Several people are looking for more ways to make profits from crypto. Since active trading is very risky (because of the volatility of the market), alternate sources of profit have been growing. One of these alternatives is yield farming.
What is Yield Farming?
Essentially, yield farming is the cultivation or promotion of profit-making activities.
The definition is similar to that. It is the process of putting your crypto assets to use, with the view of getting profit or a yield of more crypto for you.
What makes this better than HODLing?
HODLing is very much like purchasing the stock of a non-dividend-paying company: to make a profit, you have to wait for the share price to appreciate
While this strategy presents opportunities to make a profit apart from the usual HODLing.
As with all things DeFi, yield farming uses smart contracts to make higher returns for investors. These smart contracts are like asset or fund managers. A liquidity pool is a ‘reservoir’ of different assets where assets can be exchanged, loaned or invested, and it is governed by a smart contract with protocols that determine the terms of trade. These protocols are referred to as algorithms. This makes them decentralized exchanges where the same activities that take place in centralized ones like Binance and Coinbase also take place.
Yield farming involves using your crypto asset portfolio to make a profit, majorly by being a liquidity provider or more.
In the financial world, liquidity is anything that can be traded for cash, and it is what makes the world (the crypto world inclusive) go round.
To get a better understanding, let’s use the analogy of the businessperson who wants to buy a hotel, but wants to assess it to inform his decision, and makes a deposit of a percentage of the proposed price to show seriousness.
While assessing it, the hotelier uses the money to pay off some debt. Those he paid used the money to do something, thereby giving the money to someone else, and the money changes hands several times before coming back to the hotelier (because someone owed him). All these happened in time for the money to be returned to the businessperson, who decided against purchasing the hotel.
From the analogy, we can see that the businessperson is the liquidity provider who provides the liquidity that enables trade. However, in a liquidity pool, there are various liquidity providers, and at each point of trade, fees are collected and paid to the liquidity providers.
Another yield farming strategy is leveraged lending. The idea here is to earn more profit on investment by earning interest on borrowed funds.
To do this, you first lend your asset to a decentralized exchange (DEX) for an interest rate, then borrow less from them in the form of the paired token, convert it into the initial investment token on another exchange, and come back to re-invest. When you do this several times, you will be earning interest on an investment that is larger than your portfolio size.
Risks Associated with Yield Farming