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At its core, Yield farming, also known as liquidity harvesting, involves the art of lending cryptocurrency. It provides more lucrative returns than any other cryptocurrency or conventional investment. It’s a chance for the bold and risk-averse digital holders to win big. The United States Securities and Exchange Commission (SEC) is considering whether to regulate the process. In lending cryptocurrencies, the owner profits when the coin appreciates. Therefore, yield farming is an incentive that stimulates the adoption and growth of cryptocurrencies. Yield farming runs on various blockchain networks through decentralized applications (DApps).
How does Yield Farming Work?
Since last year, yield farming is a hot trend within decentralized finance (DeFi). It rewards its users for locking up their crypto coins in the DeFi market. Investors deposit crypto units into a lending protocol. Users earn interest from trading fees, and the protocol rewards them with governance tokens.Yield farming is a digital replica for bank loans. The process utilizes “idle cryptos’ ‘to provide liquidity for DeFi protocols. The process requires liquidity providers, liquidity pool, and Automated Market Maker (AMMs) model for practical functionality.Liquidity providers are investors who own cryptocurrencies and deposit them into a smart contract. A smart contract automates transactions under particular preset conditions. On the other hand, a liquidity pool is a smart contract full with crypto and fiat currencies. AMMs eliminate conventional modes of trade and execute work on predetermined algorithms.
Yield Farming Returns
You calculate yield returns using the annualized model. The coverage takes a year to take in losses and profits incurred in trade. You could be familiar with Annual Percentage Yield (APY) and Annual Percentage Rate (APR). Both aid in calculating yield farming returns. Often, however, it proves difficult due to the volatility and dynamism of the crypto market.Yield Farming is profitable for a while as both lenders and borrowers adapt to crypto bear markets. Furthermore, the outcomes increase by using optimized yearn protocols such as Yearn Finance. It’s the brainchild of developer Andre Cronje. This protocol provides its users with the highest yields on stablecoins, altcoins, and ETH deposits. When users deposit crypto coins, the protocol converts them to yTokens. These tokens come as yDAI, yUSDC, and yUSDT. Standard protocol’s smart contracts look for DeFi protocols with the best APR for farming. Once found, they allocate tokens to maximize trade. Cronje launched YFI tokens to improve Yearn’s user base.
Benefits and Risks of Yield Farming
Yield farming is by far more lucrative than putting money in a traditional bank. The assertion was favorable before start-up Initial Coin Offerings (ICOs) started offering governance tokens. The decentralized nature of cryptocurrencies accounts for profitable gains due to the risk allocated.In trading through yield farming, it is essential to establish the risks involved. The Federal Deposit Insurance Corporation doesn’t protect your investments. Other risks involved include:
- Smart Contract Risks: Smart Contracts eliminate intermediaries in trade. They offer cheaper and safe transactions. However, they are susceptible to cyberattacks, bugs, and vector attacks. Other DeFi protocols have been pump and dump scams.
- Impermanent loss risk: liquidity pools are the central element for trade. However, there is a greater risk involved with sharp market moves. The possibility is because most AMMs do not account for immediate change in the conventional market. Decentralized exchanges (DEXs) frequently do not account for price slippage.
- Liquidation risks: DeFi protocols rely on their users to provide liquidity to their markets. The danger comes in when the value of collateral drops below the loan’s price. The aspect amounts to a loss for traders.
- Complicated capital incentive process: the process revolves around capital-incentive for its users. The general concern revolves around gas fees on the Ethereum network. The fee problem affects more regular traders without significant holdings. Once one decides to trade, you should invest money you are willing to lose.
What is Collateralization in DeFi?
The rule for accessing loans in any setting is to issue collateral. The collateral acts as insurance for your loan. Collateralization ratios are different depending on the lending protocol of your choice.When your collateral value falls below the threshold, you could add more collateral. Alternatively, you liquidate it on the open market. However, due to the market volatility, most protocols work with over-collateralization to secure returns.Remember that Yield farming is a risky affair. You could lose funds if you don’t equip yourself with the right trading strategies. These range from the very simple to advanced ones. However, it’s best to leave the advanced ones for experienced traders and crypto whales. The most popular lucrative yield platforms include but aren’t limited to:
- Compound finance – runs on Ethereum as an algorithmic money market
- MarkerDao – is a credit platform that supports the creation of DAI. a stablecoin pegged to the US dollar
- Synthetix – runs as a synthetic asset protocol. It allows collateralization of anything with a reliable price feed.
- Aave – is a protocol that allows lending and borrowing. Interest rates automatically adjust to suit the market conditions.
- Uniswap – is a DEX protocol that allows trustless token swap.
You cannot deny the relevance of DeFi to the crypto industry. Its offshoots, yield farming, for instance, have not only helped expand the reach of financial services. They’re revolutionizing the financial sector. Today yield farming is the hottest trend in the Defi space. It involves lending your crypto holdings for a profit. And as crypto projects guarantee higher returns than traditional finance, many are flocking to them.They see it as an excellent way to build passive income streams. Lucrative as they may be, crypto investments are risky business. It, therefore, calls for care when you go about investing in them. As a rule of thumb, do thorough research before jumping in. Also, be sure that the amount you’re willing to invest in the amount you’re ready to lose. That said, with proper trading education venturing into this space is worth the risk.