management rules. To ease your task, we’ve gathered some trusted YF protocols that many users recommend. You can discover them below.

  • Compound Finance. Here, you can borrow or land tokens. First, registering an Ethereum wallet is a must. Only with it by your side, you can start earning prizes that start compounding. Compound Finance auto-regulates rates with respect to supply and demand. This protocol is among the top-preferred ones.
  • MakerDAO. It’s the decentralized credit service that supports and maintains DAI stablecoin establishment. Those who choose this platform can come up with a Maker Vault. They can generate stablecoin as a debit against the locked collateral assets, such as ETH, BAT, WBTC, and USDC. This platform helps to select effective yield farming strategies.
  • Synthetix. It’s an interesting distributed asset issuance protocol on a blockchain, which is built on the Ethereum network. Some specific features make this protocol stand out from others. Any user can create and convert Synths. Peer-to-contract (P2C) trading, which means that all operations are executed fast and simply with no need for an order book. One can trade any Synth for any other Synth and this platform guarantees almost infinite liquidity. A pool of coin owners is liable for providing collateral on the service, as well as supporting stability.
  • Aave. It’s an excellent option for borrowing/lending. Interest rates are auto-regulated with respect to what’s going on in the market. This platform has established native tokens to serve as rewards for participants. aTokens initiate quick earnings and compound interest upon investing funds. Those who deposit more money gain higher volumes of aTokens. In addition, Aave offers flash loans. This and many other attractive functionalities made this platform highly demanded.
  • Uniswap. This platform allows for precarious coin swaps. Liquidity pool participants should invest an equivalent value of a couple of coins to develop a market. This is how they obtain fees from pool transactions. Uniswap’s frictionless nature is one feature that attracts many traders. Think about this platform when testing different YF strategies.
  • Yearn Finance. yEarn offered by Andre Cronje suggests the highest yields on ETH deposits, best altcoins, and stablecoins. This protocol converts invested tokens into yTokens. Yearn Finance’s smart contract searches for the yield farming DeFi protocols with the highest APR for farming to send coins over there. Last July, YFI token appeared within this protocol. This coin runs on Ethereum. Its value has grown significantly by 122,417% in July 2020.
  • Curve Finance. This platform makes it possible to conduct stablecoin swaps of high value with rather low slippage. This decentralized exchange protocol’s pools are an integral part of the infrastructure. That is because of the abundance of stablecoins in the YF scene.
  • Balancer. What makes this protocol so special? It allows developing custom Balancer pools instead of 50/50 allocation claimed by some competitors. Providers can allocate custom coins in a liquidity pool. Liquidity providers then make a profit on the trades that take place in liquidity pools. Balancer can boast flexibility, and it’s a cool way to examine YF strategies.
  • Yearn.finance. This platform does its best to optimize coin lending by discovering profitable lending services. Once liquidity providers deposit funds, revenues are rebalanced and increased. This platform auto-selects effective YF strategies.

These are the top YF protocols that you can trust. Another piece of useful information is provided further, and it will reveal the benefits of DeFi YF development.

Basic Advantages of DeFi Yield Farming Development

What are the perks of DeFi yield farming development? Why is this field worth observing? Keep reading!

DeFi YF unlocks earning opportunities for LP and platform owners equally. As a result, we can witness an increased demand for DeFi yield farming development. It makes no wonder: this process has plenty of perks. Let’s focus on the four main ones.

  • Easy user interface. Plenty of yield farming tools are available that allow keeping track of your investments. They have a low learning curve. Their simple user interface allows checking projects’ availability and selecting crypto value to deposit.
  • Easy start. Once again, that is because of user-friendly applications. You do not have to be tech-savvy to start – special instruments will do the whole job for you. A quick start is also granted by the high interoperability of DeFi services. Having a crypto wallet and Ethereum are two primary requirements; usually, they are enough.
  • Profit potential. Just like with cryptocurrencies, those who invested their funds in protocols early can make big money. In other words, solid ROI is what attracts so many investors.
  • Interoperability. The industry of decentralized finance is versatile and interoperable, as you can see. Some systems auto-move crypto from service to service as it allows boosting investing outcomes.

This list of benefits is not complete. In general, YF obtained lots of attention as it’s one of the most lucrative types of crypto investment with high liquidity. Simplified regulations and increasing adoption among participants allow this yield farming to develop further.

Risks Associated with Yield Farming

As in any other area, yield farming has both perks and pitfalls. You can check out some of them below.

  • Liquidity risk. This threat takes place whenever the price of one’s collateral price has fallen lower than the fee of your loan which leads to penalty on your collateral. Liquidation occurs when a value of collateral decreases or your loan’s value grows.
  • Price risk. Imagine that a user has obtained a lot on the service via their YF strategies (for example, 210%). This person will lose as the coin’s fee has fallen down in the market. In case the collateral price drops, a specific platform will remove the borrower before they ever obtain a chance to cover their debt.
  • Strategy risk. Let’s say, loan pools may be saturated due to decreased liquidity. Arbitrage trading stands for reviewing numerous exchange services to benefit from price inefficiencies. Arbitrage trading is no longer bringing revenue in case volatility drops.
  • Scam risk. Developers possess control over your currency, so a threat is that they may end up running away with liquidity. If you do not know the developers, risks are way higher. Participants should always check that the chosen pool has been examined by a team that you believe in, but it does not fully eliminate all threats.
  • Risk associated with gas fees. Gas fees achieved roughly 100 times during the peak of the decentralized finance season. If they keep on increasing, YF might not be realistic for average traders. ETH has released Ethereum version 2.0 with layer II scaling that must solve issues with high gas fees. BNB, NEO, and TRON offer reduced gas fees as well.

So, there are two sides to the coin, but, we believe, that you should not miss an opportunity and try YF, focusing on the benefits it can provide. Yet, keep in mind all potential risks to avoid problems.

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Benefit from Yield Farming Disruptive Potential Today!

As you can see, you have enough good reasons to choose yield farming as a possible investment field. YF will probably become an efficient market with many opportunities to discover high return rates compared to traditional methods. That is to say, while cryptocurrency becomes mainstream, demand for cryptocurrency-based financial services will go up.

But it’s quite a complex strategy as well. Hence, if you are about to take an active part in the digital asset economy, you should study this phenomenon in-depth. You can do it alone or contact a reputable DeFi yield farming development company that is OpenGeeksLab.

We do believe in the successful future of YF and are here to contribute to its development, sharing our knowledge of this field. OpenGeeksLab offers a unique solution which goal is to digitize cash and develop interoperability to any system that you may choose. We are at your service in case of any questions. Let us give you a helping hand with your project. All you need to do is fill out this contact form.

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