When people talk about decentralized finance, it can seem overly magical or impossible to understand. While the ecosystem is often filled with technical terminologies and layers of complexity, it's actually largely based on simple financial concepts that we're already familiar with.
Once you understand the relationship between traditional finance and one powered by blockchain, you'll find parallels in both worlds and realize massive opportunities in the likes of yield farming as a source of passive income.
Let’s take a closer look at what yield farming is and how it works.
What is yield farming?
Yield farming is like becoming a mini-virtual private bank. Among other services, traditional banks offer lending and currency exchange. Thanks to smart contracting, it is now possible to offer those services for the crypto market. The work done by a bank’s personnel is (now) all automated by DeFi protocols.
When taking part in yield farming, you earn interest in exchange for lending and currency (token) exchange. So, when you stake crypto assets for the purpose of lending and exchange, those digital assets become a yield farm, and you become a yield farmer.
Blockchain-powered DeFi makes yield farming possible
The driving force behind DeFi combines technological advancement with external pressures. When the economy is centrally planned, many oddities occur. One of them is negative interest rates. Presenting a historic anomaly made possible only with central banking, hundreds of banks across Europe now charge customers for depositing their money.
Fortunately, this upside-down system is countered by an equally novel one thanks to decentralized finance with yield farming. Negative or near-zero interest rates — in the case of the U.S. — present the opposite force compared to yield farming’s attractively high yields. To understand how DeFi avoids the edicts of central banks, you first need to understand its underpinning technology: blockchain.
DeFi uses blockchain technology to tokenize economic activities and encode them with smart contracts. These are then placed within encrypted data blocks forming a chain, waiting to be executed when conditions are triggered. Therefore, they work without banks and regulatory authorities.
Here are a few important things to remember about DeFi:
- It works only on programmable blockchains. These are the blockchains that have smart contract capability. For example, the largest cryptocurrency — Bitcoin (BTC) — runs on its own blockchain that lacks such capability.
- There are many programmable blockchains. The most popular ones are Ethereum, Cosmos, Polkadot, and Binance Smart Chain.
- Platforms built on the programmable blockchains are called dApps, which is short for decentralized applications.
- Because DeFi dApps are open-source, anyone with sufficient programming language can develop and launch them. Likewise, many DeFi platforms have governance tokens in which yield farming rewards are paid off. DeFi’s open-source ecosystem nature makes it brimming with innovation because there is no red tape.
- ETH is the native token for Ethereum, also commonly called Ether. On the Ethereum blockchain, most fall into the category of ERC-20 token.
Vitalik Buterin, one of the creators of the largest programmable blockchain called Ethereum, defined smart contracts like this:
"A smart contract is a mechanism involving digital assets and two or more parties, where some or all of the parties put assets in and assets are automatically redistributed among those parties according to a formula based on certain data that is not known at the time the contract is initiated."
In other words, smart contracts enforce contract negotiation and execution without involving third parties. When applied to yield farming, smart contracts enforce the management of your crypto assets — tokens or cryptocurrencies.
In a nutshell, yield farming means locking your crypto assets in a smart contract to provide liquidity. This is why yield farming is also called liquidity mining. In turn, those who lock in their tokens are liquidity providers (LPs). According to DeFi Pulse, as of May 27, 2021, over $60 billion TVL (total value locked) has been poured into liquidity mining within a single year.
Importance of providing liquidity in the crypto ecosystem
Let’s say you want to convert one asset into another, making a token pair. On a traditional forex (foreign exchange) platform, token pairs are currency pairs — U.S. dollar to euro, British pound to Swiss franc, etc. In the crypto space, we have token pairs. For example, exchanging one of the most popular stablecoins, Tether (USDT), into Ethereum (ETH) makes a token pair.
However, what happens when there isn’t enough of one side of the pair? When the seller of USDT cannot be easily matched with a buyer of ETH? Then, the market would have low liquidity and high volatility.
Because the token pair is lopsided in supply, the price of tokens would be highly volatile. In traditional finance, liquidity providers are centralized exchanges such as Nasdaq or NYSE. Also called market makers, they make sure the market is liquid so buyers and sellers can easily match each other’s asks and bids.
In DeFi, liquidity providers — or yield farmers — play this critical role, with the whole process auto-executed by smart contracts, i.e., automated market makers (AMMs). For their service, they gain fees expressed as an APY (annual percentage yield), which is similar in nature to interest rate. Therefore, the reward for being a liquidity provider is yield farming.
The token pairs in which liquidity providers stake their digital assets are called liquidity pools.
A liquidity provider — or yield farmer — gains an interest rate based on the amount of tokens staked in the liquidity pool. Additionally, APY depends on the supply/demand ratio of the token pair. Compared to current near-zero interest rates, DeFi yield farming offers high yield.
It’s also important to note that providing liquidity only nets about 0.3% on trading volume. In contrast, high-yielding liquidity pools rely on token emissions. Each token has a different protocol that regulates its emissions, which just means automatic issuance of new tokens. For example, while Bitcoin is limited to 21 million coins, Ethereum has no such hard cap. Instead, five Ether coins are created about every 14-15 seconds.
Therefore, a yield farm with tokens that have a high emission rate will produce more gains.
Can anyone engage in yield farming?
Yes. Anyone with funds in a Web3 crypto wallet can connect to a dApp to lock their funds in a liquidity pool, thus becoming a liquidity provider. Currently, there is a huge selection of DeFi platforms to choose from for yield farming. Most of them are hosted on the Ethereum blockchain.
If you already hold Bitcoins, you can convert them into WBTC as a source of funds for yield farming. This is an Ethereum-compatible token equal in value to Bitcoin, just as stablecoins like USDT or USDC are equal in value to USD.
The first factor to consider when you start yield farming is the transaction fee cost on a particular blockchain. For technical reasons that are soon to be resolved, Ethereum’s transaction fees are still too high for comfort. Consequently, yield farming has momentarily shifted away from Uniswap, Curve, and Yearn Finance, the top-ranked yield farming platforms.
Instead, PancakeSwap and SushiSwap platforms have usurped their position. Binance Smart Chain hosts PancakeSwap, while SushiSwap and Curve are also on Polygon, Ethereum’s sidechain that alleviates the current problem of high gas fees. Nothing in life is free, including blockchain transactions. Gas fees represent computational power needed to validate and process them.
You can commence your hunt for the most profitable yield farming by using Yield Farming Tools:
- Liquidity level: Low means greater gains
- Risk level: Smart contract security
- Provider: Which DeFi projects you want to select
- Collateral: Which token is used to lock in your assets
- Reward: In what token do you receive your yield farming gains
When borrowers collateralize their tokens, they have to look for APR — annual percentage rate. In that case, you should seek the lowest APR. In contrast, lenders — those who are liquidity providers — have to look at high APY, which represents compound interest.
When faced with new ventures, it is important to choose credible and audited projects so that your first experience is not tainted. For this reason, try yielding with Unagii — which prioritizes security, simple user experience, and low fees.
Risks involved in yield farming
When it comes to risks and rewards involved with DeFi yield farming, it is important to understand the concept of impermanent loss (IL).
By locking tokens into a liquidity pool, you relinquish them to AMMs, which are not connected to centralized exchanges. In turn, this means that when a token price changes on centralized exchanges, AMMs don't automatically change them. This difference between the token’s price in your wallet and the liquidity pool is called impermanent loss.
You can calculate it with this Impermanent Loss Calculator, with pool weight percentages representing the distribution of tokens in a pair. Outside of IL risk, one may consider the stability of your internet connection, which might impact how fast you add/remove LP, harvest your rewards, etc. Also, some smart contract protocols may become a target for flash loan attacks. Since 2019, $284 million losses have occurred from various hacks and exploits.
For this reason, decentralized insurance dApps have emerged, with Nexus Mutual being the most popular one. In the same way liquidity pools lock in your crypto assets, insurance dApps lock them as a collateral, pooled with other insurance members to distribute the risk. Additionally, they also generate fees for providing collateral to underwrite risk for other insurance pool members.
Then, if you suffer a loss due to a hack or a technical glitch, you get a payout depending on the amount of locked in (staked) funds and how much is available to pay the claims.
The best way to start yield farming
Theory is best understood with practice. Fortunately, DeFi yield farming has come a long way from its first steps a couple of years ago. The entire process is now smoothed out and accompanied with a modern user interface. It only takes a couple of minutes for all the concepts you’ve learned here to come to life.
To seamlessly switch between DeFi dApps, start by installing MetaMask. This is the most popular Web3 crypto wallet that integrates into your web browser as an extension. Then, every time you visit a DeFi protocol, you have the option to seamlessly connect your wallet and start staking your tokens into a liquidity pool.
While many DeFi applications count on users to navigate through the complexity of yield farming, Unagii has greatly streamlined and automated this process. Moreover, it has a clean slate when it comes to smart contract vulnerabilities and hacks.
