What is yield farming and how does it work?

Spread the love

Yield farming is staking or locking up cryptos in return for rewards. While the expectation of earning yield on investments is not new, the overall concept of yield farming has come from the DeFi sector. The general idea is that people can earn tokens in exchange for their participation in DeFi apps. Yield farming is also called liquidity mining.
The popularity of yield farming has become a self-fulfilling prophesy in comparison to the initial coin offerings boom of 2017 due to the laws of supply and demand. As each new project that emerges offers new tokens or ways to earn rewards, people have been flocking to it, hoping to get a cut of the yield on offer. In turn, it creates a demand that pushes up the value invested in the project and the tokens.
How does it work?
The mechanics of yield farming depend on the terms and features of the individual DeFi app. The practice started out by offering users a small portion of transaction fees for contributing liquidity to a particular application, like Uniswap or Balancer. However, the most common yield farming method is using a DeFi application and earn the project token in return.
This practice became popular in  2020 when Compound announced it would start issuing its COMP governance token to lenders and borrowers who use the Compound app. That pushed Compound to the top of the DeFi rankings.
Since then, several projects have followed it by creating DeFi applications with associated governance or native tokens and rewarding their users with tokens. The most successful yield farmers maximize their returns by deploying more complicated investment strategies. These strategies involve staking tokens in a chain of protocols to generate maximum yield.
Farmers typically stake stablecoins, like  Dai, Tether (USDT) or USD Coin (USDC), as they offer an easy way to track profits and losses. However, it’s also possible to farm yield using cryptocurrencies such as Ether (ETH).
What are the benefits and risks of it?
Yield farming is immediately apparent — profit. Yield farmers who are early to adopt a new project can benefit from token rewards that may quickly appreciate in value. If they sell tokens at the proper time, they can make great benefit. Those gains can be reinvested in other DeFi projects to farm yet more yield.
Farmers have to put down a big value of initial capital to generate significant profits — even hundreds of thousands of U.S.D can be at stake. Because of the highly volatile nature of cryptos and particularly DeFi tokens, yield farmers are exposed to a significant liquidation risk if the market suddenly falls, like it did with HotdogSwap. Moreover, the most successful yield farming strategies are complicated. Hence, the risk is higher for those who don’t know exactly how all the underlying protocols work.
Farmers take risks on the project teams and underlying smart contract code too. The potential for gains in the DeFi space is attracting for developers and entrepreneurs who bootstrap projects from scratch or even copy the code of their predecessors. Even if the project team is trustable, its code is often unaudited and may be subject to bugs that make it easy to be attacked.
What are the key challenges and opportunities for it?
Most DeFi apps are based on the Ethereum blockchain, which makes some critical challenges for yield farmers. Ahead of the Ethereum 2.0 upgrade, the network is struggling with a lack of scalability. As yield farming is getting more popular, more transactions clog up the Ethereum network, resulting in slow confirmation times and spiraling transaction fees.
This situation has led to some speculation that DeFi could end up self-cannibalizing. However, it seems more likely that Ethereum’s woes will finally work to the benefit of other platforms.
Additionally, Ethereum’s existing DeFi operators are also attempting to alleviate the issue with their own second-layer solutions for the current platform. So assuming that the problems with Ethereum aren’t fatal to DeFi, the practice of yield farming could end up being around for some time to come.

Leave a Reply

Your email address will not be published.