What is Yield Farming?
Yield farming is an investment mechanism in the decentralized finance (DeFi) ecosystem that users use to maximize profits from various decentralized applications (dApps).
This course explains all the basics you need to know about farming yield.
How does yield farming work?
Through yield farming, farmers use several strategies to capitalize on APY (annual percentage yield). The most profitable ones usually contain several DeFi protocols combined. When one strategy is no longer profitable or another more profitable one appears, farmers will move capital. This phenomenon is sometimes called “Crop Rotation.”
The process works on the basis of certain users Liquidity Providers (LP) who provide their cryptocurrencies for the operation of the DeFi platform. These LPs provide coins or tokens to a liquidity pool – a decentralized application (dApp) based on smart contracts that contains all the funds.
Once LPs lock the tokens in a liquidity pool, they are given a fee or interest generated by the DeFi platform where the liquidity pool resides. Simply put, it is an income opportunity by lending tokens through a decentralized application (dApp), lending that takes place through smart contracts.
The liquidity pool powers a market where anyone can supply or lend tokens. Using these markets involves fees from users, and the fees are used to pay liquidity providers who put their own tokens into the fund.
How is farming yield calculated?
Yield is calculated as an annual percentage where the compound interest is taken into account in the APY, the profits can be reinvested in the short term, increasing the return on the investment. Rewards can fluctuate very quickly.
What are risks in yield farming?
Like any investment with high earning potential, there are certain risks to be aware of.
Cyber theft and fraud are major concerns beyond the regulatory risks that most digital assets are subject to due to the lack of concrete cryptocurrency policies worldwide.
Skilled hackers can find vulnerabilities and exploits in software code to steal funds.
There is also token volatility. Historically, cryptocurrency prices are known to be volatile so the price of a token can go up or down when locked in the liquidity pool. This could create unrealized gains or losses.
Smart contracts in DeFi platforms are also not as infallible as they seem. Small teams with limited budgets are building many of these emerging DeFi protocols. This may increase the risk of smart contract errors in the platform.