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DeFi Yield Farming Explained

June 20, 2022 - 6 min read

In recent years, decentralized finance (DeFi) has experienced a period of rapid expansion, with its Total Value Locked (TVL) exceeding $250 billion. The thriving DeFi ecosystem consists of trust-minimized financial applications that anyone with an internet connection can access.

Yield farming, a DeFi-unique ROI-optimization strategy, is one of the primary contributors to the exponential growth of the decentralized finance industry. It rewards investors for securing their crypto assets in a DeFi market.

What is DeFi Yield Farming

The process of yield farming enables cryptocurrency investors to receive incentives for their holdings. With yield farming, an investor deposits units of a cryptocurrency into a lending mechanism to collect interest from trading fees. Some users are also rewarded with additional returns from the governance token of the protocol. The user will provide crypto tokens for a trading pair supplied by a decentralized exchange or DEX in yield farming.

The returns have been earned in annual percentage yields (APY) that can approach triple digits since yield farming began in 2020. However, this potential return comes with a significant level of danger, as the protocols and coins gained are prone to tremendous volatility and “rug pulls” in which engineers abandon a project and steal investor funds.

A yield farm operates similarly to a bank loan. When a bank lends money, the user must repay it with interest. In yield farming, however, the banks are cryptocurrency holders like themselves. In exchange for returns, yield farming uses “idle cryptos” that would otherwise be wasted away in an exchange or hot wallet to offer liquidity in DeFi protocols such as Uniswap.

How DeFi Yield Farming Works

Users who give cryptocurrency to the DeFi platform to function are liquidity suppliers (LPs). These LPs supply coins or tokens to a liquidity pool, a decentralized application (dApp) that contains all the funds and is governed by smart contracts. Once LPs lock tokens into a liquidity fund, they receive a fee or interest created by the underlying DeFi platform that the liquidity pool is on.

Protocols that have followed the paradigm of liquidity mining encompass a vast array of applications, including decentralized exchanges, money markets, and yield aggregators. These initiatives have benefited from creating a network of early adopters who actively contribute to the project’s liquidity and governance. Initially, however, yield farming was applied to increase the liquidity of a particular asset directly.

Profitability of Yield Farming

The practice of yield farming can be a highly lucrative technique to create cash from idle crypto tokens. Various other variables will determine if yield farming is lucrative at all. Notably, whereas major yield farming DeFi sites will provide the user with a projected APY, there is no assurance that the user will realize this. However, the user will frequently discover that the most liquid currency pairs provide the lowest interest rates.

DeFi Yield Farming Taxes

Currently, taxation in the traditional cryptocurrency market is relatively transparent. Thus, if the user purchases a token and then sells it for a profit, they will likely be subject to capital gains tax in their country. However, there appears to be some ambiguity regarding the taxation of DeFi yield farming gains. In addition, the particulars will depend on the user’s country of residence, tax bracket, annual income, and other fundamental factors. 

The Risks of Yield Farming

Due to the global absence of formal policies governing cryptocurrencies, cybercrime and fraud are serious problems and the regulatory risks that most digital assets face. All transactions include digital assets that are stored within the software. Hackers might be competent at locating weaknesses and exploits in software programming to steal funds.

The user must also evaluate the inherent risk connected with the DeFi platform. The user will need to deposit funds into the platform’s liquidity pool to produce a yield. To do so, the user must believe that the platform is legitimate. If the user deposits funds on a dodgy DeFi platform, users may never see their tokens again.

Additionally, there is token volatility. There is history for the prices of cryptocurrencies being erratic. The volatility can also occur in brief bursts, causing the token price to either increase or decrease when the price of the token is locked in the liquidity pool. This may result in unrealized gains or losses, and the user may have been better off had they kept their coins available for trading.

Additionally, smart contracts on DeFi platforms are not as reliable as they appear. Small teams with minimal budgets develop many of these new DeFi protocols. This can raise the possibility of smart contract platform issues.

Yield Farming Platforms

Each platform and strategy will have its own rules and risks. If the user wants to get started with yield farming, the user must get familiar with how decentralized liquidity protocols work.

  1. Aave is an open-source system for cryptocurrency lending and borrowing. Depositors gain AAVE tokens as interest on their deposits. Interest is earned based on market demand for lending. Using their deposited coins as collateral, the user can serve as a lender and a depositor.
  1. Compound Finance is an algorithmic money market that enables the lending and borrowing of assets. Anyone with an Ethereum wallet can contribute assets to Compound’s liquidity pool and earn instantaneously compounding rewards. The rates are algorithmically changed based on supply and demand.
  1. Synthetix is a protocol for synthetic assets. It allows anyone to stake Synthetix Network Token (SNX) or Ethereum (ETH) as collateral and create synthetic assets against it. What are possible synthetic assets? Essentially everything with a reliable pricing feed. This enables the addition of nearly any financial asset to the Synthetix platform.
  1. The decentralized exchange Uniswap requires liquidity providers to stake both sides of the pool in a 50/50 ratio. In return, the user will collect a percentage of the transaction fees in addition to UNI governance tokens.
  1. The Balancer is a technique for liquidity comparable to Uniswap and Curve. However, the fundamental difference is that it permits custom token allocations in a liquidity pool. This enables liquidity providers to construct unique Balancer pools instead of the necessary 50/50 allocation by Uniswap. Similar to Uniswap, LPs receive fees for trades in their liquidity pool.

Final Thoughts

In conclusion, yield farming DeFi platforms allow the user to earn an excellent APY on their cryptocurrency holdings. If the user does not have initial experience in the cryptocurrency industry, yield farming is a risky business. The user could lose their investment in a single transaction. Investing involves risk. The world of yield agriculture is frenetic and dynamic. If the user decides to attempt yield farming, they should not risk more than they can afford to lose.

To level up and gain a deeper knowledge of all things related to the future of the cryptocurrency industry, check out the latest content in the Supra Academy section.

The information above is for informational purposes only and should not be considered financial advice of any kind.

References

  1. Aki, J. (2021, 21 Nov.). What is yield farming in DeFi, and how does it work?. Forkast
  2. Dale, B. (2022, 14 Jan.). What is yield farming? The rocket fuel of DeFi, explained. CoinDesk
  3. Hicks, C. (2021, 9 Nov.). Yield farming: An investing strategy involving staking or lending crypto assets to generate returns. Business Insider.

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