Yield Farming explained
Simply put, yield farming means locking the cryptocurrency and getting rewards for that. It’s pretty similar to depositing money in a bank. Let’s imagine that you have some savings in fiat currency and don’t have an idea of how to invest your money. If the savings just lies under your pillow, it loses value after some time. On the other hand, you can invest them in some enterprises. Or you can deposit the funds into a bank account. In that case, your savings will take participation in economic processes, and it may lead to additional profits for you.
Now, let’s apply this situation to the cryptocurrency financial system. You can HODL crypto assets, or you can let your cryptocurrency work on the crypto financial system, having expectations to receive the interests in returns. That is the main idea of yield farming. It let your coins work on your crypto wealth. So, yield farming and bank deposit are similar. But, while the investment of fiat money in the fiat economy is secured through the legal system and realizes through intermediaries, the yield farming is secured by the Ethereum’s blockchain (smart contracts) and does not require any middleman.
Yield Farming is a great way to let your coins work on your capital growth. It doesn’t mean guaranteed rewards. Yield Farmer should always learn. Each DApp before contributing coins Yield Farming contains risks, and each Yield Farmer should research and take them into account.
How does the Yield farm work?
A Yield Farmer (or Liquidity Provider) should find the DApp which he wants to contribute (to seed the DApp). DApp or Decentralized Application is a computer application that runs on a distributed computing system. DApps are often referred to as smart contracts on Ethereum Blockchain. Decentralized applications in yield farming are usually decentralized cryptocurrency exchanges, lending platforms, and others. Note that this scheme is universal and very simple. Each DApp works differently, and the working schemes are usually more complex.
So, due to begin, a yield farmer has to provide liquidity to a DApp. This is done through “seeding” a DApp (contributing to the application). It usually stables coins (USDT, USDC, DAI, etc.), but not always. Some DApps use ether, for example. Later, the contributions go to liquidity pools and they activate AMM (Automated Market Maker). AMM is a computer program that indicates the token’s liquidity. To provide the token with liquidity, AMM has to be backed by a store of wealth. So that’s where the income appears. A liquidity provider lends his coins and makes it possible for AMM to work. In return, a DApp gives the application’s tokens to the liquidity provider for that. Depending on the DApp nature, the AMM works for different purposes. It could be DEX, DEFI, or other DApps. DEX is a decentralized exchange. The contributed coins provide liquidity to the Decentralized Exchange, and the Decentralized Exchange pays to liquidity
provider its tokens as rewards. DEFI applications are decentralized finance apps. The contributed tokens are, in fact, loans. Defi App lends the coins to borrowers and pays rewards to yield farmers for the provided loans. The transactions are executed by smart contracts, so the algorithm of contract execution is laid out ahead.
1. Which risks Yield Farming may involve?
First of all, it is a liquidation risk. It could happen when the price of contributed collateral drops beyond the price of the loan. It leads to a liquidation penalty to contributed collateral. The same may happen when the price of your loan increases over the price of the collateral. The second risk is a smart contract risk. Since DApps are work on smart contracts, and smart contracts are codes on the Ethereum blockchain, hackers could find bugs in code. There is also a price risk. Different actions of Yield Farmers may lead to a token price reduction. Even when your strategy is successful, and you gain a lot enough, if the tokens price reduces, you will be at a loss. And we should take into account strategy risk. There are different strategies to be a successful Yield Farmer, but the approaches which were efficient yesterday may be useless tomorrow.
There are different DApps, and due to be a successful Yield Farmer, you should make research on each DApp, before contributing your coins. The mentioned in this webinar scheme is universal and very simple. It is construed to give you an idea, what is the nature of yield farming. But the Yield Farming schemes are different and depend on specific DApp. In general, there are different strategies in Yield Farming, such as arbitrage trading, participation in Initial Liquidity Offerings, lending, etc. You should always research specified DApp before providing it with your coins. You should also take into account the risks which yield farming may involve.