The process of yield farming involves using decentralized finance (Defi) to maximize returns. In exchange for lending or borrowing crypto on a Defi platform, users earn cryptocurrency.
More complex tactics can be employed by yield farmers who wish to increase their yield output. As an example, yield farmers can constantly switch between various loan platforms in order to maximize their profits.
- In yield farming, token holders maximize rewards across various Defi platforms.
- A yield farmer provides liquidity to various token pairs and earns cryptocurrency rewards in return.
- Some of the best yield farming protocols include Aave, Curve Finance, Uniswap, and many others.
- As a result of price volatility, rug pulls, and smart contract hacks, yield farming can be a risky practice.
How does yield farming work?
Yield farming allows investors to profit by investing in a decentralized application, also known as a dApp. Examples include cryptocurrency wallets, decentralized exchanges, decentralized social media, and other dApps.
Yield farmers frequently use decentralized exchanges (DEXs) to lend, borrow, or stake coins in order to earn interest and speculate on price swings. Defi’s yield farming is made easier by smart contracts, which automate financial agreements between two or more parties.
Types of yield farming:
- Liquidity provider: Users deposit two coins to a DEX to facilitate trading. Exchanges charge liquidity providers a small fee for swapping two tokens. There are times when this fee can be paid in new liquidity pool tokens (LPs).
- Lending: Crypto holders can lend crypto to borrowers through a smart contract and earn interest.
- Borrowing: A farmer can use one token as collateral and receive a loan from another. The borrowed coins can then be used to increase farm output. The farmer retains their initial holding, which may increase in value over time, while also earning a yield on their borrowed coins.
- Staking: There are two kinds of staking in the world of Defi. The most common is on proof-of-stake blockchains, where a user is paid to pledge their tokens to the network in exchange for security. The second option is to stake LP tokens obtained through liquidity provision to a DEX. Users can earn yield twice because they are compensated in LP tokens for providing liquidity, which they can then stake to earn additional yield.
Calculating yield farming returns
Annualized yield returns are commonly used. The anticipated returns are calculated over the course of a year. Annual percentage rate (APR) and annual percentage yield (APR) are two commonly used measurements (APY). APR does not account for compounding (reinvesting gains to increase returns), whereas APY does. Keep in mind that these are only projections and estimates. Even short-term gains are difficult to forecast. Why? Yield farming is a fiercely competitive, fast-paced industry with constantly shifting incentives.