What comes to mind when you hear the phrase yield farming? Our best guess would be a picture of farmland where farmers are either cultivating or harvesting farm produce. On the contrary, you may understand it as one of the major extensions of Decentralized Finance (DeFi), but do not necessarily know how it really works.
If either of the aforementioned scenario crossed fits your narrative, then you are definitely not on the wrong page.
In order to understand the concept of yield farming, you must first have an understanding of DeFi and what it is all about. We may be wrong to presume you must have probably heard about DeFi at one point or the other, considering the growing interest in the overall crypto space. Either way, you will find out about the fast-growing industry as we progress.
Along the line, we will also explain how to seamlessly get started as well as leverage yield farming as an investment strategy in the DeFi ecosystem. That said, what is Decentralized Finance (DeFi)?
Understanding Decentralized Finance (DeFi)
Prior to the crypto craze, the world was evolving only around traditional finance which can be otherwise described as centralized finance (CeFi). If you are a fast learner, you would have figured out that DeFi is the direct opposite of CeFi, and perhaps would represent the contrast of anything CeFi stands for.
Technically, CeFi embodies every financial activities and processes as you may be aware of today, albeit, is governed, managed, and is often intersected by a centralized authority or system. You can think of CeFi as any financial service with middle-man interference.
DeFi, on the other hand, is CeFi’s challenger and can be simply described as an emerging financial technology based on blockchain technology that operates a secure distributed ledger system.
While DeFi is also used as the ‘umbrella term’ of a wide range of decentralized financial applications (dApps) based on blockchain and facilitated by cryptocurrency, it offers several financial instruments to users without relying on centralized authorities/systems/intermediaries.
Unlike its counterpart, the DeFi system eliminates the interference/control that the traditional entities such as banks and other financial institutions have over the currency of the decentralized economy, as well as other financial products and services therein.
Furthermore, by eliminating the CeFi model, DeFi enables people to facilitate any transaction from any part of the world; more so, it gives them the ultimate control over their finances by leveraging personalized blockchain wallets, as well as trading services that are secure and hard to compromise.
How does DeFi work, and how is it applicable
We understand you’ve come to learn about yield farming, but this is the final straw before we get into the crux of the matter. So, DeFi, like we mentioned earlier is an umbrella term for dApps that facilitate financial transactions in the decentralized economy, leveraging blockchain technology as the underlying technology.
To understand how it works, one must figure out how a typical dApp works in the ecosystem. However, before we get there, it is important to note that DeFi applications which is otherwise described as DeFi instruments are broadly categorized into various types including the following;
- Decentralized Exchanges (DEXs),
- Lending Platform,
- Yield Farming,
- Wrapped Currency,
- Prediction Market,
- Liquidity Mining,
- Money Legos,
- Composability, and so on.
While the list goes on, each dApp that you may ever come across are built or purposed for the aforementioned DeFi instruments. This also implies that a dApp can be designed to offer one or several of these instruments as service(s).
Now, an individual dApp is built on any suitable blockchain network including the likes of Ethereum which is adopted by most dApps, Binance Smart Chain, Polkadot, Solana, and many more.
While each of these blockchain networks has their special attributes, developers makes their selection based on the complexity of the dApp protocol/project they are building. More so, each blockchain network is designed to create and deploy smart contracts for hosted dApps.
As such, with smart contact at the core, each dApp is automated and is able to facilitate transactions from one point to another without involving centralized authority.
That way, each dApp protocol ultimately process financial transactions and have them stored on the blockchain. On the other hand, transactions that are stored in blocks on the blockchain are subsequently validated by other users (i.e a network of verifying nodes which are otherwise known as verifiers).
If all of the verifiers agree on a transaction, the block is closed and encrypted, and a new block is created containing information from the preceding block. That said, what is yield farming as a financial instrument in the DeFi ecosystem?
Understanding Yield Farming
As previously said, yield farming is a crucial financial instrument in the DeFi ecosystem, and it essentially describes a process in which skilled traders – who also are risk tolerant – hunt for and invest in tokens with long-term profit potential.
Yield farming is similar to operating a fixed account in a traditional banking system where you save your money for a period of time and thereafter, withdraw it alongside the return on investment (ROI) upon the completion of the saving period.
In yield farming, the process of safe-locking cryptocurrency is called ‘staking’ and while it is done over a period of time, investors are entitled to various forms of incentives which can range from interest (i.e Annual Percentage Yield or APY), veto power, and other customized benefit depending on the type of project.
Also, in a traditional banking system, banks (for instance) are able to generate revenue from the fixed account by lending out the money to other people in exchange for interest, part of which is paid as ROI for fixed account holders. In some cases, some banks venture into other investment portfolios such as real estate, hospitality, bonds and so on, in an attempt to make more profit.
In the same manner, once an investor stakes a crypto asset in DeFi yield farming, the protocol proceeds to lend to other users as well as invest in other verticals to maximize profitability. Afterwards, yield farmers are rewarded in form of APY which can boost the value of staked investment significantly.
How does Yield Farming Works?
Now that you are aware that yield farming works like a safe-lock that rewards investors after a given period of time, you may be wondering how do you go about it?
To begin with, yield farming which is also described as liquidity farming requires investors to first, deposit/stake their crypto asset in a lending protocol via their chosen dApp.
Recall that we mentioned earlier that most dApps are designed to cater to one or more financial instruments. As such, it is typical of any dApp that offers yield farming as a financial instrument to also offer lending services and liquidity farming as additional financial instruments.
As a result, once an investor stakes crypto assets in a liquidity pool, other persons (i.e. borrowers) can borrow crypto assets from the liquidity pool for a certain period of time and then repay them along with the accrued interest rate. On the other hand, the accrued interest is distributed alongside the total value locked (TVL) among liquidity providers once the staking tenure elapses.
That said, yield farming can be compared to a reward program that is facilitated by smart contracts which are essentially digital documentation or signatory that run on blockchain technology. This smart contract also doubles as the liquidity pool with which lenders and borrowers interact.
That’s not all, just like with traditional financial systems, DeFi yield farming also requires what is described as collateralization to operate smoothly, so what does that mean?
Understanding the Role of Collateralization in Yield Farming
While borrowing an asset via a lending platform can be done seamlessly, it doesn’t guarantee that the borrower will return the loaned asset in due time or at all. As a result, most lending platforms require a borrower to provide a valuable item as collateral for the loaned asset. This way, once all loan agreements have been met, the borrower will have complete access to the collateral.
The above narrative is also the same for yield farming where collateralized items act as issuance for a loan application. However, while this is a common practice among most yield farming protocols, they all adopt different collateralization policies i.e their own collateral-to-loan ratio.
Depending on the platform chosen, a borrower may be required to provide a collateral item that has at least half or equal value with the amount to be borrowed. In extreme cases, some platforms might even ask for a collateralized item that has more value than the proposed loan amount.
How to onboard on a yield farming protocol?
Understanding how yield farming works is obviously not enough for someone who is about to launch a career as a yield farmer, so here is how to do it.
- Choose a suitable platform: The first thing to do as a grooming yield farmer is to learn about different yield farming protocols and choose the one that offers you the best value. Some protocols that you may want to consider include Aave, Compound Finance, Curve Finance, Balancer, Synthetix, InstadApp, and Uniswap among several others.
- Choose a farming activity: Once you select the platform of your choice, proceed to decide how you want to participate, whether as a borrower, a lender (staker), or as validator (verifier). If you are participating either as a borrower or as a lender, then you are expected to pay a token as participant fees. These fees are collected and used as incentives for validating nodes.
- Request to borrow from the liquidity pool or become a liquidity provider: At this point, if you are borrowing from the liquidity pool, then you will be required to provide collateral based on the policy of the chosen platform. More so, at the end of the loan tenure, you do be paying back the amount borrowed alongside interest.
On the other hand, if you are providing liquidity, you can proceed to customize your terms of agreement i.e duration, interest rate, etc., and subsequently wait to harvest your APY or interest at the end of the loan tenure.
- Reinvest: As a liquidity provider, you can decide at the end of your investment, either to reinvest by shifting reward collection to a further date or simply withdraw the total value locked (TVL) alongside the APY/interest at a given period.
Ultimately, how much a liquidity provider makes from a lending/yield farming protocol is subject to the pool’s activity. Do you find this helpful? Please drop your opinion in the comment section below.