Hackernoon logoWhat is Yield Farming? by@anupam-varshney

What is Yield Farming?

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@anupam-varshneyAnupam Varshney

For blockchain, 2020 was undoubtedly the year of decentralized finance.

In August, Uniswap’s monthly trading volume was nearly $100 million higher than Coinbase Pro’s. Its implementation of automated market makers (AMMs) to improve liquidity brought unprecedented attention to decentralized exchanges, pushing the DEX model from crude proofs-of-concept to rivaling the largest crypto exchanges in the world.

Among the seemingly endless trends DeFi sparked in 2020, one received far more interest than the rest. Liquidity mining, a form of yield farming, became one of the most notorious topics in the blockchain space due to its ability to reel in profits like nothing before it.

The trend may have started with Compound’s COMP token, but it certainly didn’t end with it. Countless other platforms have since leaned into the demand for liquidity mining, offering their respective tokens to be re-invested on other services.

Investing in any cryptocurrency is risky, and while it can bring in profits faster than any other asset class, it can also lead to debilitating losses. Yield farming is arguably much riskier than investing in the more stable large market capitalization cryptocurrencies, so it’s essential to be as informed as possible before spending any capital you don’t want to lose.

Solving Liquidity

Before the widespread use of automated market markers, decentralized exchanges weren’t quite as polished as they are today. It’s one thing to design a central order book system to handle the copious number of transactions exchanges processes, but when running on a distributed network, the orderbook model quickly breaks down.

For a while, DEXs simply existed in this state. Orders were incredibly slow to execute, with no incentive for market makers to fill the gaps between bids and asks. Greater adoption may have helped, but without the performance afforded by centralized exchanges, traders were never going to bite.

It was after AMMs came into the picture that DEXs picked up the pace. Automated Market Makers use an algorithm to establish an asset’s price based on its ratio with other tokens in a liquidity pool. Some advanced AMMs can even support up to eight tokens in a single pool, but most just carry pairs.

The specific algorithm used differs between platforms, but they all work based on the same underlying concepts. For example, if a liquidity pool contains an ETH/USDT pair, anyone can purchase either token by depositing an equivalent amount of the other. A smart contract then recalculates the token ratios in the pool to determine the assets’ values.

This allows traders to purchase and sell any token without the need for a counterparty. With regular deposits and withdrawals, these pools update asset prices in real-time, creating robust, inexpensive, and highly liquid markets for any digital asset.

While borrowing and lending cryptocurrencies was already an option before AMMs, their introduction has made the experience significantly better. Not only can traders earn interest on token deposits, but they can earn rewards in collateral tokens for lending crypto assets.

Yield farming is the process of investing tokens and reinvesting rewards on DeFi platforms to maximize profits. However, this can be a double-edged sword, as a sudden depreciation of either token in the liquidity pool can lead to the impermanent loss.

With so many platforms offering unbelievably high returns, it’s no wonder DeFi is such a hot topic in blockchain today. While quite a few projects have been exposed as exit scams and Ponzi schemes, there are several fantastic services on offer within the DeFi space. Legitimacy, however, is only part of the problem.

The Tools of the Trade

The fundamental strategy behind yield farming is to regularly move your assets between separate liquidity pools, chasing the one that provides the highest return. There are dozens of reputed platforms to yield farm on, and most of them cater to specific niches.

Synthetix, for example, allows traders to lend and borrow synthetic assets against ETH or its native SNX token as collateral. Balancer allows liquidity providers to create customized pools with personalized allocation ratios and up to eight tokens in a pool.

Curve.Finance caters to the exchange of stablecoins at low fees, and Compound allows users to earn compounding rewards. Most traders measure the annual percentage rate (APR) or annual percentage yield (APY) to gauge the potential returns on investment, but there’s more nuance to yield farming than merely depositing tokens.

Before choosing a DeFi platform or liquidity pool, make sure to do your research on the tokens, the platform, and the people behind it. Decentralized exchanges generally allow anyone to list a token, and some even allow different assets to share a ticker symbol, which can confuse traders into purchasing the wrong token.

Ensure you’re aware of the risks involved with purchasing DeFi tokens, some of the most volatile assets in the blockchain space. That being said, DeFi also has lower risk options like Centric, a DeFi platform that allows for quantifiable long-term growth through its dual-token system.

Yield farming can be extremely tempting, especially with how lucrative the rates can be once the yield is optimized across multiple platforms and pools. But as with any investment with high-profit potential, it can be a risky business. It might sound simple in theory, but it takes a genuinely skilled trader to defy those odds.

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