What is Yield Farming? Risks and Benefits Involved

When Satoshi Nakamoto invented Bitcoin (BTC), the world’s flagship cryptocurrency, his primary objective was to establish a decentralized monetary system that gives the masses the power to be their own banks. Now, ten years down the line, the “cryptoverse” has expanded into an ecosystem that’s more than just Bitcoin. In this article, we’ll try to demystify yield farming or crypto lending, the hottest meme bringing unlimited excitement to “hodlers” in the world of decentralized finance (DeFi)

For the uninitiated, yield farming is simply the act of putting crypto assets to work and earn from decent, to outrageous returns on your holdings. In other words, yield farming makes it possible for smart crypto holders to lend their crypto assets to DeFi platforms such as Compound (COMP), Aave. or centralized platforms like Nexo and generate massive returns on their crypto assets, in the form of interest and sometimes fees.

For those who are unaware, decentralized finance or DeFi is simply an ecosystem made up of decentralized applications (dApps) that are designed to foster financial inclusion. It enables anyone with an internet connection and a smartphone or PC to access a vast array of financial services including margin trading, crypto asset exchanges, algorithmic trading, and a host of others.

It’s worth noting that yield farming is one of the most serious and first mainstream use cases of DeFi. The reason lies in its ability to enrich yield farmers with massive interest rates that are oftentimes 100 times higher than what’s obtainable on traditional bank savings accounts.

How Yield Farming Works

The most basic approach to yield farming is to lend your crypto assets such as Tether (USDT) or DAI stablecoins to a DeFi money market like Compound or Aave, which will, in turn, lend out the digital assets to borrowers who oftentimes use them for various purposes including speculation and interests are then paid to lenders on the platform.

Notably, interest rates are not fixed. They are a function of liquidity determined by demand and supply. However, in addition to earning interests, yield farmers on Compound are rewarded with Comp, the dApp’s native token for their participation (lending or borrowing) on the platform.

Providing capital to these DeFi money markets in the form of lending is the easiest way to earn interest on your digital assets. Interest rates on each digital asset vary from platform to platform.

For instance, the 30-day average lending rate for DAI on Compound sits at 1.59 percent at the time of writing this article, while the same on Aave sits at a massive 5.35 percent, as seen on DeFi Rate.

Compound, Aave, and a host of other DeFi money markets use asset over-collateralization to maintain balance on their platforms. Over-collateralization simply means that before a borrower can borrow funds from the platform, they must have deposited at least 2x the amount they intend to borrow.

When the collateralization ratio (value of deposited collateral/value of loan obtained) drops below a certain level, the collateral is automatically liquidated by smart contracts and repaid to lenders. This excellent feature ensures that lenders do not lose their funds even when borrowers fail to repay their loans.

Liquidity Pools

Another way smart hodlers can carry out yield farming is by depositing crypto assets on liquidity pools. Uniswap and Balancer are among the top-three largest liquidity pools in the DeFi ecosystem. On liquidity pools, liquidity providers (LPs) receive fees as rewards for depositing their digital assets on the platform.

On Uniswap, liquidity pools are configured between two crypto assets in a 50-50 ratio, while Balancer supports up to eight different digital assets in its liquidity pool with custom allocations across the entire assets. Every time a trader trades a digital asset on exchange platforms such as Uniswap, the LP’s earn a fee.

Anyone can become a liquidity provider on Uniswap and start earning fees with just a few easy steps.

Risks Involved in the Yield Farming

Generally, investment vehicles that offer juicy returns on investment (ROI), often come with a significant level of risk, and DeFi yield farming is not an exception. The world of decentralized finance and distributed ledger technology, in general, is rapidly gaining traction across the globe, however, the fact still remains that the industry is nascent and still trying to find its footing.

DeFi protocols are powered by smart contracts and as such there are bound to be bugs, and loopholes exploited by bad actors once in a while. There is also the risk of liquidation, as crypto assets could lose their value at any moment, regulatory issues – some crypto assets are still labeled as unregistered securities by regulators.

In conclusion, while yield farming is one of the hottest trends in crypto at the moment, newbie yield farmers must tread with caution and avoid investing more than they can afford to lose. For those who are just interested in earning decent yields on their stablecoins, money markets like Compound and the rest are the way to go. Liquidity pools are ideal for crypto big whales who are ready to take risks and earn good fees plus incentives on their crypto assets.