Understanding “Yield Farming” and what it means
Decentralized Finance(DeFi) is getting huge attention in the blockchain space. One of the main reasons is DeFi applications are permissionless. Anyone with an internet connection and a supported wallet can communicate with them. Besides, they don’t require the users to trust any third-party vendors. So, DeFi applications are trustless.
One of the new concepts in the DeFi application space is yield farming. It enables users to gain rewards with their cryptocurrency holdings with the help of permissionless liquidity protocols. It is a popular way to earn passive income using cryptocurrencies. Yield farming can potentially change the future of investors who HODL cryptocurrencies.
What is yield framing?
In simple terms, yield farming is a way to make more crypto using your present crypto holdings. You need to lend or lock up your cryptocurrencies to others with the help of smart contracts and in return, you earn fees in cryptocurrencies. Investors or users who do yield farming are called yield farmers — simple, right?
Yield farming is an act of trying to get the best yield from DeFi protocols. Yield farmers use complicated strategies to maximize their returns. They move their crypto constantly between different marketplaces that give high returns.
How’d it get started?
The term ‘yield farming’ originated in 2020. A sudden interest in this space has started when the Compound Finance ecosystem launched the governance token i.e., COMP token. To make the network as decentralized as possible, COMP tokens were distributed algorithmically with liquidity incentives.
The concept involved liquidity providers to ‘farm’ the new tokens by providing liquidity to the protocols. Though the COMP project didn’t create yield farming, it has fostered this type of token distribution model. After COMP, many other DeFi projects came up with innovative strategies to draw liquidity to their ecosystems.
How does yield farming work?
Yield farming and automated market maker(AMM) concepts are related in terms of involving liquidity providers(LPs) and liquidity pools. But the yield farming technology and implementation are different from AMMs.
When liquidity providers contribute their funds to liquidity pools, they earn a share of transaction fees of the trades incurred in the liquidity pool. Whereas, in yield farming, in addition to fees, distribution of a new token also takes place. One advantage of this is to get a token while it may not be possible to get it in an open market.
Yield farming depends on the unique implementation of the protocol. The similarity between yield farming and AMM is LPs get returns based on the amount of liquidity they provide to the pool. Unusually, the funds deposited into the pool are stablecoins pinned to the USD like DAI, USDT, USDC, BUSD, etc.
Yield farming platforms
Each yield farming platform works differently and has its own risks and rules. The strategies of yield farming change by the hour. Some of the popular yield farming protocols are Compound Finance, MakerDAO, Synthetix, Aave, Uniswap, Curve finance, Balancer, Yearn Finance, etc.
Some yield farming protocols mint tokens that represent what coins you deposited into the pool. For instance, if you have deposited ETH to Compound, You will get cETH or “compound ETH” in return. You can deposit this token, cETH into another liquidity pool that mints a third token representing cETH. There may well end being many layers of complex strategies that users will follow to get high returns.
Yield farming will continue to evolve in the future. As it gets stronger in the DeFi space, investors may be able to get liquidity incentives in sophisticated ways. Many yield-harvesting products are being introduced and the concept is here to stay.
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