What is Yield Farming? Beginner's Guide

A method of generating interest on your cryptocurrencies, yield farming works analogous to how you would receive interest on any money kept in a savings account.

In a manner analogous to putting money in a bank account, yield farming requires you to “stake” your cryptocurrency, which means locking it up for an extended length of time to receive interest or other rewards, such as additional cryptocurrency.

According to Daniel R. Hill, CFP, AIF, and president of Hill Wealth Strategies, “When typical loans are made through banks, the amount that is lent out is paid back, plus interest is added on top of that.” The same basic idea underpins yield farming and cryptocurrency lending: rather than keeping bitcoin in an account, yield farming involves lending it out to create profits.

Yield farmers have been able to earn returns in the form of annual percentage yields (APY) that can approach triple digits ever since yield farming was first implemented in 2020.

But this potential return comes with considerable risk. The protocols and coins acquired are susceptible to extremely volatile market conditions and rug pulls when creators abandon a project and make off with the investors’ money.

What is Yield Farming?

Each decentralized DeFi initiative has a unique governance mechanism. The utilization of governance tokens gives that approach its practicality as a solution. A participant contributing liquidity to a DEX that utilizes a governance model is rewarded with fees and governance tokens.

Another option is for the protocol to hand out LP tokens representing a user’s proportional share of the liquidity pool. LP tokens are ERC-20 tokens retained in the contributor’s wallet.

Because of this, LP tokens are compatible with various DeFi protocols and can be actively utilized on other networks. The end consequence is that one can optimize his income by farming both current crypto assets and new LP tokens. This may be done by farming both existing and new LP tokens.

Yield farmers operate hostilely in the cryptocurrency market, another important aspect that needs to be brought to your attention. They are compelled to continuously pursue the liquidity pools that offer the greatest APY rate to maintain their competitive edge and receive the finest rewards.

This frenetic activity resulted in the development of yield-farming aggregators. These protocols allow farmers to participate in the most successful LPs without moving from a single location. Yearn Finance, the well-known DEX developed by the well-known DeFi developer Andre Cronje is a good illustration of a prominent yield farming aggregator.

In a manner analogous to that of liquidity mining, yield farmers also run the danger of experiencing temporary loss. The primary distinction is that the risk is significantly increased if yield farmers also elect to farm LP tokens.

You should keep several things in mind when yield farming, including the fact that the market still needs to be more mature. Therefore, it can be challenging to identify the tokens that showcase market price stability.

One must remember that yield farming often entails a considerable amount of risk because of the volatility of the cryptocurrency markets. In addition, you should always remember that yield farmers often experience sharp devaluation in their portfolio when a rug pull occurs. Ethereum Classic (ETC) is an excellent example of this.

How does yield farming work?

You must make it available on a trading platform to earn interest on a cryptocurrency. Once a platform accepts your liquidity, it will provide you access to the asset pool assigned to you. The asset pool is typically represented by a Lending Pool (LP).

Often, yield farming protocols offer low-interest rates that are pegged to the value of Bitcoin (BTC). Other protocols, such as Hotbit and Yield Financial, work by combining yield farming with other strategies, such as margin lending.

The process of yield farming, also known as liquidity farming, begins with an investor being allowed to stake their coins by depositing them into a lending protocol thru a decentralized app, also known as a dApp.

Other investors can then borrow the coins using the decentralized application (dApp) to utilize for speculating, which is when they attempt to make a profit off of big fluctuations they anticipate in the price of the coin’s market.

“Yield farming is simply a reward system for early adopters,” says Jay Kurahashi-Sofue, the vice president of marketing at Ava Labs. This team supports the development of the Avalanche public blockchain and collaborates with several defi applications that offer yield farming. “Yield farming” refers to growing crops to harvest their produce.

Users of applications built on blockchain technology are incentivized to provide liquidity through a practice known as staking, which locks up their currency.

According to Hill, “staking occurs when centralized cryptocurrency platforms receive deposits from users and lend them out to individuals looking for credit.” “Depositors receive a specific part of the interest that creditors pay, while the bank keeps the remainder of the funds collected.”

According to Brian Dechesare, a former investment banking executive and the current CEO of the financial career platform Breaking Into Wall Street, “this lending is typically facilitated thru the smart contracts, which are largely just a piece of code running on a blockchain, operating as a liquidity pool.”

Users that engage in yield farming are sometimes referred to as liquidity providers. These users lend their funds by putting them into a smart contract.

The true benefit of the transaction is realized when investors lock up their coins using the yield-farming technique, which allows them to collect interest and frequently other digital currencies. The rewards for the investor go up in proportion to the extent to which the value of the extra coins rises.

According to Kurahashi-Sofue, this procedure offers the liquidity recently released blockchain applications require to maintain long-term growth.

According to Kurahashi-Sofue, “[These apps] can boost community participation and safe this liquidity by satisfying users with rewards like their own governance tokens, app processing fees, and other funds.” “[These apps] can reward users with rewards like their own governance tokens, app processing fees, and other funds.”

In addition, Kurahashi-Sofue suggests that one could draw parallels between the early days of ride-sharing and yield farming.

According to him, “Uber, Lyft, and other ride-sharing apps wanted to bootstrap growth, so they provided incentives for early customers who referred additional users onto the platform.” This was done because “Uber, Lyft, and other ride-sharing apps needed to reduce their dependence on advertising.”

According to Daniel J. Smith, an economics professor at the Political Economy Research Institute at Middle Tennessee State University, another incentive for staking is accumulating sufficient shares of the cryptocurrency to force a hard fork, which is when a major infrastructural change occurs to the layout of the cryptocurrency. This is something that can be accomplished by accumulating enough shares of the cryptocurrency.

According to Smith, “Hard forks enable the holders of crypto to compel modifications that would, at least in the perspective of the majority of the holders, strengthen the cryptocurrency going ahead.”

Cryptocurrency hard forks have been increasingly popular in recent years. Hard forking provides cryptocurrency investors with a power analogous to stockholders’ influence via share voting.

In the same way that shareholders can vote on significant issues that impact the management or direction of the companies in which they have invested, holders of cryptocurrencies can employ hard splits to push a cryptocurrency protocol in a particular direction.

Types of Yield Farming

Yield farming can be broken down into two major subcategories: staking farms, often known as liquidity pools or LP farms, and staking farms. The farming prospects offered by these variants center on users’ need to deposit cryptocurrency in smart contracts.

This definition describes the situation in its most basic form. On the other hand, the kind of smart contract being used is where the primary distinction lies. Gaining a more in-depth grasp of yield generation or farming methods could help me fully understand yield farming.

Liquidity Pool or LP Farms

Users must place their crypto assets in a smart contract coded specifically to provide a liquidity pool if the farm in question is a liquidity pool farm. The functionality of these pools can be compared to that of a decentralized trading pair, which involves the simultaneous trading of two or more cryptocurrencies.

Only the cryptocurrencies that are made available by the liquidity providers can be used for trading within the LP farms. Decentralized Finance, often known as DeFi apps, offers rewards in the form of LP tokens to liquidity providers in exchange for their deposits.

Along with the supplementary interest in trading fees, the yield farming token can retrieve the deposits that are the foundation of the liquidity pool at any given time.

Because the DeFi apps that operate the liquidity mining programs construct staking interfaces to deposit the liquidity provider tokens, these tokens are crucial. As a consequence, you will be able to lock in your liquidity, after which you will receive automatic and ongoing governance token awards for lock-in.

Stake Farms

Stake farms are the most reactionary method of generating yield farming tokens, as they are classified by their ability to facilitate the maintenance of staking pools. Staking farms that sometimes also provide other services like margin trading and trustless lending can be compared to the operation of a central office and branch offices.

Stake farms are similar to staking pools, but they work in a decentralized manner where users can deposit liquid holdings at any time. The liquidity comes from the profit-making endeavors contributed by stakers.

Staking pools are the most reactionary method of generating yield farming tokens, as they are classified by their ability to facilitate the maintenance of staking pools.

Staking pools that sometimes also provide other services like margin trading and trustless lending can be compared to the operation of a central office and branch offices. Staking pools are similar to staking farms, but they work in a decentralized manner where users can deposit liquid holdings at any time. The liquidity comes from the profit-making endeavors contributed by stakers.

The Future of Yield Generation

Yield farming has been here for some time, but its brightest days are still ahead. While the process is still in its infancy, there is much to look forward to.

As users can earn passive income whenever they choose, this kind of yield generation or farming should enable them to monetize their time and attention for themselves – just as many other apps have done.

It’s important that users understand the similarities between yield generation or farming and playing the stock market. In the same way that investors in stock certificates have to answer the question of why they are purchasing a given security, yield farm users have to be able to explain their reasoning for investing in the yield generation or farming app they’ve chosen.

Additionally, users must be aware of the dangers involved in yield farming. One of these dangers is the possibility that users could lose their investments when using yield generation or farming apps, so they must keep their cryptocurrencies safe.

Even if it is evident that yield farming has a credible set of benefits in addition to hazards, many individuals would understandably be curious about the prospects of yield generating. Why should you worry about the amount of yield generated if nothing is in it?

If you go back in time only one year, you’ll see that the Ethereum network was a bustling playground for making money through yield farming in the cryptocurrency market.

Ethereum has provided the foundation for developing the most decentralized exchange systems. As a direct consequence, one can see the profitable promises individuals have associated with the DeFi environment.

The generation of yield is quite important since it has the potential to offer huge levels of liquidity in the beginning stages.

On the other hand, given that it has the potential to make obtaining loans much simpler, it is ideally suited not only for borrowers but also for lenders. People with a large amount of wealth backing them up in yield farming are typically the ones who generate big profits from the practice.

On the other hand, individuals interested in getting any loan can obtain cryptocurrency with low-yield farming rates going as low as 1% annual percentage rate.

Borrowers can also place their funds in an account that provides a greater interest rate while maintaining an easy-to-use interface. In contrast to conventional financial services, there are still certain opportunities for generating large rates on assets. Currently, these opportunities exist.

It is also essential to keep in mind that the question of yield generation is still up for debate in cryptocurrency. Some subgroups within the cryptocurrency community do not consider yield farming to be an intervention of substantial importance.

It’s interesting to note that various authorities in the cryptocurrency industry have also advised that people desist from yield generation. For example, due to the greater risk levels, Ethereum developers tend to criticize flash farms as one of the more famous subjects of criticism.

Yield farms are usually constructed and operated by DeFi platforms built using smart contracts on the Ethereum chain. The output of most yield farms is a carousel of new assets delivered to the smart contract every five minutes.

These assets exist independently of any other blockchain focused on monetary transactions. As their name suggests, they are based on future contracts where users can obtain them when they want or need to.

Conclusion:

The idea of yield generation is a concept that has been introduced previously. The benefits of it are well known, but the practice could be more sketchy. Users should confirm that they only use yield generation and farming apps with a proven track record, as this will give them the best chance at earning passive income.

There are still some unanswered questions around yield generation, such as whether it’s comparable to other investment strategies people might be familiar with or how big it can become.

The regulatory framework for yield farming is likely one of the most significant drawbacks to the practice. Even though some big names in Finance and the business world do not approve of yield farming, it’s nonetheless an attractive prospect for many users.

Certain risks have been associated with yield farming in the past. These risks have included pump-and-dump schemes, fraud, and market manipulation.