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A strong incentive in Decentralized Finance: Introduction to Yield Farming

By Inkarias - 2020-10-02

Yield farming is a new efficient way to make more from your already held cryptos as Yield farming system involves lending funds to other people through the well-known technical contracts originally implemented in Ethereum, the “smart contracts”. In exchange for the lending service, the user receives a fee in the form of cryptocurrency.

Yield Farmers will use very complicated strategies. They constantly move their cryptos between different lending markets to maximize their returns at any time and depending on the market situation. This is also a field where most people will remain silent about these solutions as the more people know about a strategy, the less effective it can be. Yield Farming can be compared to the battlefield of decentralized finance, where farmers compete for a chance to grow the best results and earn the most quickly.

The decentralized finance movement has been at the forefront of innovation in the blockchain arena. Defi applications are completely unique in the sense that they are unauthorized, which means anyone or anything, such as a smart contract with an internet connection and a supported wallet can interact with them. In addition, they generally do not require trust in custodians or intermediaries. In other words, they are trustless and bring several innovative use cases. In short, yield farming allows anyone to earn rewards with cryptocurrency holdings using unauthorized liquidity protocols but also to earn a passive income using the decentralized ecosystem built on Ethereum. Therefore, yield farming could change the way investors protect themselves in the future and revolutionize the financial sector with the unprecedent productivity even for small individuals.

How does the system work

The yield farming activity is closely linked to a model called automated market maker or AMM which usually involves liquidity providers (LPs) and liquidity pools. Liquidity providers deposit funds into a liquidity pool. This pool feeds into a marketplace where users can lend, borrow, or trade tokens. There are fees for using these platforms, which are then paid to liquidity providers based on their share in the liquidity pool. This is the basis of how an Automated Market Maker works. However, the implementations can be very different, not to mention that this is new technology. There is no doubt that we are going to see new approaches that improve on current implementations deployed on the market.

In addition to fees, another incentive to add funds to a pool could be the distribution of a new token. For example, there might not be a way to buy a token on the open market, but only in small quantities. On the other hand, it can be accumulated by providing liquidity to a specific pool. The distribution rules will all depend on the unique implementation of the protocol. The bottom line is that liquidity providers earn a return on the amount of liquidity they provide to the pool.

Deposited funds are typically “stablecoins” pegged to USD, although this is not a general requirement. Some of the most commonly used stablecoins in DeFi are DAI, USDT, USDC, BUSD, and others. Some protocols allow you to mint tokens that represent your coins deposited in the system. For example, if you drop DAI into Compound, you will get cDAI, or compound DAI. If you deposit ETH in the Compound, you will get cETH.As you can imagine, there can be multiple levels of complexity. You could deposit your cDAI in another protocol which hits a third token to represent your cDAI which represents your DAI. And so on these chains can get really complex and difficult to follow and thus DeFi remains a field where knowledge is the key to success and to answer community’ demands.

Yield calculations explained

Usually, estimated yields are calculated on an annualized basis. This is an estimate of the returns a user can expect over a period of a year. The most common measures are the Annual Percentage Rate (APR) and the Annual Percentage Return (APY). The difference between the two is that the APR does not take into account the effect of capitalization, whereas the APY does. Capitalization, in this case, means the direct reinvestment of profits to generate more return. It should also be borne in mind that these are only estimates and projections. Even the short term rewards are quite difficult to estimate accurately as the performance business is a very competitive and changing marketplace, and the rewards can fluctuate quickly. If a yield strategy works for a while, many yield growers jump at the opportunity and it may stop producing high yields after a certain period of time. As the APR the APY come from traditional markets, DeFi may need to find its own parameters to calculate returns. Due to the rapid pace of DeFi, weekly or even daily revenue estimates may make more sense in investors mind.

Collateralization within DeFi sector

Generally, if one borrow an asset, he needs to post collateral to cover the loan. Essentially, this is considered as an insurance for the set loan. This parameter also depends on the protocol tied to the funds. If the value of the collateral falls below the threshold required by the protocol, the collateral can be liquidated on the open market, a major problem that can be avoided with additional guarantees.

Each platform will have its own set of rules for this such as its own required collateralization ratio. In addition, they generally work with a concept called oversizing. This means that borrowers have to deposit more value than they want to borrow in order to reduce the risk of severe market crashes that result in the liquidation of a large amount of collateral in the system.

The associated risks of Yield Farming

The yield farming activity is not an easy task for beginners or persons not aware about all the conditions and inherent requirements. The most profitable strategies are very complex and are recommended only for advanced users. In addition, the yield farming is generally more suited to those with a lot of capital to deploy. One of the obvious risks of yield farming is that of smart contracts. Due to the nature of DeFi, many protocols are built and developed by small teams with limited budgets and can increase the risk of bugs in smart contracts if not well prepared or audited.

Even with larger protocols that are checked by reputable auditing companies, vulnerabilities and bugs are constantly discovered. Due to the immutable nature of the blockchain, this can result in the loss of user funds. A person wishing to take part in yield farming may have to take this into account before locking funds in a smart contract for a certain time.

In addition, one of DeFi's biggest benefits is also one of its biggest risks, namely the ‚Äč‚Äčinteroperability. DeFi protocols are unauthorized and can integrate seamlessly with each other. This means that the entire DeFi ecosystem relies heavily on each of its building blocks. In that case, if just one of the building blocks or main component does not perform as well as expected, the entire ecosystem is at risk. This is one of the greatest risks for yield farmers and liquidity pools or providers.