{"id":21079,"date":"2024-11-17T21:35:08","date_gmt":"2024-11-18T02:35:08","guid":{"rendered":"https:\/\/coincentral.com\/?p=21079"},"modified":"2024-12-30T15:22:16","modified_gmt":"2024-12-30T20:22:16","slug":"what-is-yield-farming","status":"publish","type":"post","link":"https:\/\/coincentral.com\/what-is-yield-farming\/","title":{"rendered":"What is DeFi Yield Farming? A Beginner’s Guide on the Risks and Rewards of Earning Yield in Crypto"},"content":{"rendered":"

Yield farming is a method of using cryptocurrencies like Ethereum and USDC to earn interest (distributed in that coin’s denomination) through DeFi mechanisms such as staking and lending. <\/span>The term “yield farming” might conjure images of a passive, relatively risk-free scenario comparable to growing crops, but it’s a fairly risky endeavor.\u00a0<\/span><\/p>\n

\u00a0Yield isn’t guaranteed, and performance varies significantly.<\/span><\/p>\n

For example, yield farming with UST, Terra’s stablecoin, through dapp Anchor,\u00a0 brought users about 20% yield consistently\u2013 up until UST depegged and was suddenly caught in a worthless spiral. Sure, the decentralized automated mechanism of earning yield on Anchor might still work, but the rewards are effectively worthless.<\/p>\n

Alternatively,\u00a0 simply just staking Solana earns about 7% APY, and the token has comparatively maintained its value (despite having an ATH north of $250 and currently sitting at about $60.)<\/p>\n

How Does Yield Farming Work?<\/h2>\n

Yield Farming helps stimulate the\u00a0flow of value within the decentralized ecosystem system,.<\/strong><\/p>\n

Let’s consider earning yield in traditional finance: money is issued by a central bank, and then commercial banks lend those funds to businesses and individuals. Banks levy an interest rate on those loans, thus making a profit.\u00a0<\/span><\/p>\n

In the cryptocurrency DeFi economy, <\/span>a yield farmer recreates the role of a bank, lending their funds for a specific purpose:<\/b><\/p>\n

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  1. These coins may go to a liquidity pool, helping a decentralized exchange facilitate trades,<\/li>\n
  2. Or, Proof-of-stake coins can be staked to support the overall network.<\/li>\n<\/ol>\n

    \u201cFarming\u201d refers to reaping the annualized percentage gains through any of these mechanisms.<\/b><\/p>\n

    Is yield farming worth it? Let\u2019s dive into the mechanics of yield farming so you can become more educated on what yield farming and how it functions.\u00a0<\/span><\/p>\n

    In this article, we’ll explore:<\/p>\n

      \n
    1. Yield farming’s relationship with DeFi<\/li>\n
    2. How yield farming works<\/li>\n
    3. Are your funds safe?<\/li>\n
    4. The risks of decentralized lending<\/li>\n
    5. The best DeFi projects for yield farming<\/li>\n
    6. The future of yield farming<\/li>\n<\/ol>\n

      Is Yield Farming DeFi?<\/span><\/h2>\n

      Yield farming is one of the many facets of <\/span>Decentralized Finance (DeFi)<\/span><\/a>, and the term entered the popular lexicon of the cryptocurrency world in 2020.<\/span><\/p>\n

      DeFi, as we know it, is an amalgam of various decentralized protocols and applications. It’s notable because it often doesn’t require the same barriers to entry traditional finance systems, and just about anyone with an internet connect can participate. However, the democratization of access shouldn’t distract away from the fact that it requires a high degree of scrutiny and responsibility\u2013 it can be far riskier than its traditional finance counterpart.<\/p>\n

      DeFi sprung from one of the use cases for the Ethereum protocol. The possibility for cheap and borderless transactions pushed the creation of startups that tried to mimic banks and financial brokers. DeFi applications branched out in various directions, including novel cryptocurrency trading algorithms, derivatives trading, margin trading, money transfers, and most importantly, lending markets.\u00a0<\/span><\/p>\n

      Cryptocurrency lending entered a phase of functional maturity largely due to two behemoth projects – <\/span>Maker DAO<\/span><\/a>, and Compound.\u00a0<\/span><\/p>\n

      So, where does yield farming come into play?<\/b><\/p>\n

      How Yield Farming Works<\/span><\/h2>\n

      Yield farming depends on the <\/span>inflows and outflows of a certain anchor asset, <\/span><\/a>such as DAIm, the dollar-pegged coin that originated with the Maker DAO protocol. The DAI dollar peg makes the system more predictable by setting an intuitive value for each token, $1. Yield farming depends on a collateral of ETH or another token, which is used for loans and generates rewards.<\/span><\/p>\n

      A DeFi user usually locks in the chosen coins using the MetaMask browser plugin. Locking in funds means the wallet will communicate with a smart contract on the Ethereum network. Depending on the logic of the smart contracts, there are various ways to extract value, though the most traditional one is to levy an interest rate on a cryptocurrency loan. Users will pay fees to transact on the Ethereum network, and due to heightened interest, those fees may rise rapidly or make the network too congested to be able to participate successfully.<\/span><\/p>\n

      In the middle of March 2020, ETH prices dropped sharply, creating a perfect storm of market panic and <\/span>triggering of multiple algorithms on the Maker DAO platform<\/span><\/a>. The Ethereum network also slowed down transactions, not allowing the owners to increase their collateral. Multiple deposits (known as vaults) were liquidated, and DAI briefly lost its dollar peg.<\/span><\/p>\n

      In the case of falling prices, the 150% over-collateralization can help offset the risk partially. Projects like DeFi Saver can automatically increase the collateral to stave off liquidations. Liquidations happen when the minimum collateral requirement breaks down due to price volatility.<\/span><\/p>\n

      DeFi tends to work better in climate climbing asset prices, because the collateral locked for yield farming is safer. For example, if ETH prices drop by 33%, this would liquidate most deposits on Maker DAO. Smaller price fluctuations also mean holding ETH may, in the long run, be more profitable than yield farming.<\/b><\/p>\n

      Alexander Ivanov<\/span><\/a>, the founder of the <\/span>WAVES protocol<\/span><\/a>, compares DeFi to the frenzy for initial coin offerings (ICOs). Ivanov is still optimistic about the future, only warning against another bubble due to irrational enthusiasm.<\/span><\/p>\n

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      Please let’s not make a new ICO bubble out of #DeFI<\/a><\/p>\n

      \u2014 Sasha Ivanov (@sasha35625) June 23, 2020<\/a><\/p><\/blockquote>\n