Yield farming is a method that allows crypto traders to lock their assets in exchange for rewards.
At a basic level, yield farming allows crypto traders to profit from their investments. Yield farming is a method of earning interest on transaction fees by depositing cryptocurrencies into a lending mechanism. The protocol’s governance token also rewards some users with additional payments.
Yield farming is similar to getting a loan from a bank. When a bank lends you money, you have to pay it back with interest. Yield farming works in a similar way, but this time the banks are crypto investors like you. Yield farming provides liquidity in exchange for yield in decentralised finance (DeFi) protocols like Uniswap, using ‘idle crypto’ that would otherwise be wasted on an exchange or in a hot wallet.
What are the key components of DeFi yield farming?
Liquidity providers, liquidity pools and automated market makers (AMMs) are the key components of yield farming.
Yield farming is used to power a DeFi market with the help of a liquidity provider (LP) and a liquidity pool. An investor who deposits funds into a smart contract is known as a liquidity provider. The liquidity pool is a smart contract full of cash. The AMM model is used to perform yield farming.
The AMM technique is common on decentralised exchanges (DEXs). The traditional order book, which stores all ‘buy’ and ‘sell’ orders on a cryptocurrency exchange, is replaced by an AMM that creates liquidity pools using smart contracts instead of announcing the price at which a product will be traded. These pools execute trades using pre-programmed algorithms.
Liquidity is essential for AMMs to operate successfully. Pools that are not properly supported may experience slippage. AMMs incentivise users to deposit digital assets into liquidity pools so that other users can trade against them, which reduces slippage.
The protocol pays LPs a portion of the fees spent on transactions completed in the pool as an incentive. In other words, if your deposit is 1% of the liquidity locked in a pool, you will be given an LP token worth 1% of the pool’s collected transaction fees. When a liquidity provider wants to leave a pool, it can use the LP token for part of its transaction costs.
Furthermore, AMMs issue governance tokens to both LPs and investors. As the name suggests, a governance token gives the bearer the right to vote on matters related to the management and growth of the AMM system.
What is total value locked (TVL) and why is it important?
Total value locked (TVL) is a crucial metric for assessing the liquidity, acceptance, and utilisation of a DeFi. TVL also indicates the capacity and reliability of a DeFi protocol.
When calculating TVL, DeFi protocols require capital to be deposited into trading pools as liquidity or credit collateral to hold the borrower accountable. TVL is crucial to the DeFi community as it informs traders and investors on how capital affects the protocol’s gains and losses. In addition, TVL becomes a more accurate indicator than market capitalisation, showing the health of DeFi protocols and networks.
A DeFi protocol with a high TVL means that it locks more capital. It also signals a more significant ROI for the project as more active and regular consumers become aware of the project. Furthermore, greater efficiency in lending markets and an adequate supply of liquidity for borrowers are associated with higher TVL. On the other hand, a smaller TVL suggests that the DeFi protocol has less liquidity and offers lower returns.
In addition, by combining the TVL value with the market capitalisation, it is possible to determine whether a protocol’s native coin is undervalued or overvalued. For example, if a project’s market capitalisation is high or low compared to its TVL, the token can be said to be overvalued or undervalued.
How does yield farmin work?
Yield farming involves lending cryptocurrency to earn interest and sometimes fees.
An investor goes to a DeFi platform, such as Compound, to collect crypto assets and lend them to borrowers to collect interest on the loan. Interest rates can be fixed or variable depending on the unique platform. Users are rewarded with Compound’s native token COMP and interest payments.
To borrow money through the platform, a borrower must deposit twice the amount borrowed as collateral before proceeding with the transaction. The value of the collateral can be reviewed at any time using smart contracts.
If the collateral is less than the amount borrowed, the contract can be triggered, causing the borrower’s account to be liquidated and interest to be paid to the lender. This means that the lender will never lose money even if the borrower does not repay the loan.
How are yield farming yields calculated?
The annual percentage yield and annual percentage rate are used to calculate yield farming returns.
Various DeFi platforms have their own yield farming calculators to estimate yields. Usually, an annualised model is used to calculate estimated yield returns. This metric shows the potential gain from storing your cryptos for one year.
APY and annual percentage rate (APR) are the two most commonly used metrics for estimating yield returns. The main distinction is that the APR does not take into account interest compounding over the course of a year. The APY, unlike the APR, takes into account the frequency with which interest is applied, i.e. the effects of intra-year compound interest.
Nevertheless, most calculation models can only provide estimates. Since yield farming is a dynamic business, it is difficult to assess returns accurately. A yield farming approach can generate large returns quickly, but farmers may adopt it in large numbers. It results in reduced profitability. The market is very volatile and risky for both borrowers and lenders.
Yield farming vs staking: Key differences
The main difference between yield farming and staking is that the former requires consumers to deposit their cryptocurrency cash on DeFi platforms. While the latter requires investors to deposit their money on the blockchain to help verify transactions and blocks.
Yield farming requires a well-thought-out investment strategy. It is not as simple as staking, but can result in significantly higher payouts, up to 0. Staking has a predetermined reward, which is expressed as an annual percentage return. It is usually around 5%, but can be more significant depending on the staking token and technique.
The liquidity pool determines the yield farming rates or rewards, which may change as the price of the token changes. Validators who help the blockchain build consensus and generate new blocks are rewarded with staking incentives.
Yield farming relies on DeFi protocols and smart contracts, which hackers can exploit if the programming is done incorrectly. However, staking tokens has a strict policy that is directly tied to the consensus of the blockchain. Bad actors who try to cheat the system risk losing their money.
Due to the unpredictable pricing of digital assets, yield farmers are exposed to some risks. When your funds are trapped in a liquidity pool, you will suffer a non-permanent loss if the token rate is not equal. In other words, if the price of your token changes while you are in the liquidity pool, you will suffer a non-permanent loss. When you stake crypto, there is no non-permanent loss.
Users do not need to lock their funds for a certain period of time when using yield farming. However, with staking, users need to stake their funds on various blockchain networks for a certain period of time. In some cases, a minimum amount is also required.