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Every crypto user, including the beginner, has met with the word DeFi, an acronym for Decentralized Finance. DeFi consists of an ecosystem of Financial applications developed on top of blockchains. In addition, DeFi introduces the investors’ aspect, making returns on the value of their assets through yield farming markets.
Yield farming, also known as liquidity mining, is where crypto holders lend cryptocurrencies and get fees and interest as returns. For example, yield farming imposes a similar principle when an individual deposits some amount into the bank’s savings accounts and receives interest.
Investing in a crypto asset does not qualify as yield farming until lenders lend out and receive interest.
How To Mine Liquidity/ Farm Yields
Use Compound and Aave Money Markets
Compound and Aave are the primary DeFi yield farming protocols. Therefore, to mine liquidity, you first need to deposit a stablecoin to either Aave or Compound money markets.
The Compound money market has a token called COMP. COMP acts as a reward to anyone borrowing or lending in the compounds market. However, Aave has better returns than Compound because it offers borrowers stable rates rather than variable rates. The fixed rates have higher returns when compared to the variable rates.
DeFi money markets come with the advantages of security against financial risks. The high security comes from the over-collateralization protocols employed in the money markets. Therefore, a borrower will need to deposit many assets with more value than the borrowed loan.
If the collateralization ratio falls below a particular threshold set at any point, the collateral is sold, and the lender receives his amount plus interest. Over-collateralization helps to ensure that borrowers will pay the full amount.
Uniswap can hold two assets at a time, and the proportion of each asset has to be 50%. Balancer allows up to eight assets in a liquidity pool, all with different ratios.
How do liquidity providers earn in liquidity pools? Every time an individual trades through the pools, the liquidity providers contributing to the pool receive a small fee. In Uniswap, liquidity providers should consider the impermanent loss to increase their profits. That is the loss that comes with providing liquidity for a highly volatile asset.
In Balancer, liquidity providers can mitigate their impermanent loss by setting up an 80-20/90-10 allocation. Also, the providers can earn BAL by providing liquidity on a Balancer pool.
Curve finance also helps liquidity providers to eliminate their impermanent losses. That is done by enabling the trading between assets pegged to the same value. For example, a pool deals with USD-pegged stablecoins, and another deals with stablecoins related to BTC. Since the assets are worth the same amount, there is no chance of impermanent loss. Uniswap and Balancer focus on getting higher fee collection, while curve finance eliminates impermanent losses.
Risks Associated With Yield Farming
Highly profitable investments often come with serious risks. The situation is similar in DeFi yield mining. The crypto world is already widely used; however, it still has a long way to go regarding technology and growth.
DeFi protocols are run by smart contracts and therefore experience the same vulnerabilities seen in the smart contracts. These vulnerabilities include reentrancy attacks, DOS, and gas limits, in which untrustworthy traders can take unfair advantage.
Liquidation is another risk that vastly affects the crypto market since the crypto assets can lose their value anytime.
The issue of regulation of the crypto asset is also a risk to enthusiasts. Some of the coins in the market are still unregistered as securities in the exchanges. Therefore, a trader should be aware of the risks in the market and choose to trade cautiously.
Big players in the crypto market can easily manipulate the market, leading to reduced income for small players. For example, a trader can lend crypto through DeFi and then borrow the crypto back, thus creating a high but artificial demand for the coins. Doing this will, as a result, cause unrealistic price movements in the market.
DeFi liquidity mining (yield farming) is the right way for crypto enthusiasts to get returns on their assets’ value. However, since it’s still in the early stages, it has a long way to go regarding growth and adoption. Furthermore, although the yield obsession is fun, it may, in the long run, cause damage if not correctly handled.
Liquidity pools are a thing for the big crypto whales, who are always ready to take risks to enjoy even higher returns. Moreover, DeFi yield farming earns higher interest than fiat bank savings accounts. Therefore, yield farming will continue to drive faster crypto adoption.