Decentralized finance, or DeFi, seeks to decentralize traditional financial services. By utilising smart contracts, which are programmable functions updated on the blockchain, DeFi protocols are able to run an automatic, trustless and permissionless service.
DeFi protocols are experimental works in progress. Funds deposited into DeFi protocols in general can be at risk of smart contract vulnerabilities, malicious developers and hacks. DeFi Protocols are generally governed by token holders through a DAO (decentralized autonomous organization).
The number of platforms and applications within this sector of the cryptocurrency industry has increased dramatically over the last 3 years. One of the more lucrative advancements for cryptocurrency investors is having the opportunity to lend cryptocurrency holdings for a return on investment. This process within DeFi is often referred to as yield farming.
Yield farming is the process of lending cryptocurrency assets to DeFi protocols so that the assets, or "liquidity", can be utilized by others. In return for lending digital assets, users are rewarded with more cryptocurrency tokens. It is a way for cryptocurrency investors to earn passive income from digital assets that would otherwise be sitting idle.
The process is similar to staking as it involves depositing and locking cryptocurrency holdings for a certain period of time. However, while staking uses cryptocurrency tokens to power a blockchain or protocol, yield farming uses cryptocurrencies as liquidity for other investors or traders.
Those that take part in yield farming and provide liquidity to DeFi platforms are known as liquidity providers (LPs). The liquidity is often used for decentralized exchanges, trading or loans. As the sector advances, there will undoubtedly be even more use cases in the future.
At the time of writing, the total value locked (TVL) in DeFi protocols by liquidity providers is $65 billion.
Yield farming is made possible by the application of automated market makers and liquidity pools, which are used to power decentralized exchanges or lending platforms.
Liquidity providers, those seeking to earn interest from idle cryptocurrency holdings, can deposit their funds into a liquidity pool. Liquidity pools can be thought of as a "pot" of cryptocurrencies that other users can use for exchanges or loans. To use the pot of cryptocurrencies, the user has to pay a fee. These fees are then distributed proportionally to liquidity providers depending on their share of the liquidity pool. The rewards are usually in the form of cryptocurrency tokens.
Automated market makers are algorithms (a series of smart contracts) that calculate the exchange prices and interest rates on a platform based on the available liquidity held within liquidity pools.
Automated market makers (AMMs) explained.
Rules surrounding the distribution of fees and the length of time cryptocurrency assets must be locked in can vary between protocols. The use of AMMs and liquidity pools has facilitated the growth of yield farming in the sector.
Yield is the annual return that a liquidity provider can receive for lending cryptocurrency assets. This is often written as a percentage, either as annual percentage rate (APR) or annual percentage yield (APY). As the AMM calculates interest rates using supply and demand, unlike traditional financial investments, yields can vary daily.
Yield farming refers to the process where liquidity providers move liquidity between high-yield pools to take advantage of these dynamic changes in yield. Obtaining the optimum yield could involve moving to a different liquidity pool on the same platform or changing platforms altogether.
Many DeFi protocols mint liquidity provider tokens when a user deposits cryptocurrencies into a liquidity pool. For example, if a user deposits ETH into the borrowing and lending protocol Compound, they would receive cETH tokens in return. The token represents the user's stake in the liquidity pool and ensures custody of the deposit remains with the user.
Yield farming can be simple with a liquidity provider lending cryptocurrency assets to one platform. On the other hand, investors can utilize complex strategies to increase returns. This involves moving cryptocurrency assets between liquidity pools to catch the best interest rates.
With a variety of platforms offering yield farming opportunities, there is no "best way" to yield farm. Risk management should always be the focus as opposed to high-yield returns. A user needs to understand the protocol and remain in control of their funds throughout.
Thanks to increased popularity, there are now platforms that automate yield farming, which can be attractive for many passive investors. Yield farming can be time consuming and confusing for those initially entering the space, so automated options are a good solution.
How to get started using Yearn Finance.
How to get started using Zapper.
The expansion of the DeFi sector has resulted in the expansion of yield farming opportunities. Here is a list of some of the most popular platforms currently used for yield farming:
Although dramatically increasing in popularity over the last year, the DeFi sector is still a young industry which means that risks need to be evaluated carefully.
Yield farming is undoubtedly one of the most exciting aspects of the DeFi sector. It hands control to the individual user and offers the opportunity to put cryptocurrency assets to work.
The industry is still in its infancy, which comes with associated risks, but it is advancing at an incredible rate. With each advancement comes increased security, improved decentralized governance and more opportunities.
Yield farming can be simple or complex, but it provides cryptocurrency investors with a way to earn a little passive income from otherwise idle investments.
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