Yield farming has created a lot of buzz in recent times. Cryptocurrency asset holders want to take advantage of this technique and earn higher returns. So, what is yield farming? How does it work?
What is Yield Farming?
It simply means storing cryptocurrency asset in such a way that it keeps giving good returns. These returns are paid in the form of dividends. Such returns can be high and in some cases the asset holder can get double of the original investment. However, it also comes with a high risk. The investors can lose a big part of the investment as well. The loss can be as much as half or more of the amount. More sustainable and less risky strategies are available but all of it requires a good analysis of the investment options and their promoters.
Investors store their cryptocurrency assets in different DeFi (decentralized finance) applications. This way the yield can be multiplied further. It is one of the reasons why it is termed “farming”. It is similar to farming where some small seeds give higher returns in the form of produces. As more and more investors of cryptocurrencies keep looking for better returns on their investments, the demand for higher return giving investment options keep increasing.
A Way to Lend and Borrow Cryptocurrency
Yield farming comes down to this simple solution where a cryptocurrency holder can lend this asset to people who need loans in cryptocurrency. The cryptocurrency holders use this option to increase their asset by lending. The earning is in the form of an interest. This process here is different from the bank lending. In case of the bank, bank account holders invest the money but do not earn high return on their investment. Most of the money earned in the form of interest from loans is taken away by the bank. Yield farming removes this middleman so most of the interest goes to the crypto lender.
This high return on the crypto asset is achieved mostly due to the decentralized system. In this setup, the owners retain full ownership of their cryptocurrency assets. A centralized system increases nodes where fee, commission or tax must be paid at each node. These costs are eliminated when the cryptocurrency is loaned without a middleman. It does not eliminate the cost of lending completely because the transactions are still held through some exchange or platform. However, the lost amount in this process for the asset holder is not as high as in traditional banking system. The cryptocurrency holder-lender gets maximum benefits of the decentralized finance system.
In case of yield farming, most of the lending and borrowing transactions are carried out through the Ethereum network.
The advantage of yield farming for the cryptocurrency investors is that their asset is not sitting idle in their wallet or exchange. Similar to fiat money holders who earn interest by keeping their money in the bank, cryptocurrency holders also earn interest by lending their crypto asset to others. The crypto lenders use different protocols or smart contracts to receive a return on their investment.
How Does It Work?
The first step of yield farming requires adding fund to a smart contract liquidity pool. This pool is like a bank from where people in need of cryptocurrency can borrow. The borrowers have to pay a fee to borrow the cryptocurrency. This fee earning is distributed to the liquidity providers based on their share in the liquidity pool. Cryptocurrency tokens are given to them as interest or reward.
Those who add their funds to this pool are called liquidity provider. Once they authorize lending of their fund stored in the pool, they start earning rewards in the form of fees generated by the exchange or DeFi platform.
Those with experience of Ethereum network and related technologies keep moving their funds across different crypto platforms to get higher returns. Rules related to this process vary slightly from one platform to another and one protocol to another. The annual return received by the liquidity provider is called a yield. It is written in the form of a percentage and referred as APY (annual percentage yield) or APR (annual percentage rate).
Yield farming services are provided by many crypto exchanges and platforms. This investment option carries high risk so the investors should always assess the associated risks before investing in it.