Since the summer of 2020, the concept of yield farming on the Defi decentralized financial system has become the most searched keyword. In 2022, although the market was affected by the Covid-19 epidemic, the total capitalization of assets on liquidity pools continued to increase.
So what exactly is yield farming?
How to earn 20% APY on coins per year from Yield farming. Let’s find out the information we have analyzed below.
What is APY in Yield Farming?
Yield farming means the process of staking or lending crypto assets in order to generate profits or rewards in the form of additional cryptocurrency. Since its inception, the DeFi decentralized financial system applications have been notorious for their riskiness and value volatility. But recently, DeFi has had a significant innovation with the appearance of a liquidity mining method.
Yield farming is now the most advanced method of DeFi, helping DeFi increase its market capitalization from $500 million to $10 billion by 2020. Yield annual farmers and decentralized finance protocols, DeFi application platforms all calculate estimated returns in percentage yield (APY). The APY is understood as the rate of return earned over a year for investment. Compounding interest is calculated regularly and applied to the amount, which is also included in APY.
Many yield farmers have obtained thousands of percent of APYs in 2020. However, these protocols also carry many risks. The profits investors earn in the form of tokens are also capable of changing prices very quickly.
How to Yield Farming Works?
The yield farming protocols require investors (liquidity providers – LPs) to stake or lock their cryptocurrencies in a liquidity pool. The rewards for investors can come from transaction fee commissions, interest from lenders, or tokens of the governance system. The returns investors receive will be statistically expressed as an annual percentage (APY).
The most popular DeFi protocols currently operate on the Ethereum network and provide tokens for liquidity mining operations. Liquidity mining occurs when a participant cultivating profits earns token rewards as additional compensation. The tickets are farmed in these liquidity pools to provide liquidity to decentralized exchanges (DEXs).
The Drawbacks of Yield Farming
Yield farming is a complex and potentially risky method of financing for both borrowers and lenders. This method consumes a high level of Ethereum gas fees and only generates significant returns if you invest thousands of dollars or more. If you are a retail investor, this method will not work because of the large surcharge.
Investors are also at risk if market volatility causes a slide in the price of the cryptocurrency you farm.
Yield farming is vulnerable to attack and fraud because of the possibility of a vulnerability in some smart contracts. Although rare, system failures can occur when protocols conflict. Errors can even happen in bulk because protocol duplication is quite common nowadays.
There has been an increase in risky protocols that issue so-called meme tokens with names based on animals and fruits, bringing APY returns to thousands of percent. We advise you to exercise care with these protocols, as their code is untested mainly, and profits often carry the risk of sudden liquidation due to price fluctuations. Many of these liquidity pools are elaborate scams that result in investors losing their tangible assets.
Because blockchain is immutable by its nature, most DeFi vulnerabilities are permanent and cannot be undone. Therefore, users should familiarize themselves with the risks of productive farming and conduct thorough research.
How to Get Started?
An investor would approach a DeFi platform like Compound, collect crypto assets and lend it to the borrower, returning interest on the loan to the investor. The interest rate can be fixed or variable at the rate specified by the cryptocurrency platform you join.
To borrow some money from the platform, the borrower will need to deposit twice the borrowed amount as a form of collateral before proceeding with the transaction. Investors can check the value of the collateral at any time, thanks to smart contracts. If the collateral value is less than the borrowed amount, the agreement can trigger liquidating the borrower’s account, and interest is paid to the lender. It means that the lender will never suffer a loss, even if the borrower defaults.
A yield farming strategy will focus on creating the highest returns on the capital. Investment steps will involve lending, borrowing, providing capital to liquidity pools, or staking LPs.
A simple way to get APY on your capital is through lending and borrowing. For example, a farmer can offer a stable coin like DAI on the lending platform and start getting some return on their capital. With liquidity and leverage, investors can get many times higher returns.
The DeFi system will reward high-yielding farmers with fees charged when swapping different tokens by offering crypto to one of the liquidity pools. With liquidity mining, they can grow that profit double again to earn more tokens. For example, with Balancer, they can get more BAL tokens, which increases APY.
Some DeFi protocols will further incentivize farmers to stake their liquidity providers or LP tokens representing their participation in the liquidity pool. It’s a bit more complicated here, and you should read a more in-depth guide to this bet to understand how it works.
Each strategy can combine multiple forms of mining to bring higher returns to yield farmers. Like most financial markets, a plan can quickly become obsolete due to changes in protocols or incentives, so you must update every day and revise your strategy.
For the average investor, a 20% annual gain is hard to come by consistently. However, thanks to the power of DeFi, this is now possible, at least in the short term. As more users use DeFi, profits are likely to drop with the widespread use of DeFi among more people.
Profit farming uses investors’ money to create liquidity in the market in exchange for profits. It has significant growth potential but is not without its flaws.