What is Yield Farming?

cioreviewindia Team | Friday, 25 June 2021, 11:09 IST

What is Yield Farming?As cryptocurrencies and crypto assets grow in popularity, there has been an ever increasing need for investors to maximize the potential profits they can get from these assets. Yield farming is one of the ways investors can earn profit off their crypto without actively trading the asset. In this article we will give a short exposè on yield farming and how investors can benefit from it.

How Does Yield Farming Work?

Unlike trading crypto assets on exchanges and affiliated websites such as Bitcoin Prime, Yield farming which is also referred to as liquidity farming is the act of lending crypto assets and earning rewards on these assets. The entire process is powered by smart contracts and the rewards earned can be in the form of tokens (majority of these tokens are on the ERC-20 standard). Simply put, yield farming is the locking up of crypto assets to earn rewards on those assets.

The percentage on locked crypto assets varies depending on the De-Fi platform being used. This makes investors move their assets around various farming protocols looking for the best returns on their assets. I'm the next section, we will discuss the means by which the returns on assets are calculated.

Yield farming uses a model quite similar to the AMM (automated market maker) model to work. Liquidity pools are funded by LPs or liquidity providers who deposit their funds. Other parties are able to lend, exchange tokens, and borrow from this pool. Liquidity providers get tokens for their contribution and the percentage of rewards they get is usually based on the size of their contribution to the pool. This incentivizes LPs to contribute more to a pool

How Yield Farming Returns are Calculated

The mode of calculating returns varies depending on the protocol being used. Some protocols calculate Annual Percentage Rate (APR) while others calculate the Annual Percentage Yield (APY). What is important to note is that the returns are usually calculated on an annual basis. The key difference between the APR method and the APY method is compounding.

When calculating returns, the APY method accounts for compounding while APR does not which makes APY more desirable than APR. It is important to note that with all these calculations, it may be difficult to calculate the exact returns you will make because it constantly varies.

Risk Associated with Yield Farming

Like every venture in the crypto space and the world at large, there is no venture without risks and rewards. Although yield farming is great for getting rewards on idle crypto, there are some risks associated with it and we will highlight those risks in this section.

  • There might be vulnerabilities in the Smart contracts used in the protocol therefore, they may be susceptible to hacks or fraud (it is always best to make proper research before locking your funds in a smart contract).
  • The Ethereum gas fees are quite high and it may not be profitable for small players to participate in Yield farming due to this. If you do not have a few thousand dollars to lock in a smart contract, the gas fees may eat up all your profits.
  • Yield Farms work based on a number of protocols and if there is a problem with even one of these protocols, the whole system will be impacted.

Conclusion

Yield Farming is a great way to create more value from your parked crypto assets instead of them lying fallow. Although there are many platforms that offer this service, the returns vary and some are more trustworthy than others. Before you commit to any platform, ensure that you have conducted extensive research about the platform. Happy earning!

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