Yield farming is one of the most popular emerging trends in the cryptocurrency world. It has grabbed the attention of many crypto enthusiasts, and that’s for a good reason. Yield farming looks quite promising, and currently, it’s ranked among one of the most lucrative ways of making more crypto with your crypto. Essentially, that’s by generating great rewards simply by locking up your cryptocurrency holdings.

Yield farming is the leading life force- the rocket fuel that has driven DeFi to its incredible highs. I bet the reason you are here is that you are still fresh in this realm of yield farming. Luckily in this guide, we explain some of the basics of yield farming and how it works. With that said, let’s get to it!

So, what’s Yield Farming?

As we mentioned earlier, yield farming simply is a way to earn more crypto with your crypto. Some people will refer to it as liquidity mining as the crypto holders use their cryptocurrencies to earn rewards. In some way, it can even be paralleled to staking. You can even store your earnings in a physical bitcoin metal coin wallet.

A few years back, people thought you just have to leave it in cold storage once you have your crypto investment. However, yield farming has changed this narrative. And with the help of DeFi, you can now put your cryptocurrencies to work and generate more value.

All in all, that’s just the tip of the iceberg; there is a lot more that happens in the background. Yield farming works with liquidity providers who add funds to the liquidity pools. The same way banks give out loans via fiat money, and the lent-out amount is paid with interest. A similar concept applies to yield farming.

With yield farming, crypto that would otherwise be sitting in wallets or exchange platforms is lent out via different DeFi protocols or, in other cases, locked into smart contracts to get returns. Yield farming is run on ERC-20 tokens on Ethereum. That means rewards are also in the form of ERC-20 tokens. Right now, all yield farming transactions occur on the Ethereum ecosystem, although things might change in the future.

How Does it Work?

Liquidity providers and liquidity pools are vital to the functioning of yield farming. You start by adding funds to a liquidity pool which essentially are just funded smart contracts. The liquidity pools provide a marketplace for users to exchange, lend and borrow tokens. As soon as you add your funds to the pool, you become a liquidity provider.

Once you lock up your funds in the pool, you get rewards from the generated fees on the underlying DeFi platform. All in all, you need to know that investing in ETH itself doesn’t count as yield farming. However, if you lend out your ETH on a non-custodial decentralized money market protocol, you receive rewards.

Further, you can deposit reward tokens back to the liquidity pool. This is a common practice for people who want to shift their funds between different protocols to earn higher yields. Since yield farming can be a bit complex, yield farmers need to be very experienced with the Ethereum network and its technicalities. That helps them to move their funds across different DeFi platforms, like BlockFi to boost their returns.

Most people might think yield farming is an easy way to make money but- no, Siree! Besides all the technical knowledge required, rewards are based on the amount of liquidity provided. That means to reap huge rewards, you must have correspondingly huge capital.

Yield farming has witnessed surreal popularity over the last couple of years, thanks to the sweet profits it brings investors. Currently, it is providing more attractive interest rates than traditional banks. But that’s not without several risks; we’ll get to that shortly.

In 2020 alone, lots of money was made through the Ethereum network, especially with the yield farming platforms and DeFi tools. The biggest challenge is the volatility of the interest rates, making it hard to predict what your rewards could be like in a few years. Not to mention, DeFi is already a risky environment to put your money.

What are the Risks of Yield Farming?

Yield farming is not only complex but sometimes can also be risky. What’s more, it involves some high Ethereum gas fees, but it’s definitely worth trying out if you have a large investment capital. Far from that, there are more risks associated with it. That includes; smart contract risks, liquidation risk, and impermanent loss.

  1. Smart Contract Risk

Smart contracts are always the most reliable and secure way of processing various transactions and deals. They help to curb human error and prevent corruption as everything is automated. However, just like any other computer code, smart contracts can have bugs. Although developers try to ensure everything works as intended, sometimes they may overlook errors that could be a hotbed for hackers.

Potentially, these hackers even withdrawing money from the projects. This means users risk losing their income. Sometimes, cybercriminals can also take advantage of loopholes to outdo algorithms. In 2020 alone, hackers managed to steal precisely $100 million from the DeFi sector.

  1. Liquidation Risk

In yield farming, you face liquidation risk if the user’s collateral is insufficient to cover the loan. If that happens, there might be a liquidation penalty charged to the collateral if the loan value increases or the collateral value plummets. All in all, you can reduce liquidation risk by using less volatile assets and tracking market conditions constantly. You can even use a stablecoin for both the loan and the collateral.

  1. Impermanent Loss

Just like any market, sharp moves could cause users to lose their money. This is known as impermanent loss, and as a liquidity provider, you need to be aware of it. Although DeFi has been going strong for quite some time now, no solution can eradicate impermanent loss.

In Summary

As we have seen, yield farming is a tremendous financial incentive within the DeFi protocols. It is capable of incentivizing liquidity while allowing a fair distribution of tokens. This had brought great benefits to the DeFi stakeholders. Evidently, yield farming will continue to evolve over the years, giving us more breakthroughs and technological advances in the sector.