Most of the time, when cryptocurrency is mentioned, crypto trading is what comes to people’s minds, which involves mostly buying and selling of cryptocurrencies. However, there are many opportunities in the crypto space that can span beyond crypto trading. These opportunities create avenues to make money. Yield farming is one of them.
This investment option recently rose to popularity. Investors, traders, and holders of cryptocurrency across most DeFi platforms have been making the bold move of trying out this investment option. According to statistics from Defi Pulse, there is over $103.29B total value locked (TVL) of cryptocurrencies on the DeFi protocol. This value is on the rise due to the influence of yield farming.
Before joining this pool of investors practising DeFi yield farming, you can read this article to understand how yield farming works.
What Is Yield Farming?
Yield farming is a process involved in the decentralized finance practice where holders lock up their holdings to earn rewards in different cryptocurrencies. The purpose is known as lending or stalking. It is an encouraging innovation process. Although, there are still significant risks attached to it. Investors can choose to either stalk for a short or more extended period. Any option will still bring profitable returns. The profit will vary from fixed interest to variable interest. This DeFi yield farming system evolves as its creators are always looking for means to improve its functionality. One of the notable latest innovations, is liquidity mining.
A simple illustration: when you save your fiat currency (money), in any financial institution like banks, the fund is placed in a fixed deposit account. The bank knows you won’t be needing the funds anytime soon. These funds are then diverted and given out as loans to organizations or individuals in need of it. These loans are usually paid back after a stipulated period with interest. The bank, in turn, compensates you with interest on your savings. This process is exactly how yield farming works. It runs on the Ethereum blockchain.
The investors, usually addressed as liquidity providers, are compensated with ERC-20 tokens when they lock up their crypto accounts for stalking. The returns are called annual percentage yield (APY). Surprisingly, they reduce due to increment in the liquidity provided by the liquidity provider.
How Does Yield Farming Work?
There are various steps involved in crypto yield farming. Below is a step-by-step guide to understanding how yield farming works:
Step One: Become A Liquidity Provider
Liquidity providers are the investors that deposit funds into a liquidity pool. It is the first step involved in yield farming. You have to decide on which pool you would like to make contributions because yield farming is like a smart contract. It contains many funds that practitioners of yield farming exchange, borrow, or lend tokens in the Ethereum ecosystem. Once you become a liquidity provider, you have already become a yield farmer.
Step Two: Deposit Funds
The best cryptocurrencies are stable coins with links to USD, such as DAI, USDT & USDC. Users can stake cryptos to earn yield. Although it might sound risky, you can try this investment opportunity. Users can also reinvest their reward tokens into other liquidity pools. There, you have created multiple income streams. You will get a reward in the new pool. Note that the ROI is dependent on investment and the rule governing the protocol funded.
Role of Automated Market Maker (AMM) In Yield Farming
You must be wondering what yield farming operates on. It thrives on three main contributors, namely: liquidity provider, liquidity pool, and AMM. From the above points, Liquidity providers are the investors that make funds available, while liquidity pool is the collection of all the funds provided into a smart contract. So, Automated Market Maker is the model on which yield farming functions. This model functions on the DeFi exchange even before its use in yield farming. AMM uses smart contracts to manage the trading platforms by creating a liquidity pool instead of regular buying and selling. Trades are based on predetermined algorithms on the model.
What Are Yield Farming Risks?
People come up with questions such as; can you lose money in yield farming? Just as expected, with things relating to a decentralized financial system, there is a high risk attached to it. In addition, a crypto investor or trader is a risk-taker. Not just any risk though, an investor ought to only carry out calculated risk.
The following are yield farming risks. You should always prepare yourself for risk if you want to become a liquidity provider.
Ordinarily, smart contracts are very secure for all types of cryptocurrency. They are generally safe, but sometimes there is a third-party risk involved. Cybercriminals can take advantage of small opportunities to steal from people and exploit the project.
The loss that occurs due to unexpected events is known as imperative loss. It is due to fluctuations in the market movement. The cryptocurrency market is known to be volatile. If users are not careful, they can lose their money.
In situations where a fiat currency benefits from liquidation risk, the reverse is the case for a DeFi network. Balance can run to zero. In a DeFi network, liquidation risk occurs if the market price of the collateral drops below the market price of the loan. Thus, the collateral can no longer account for the loan. It amounts to a loss for the users.
The developer of the coin can sell off his assets, resulting in a drop in the value of the cryptocurrency, thereby putting every investor at liquidation risk.
Setbacks can occur due to poor strategy and planning. There are four key factors you have to make your primary concern. They are loan pool participation, set income goals, arbitrage trading, and lending.
What to Do After A Yield Farming Loss?
At a point, it should be expected that you will experience a setback or loss. It should not be the end of your trading career. Instead, you should see it as an experience and a mistake you won’t be making anymore.
The first thing you should do is to pull out of the pool. Do not let your emotions get the better of you; strategize by pulling out of the investment.
When re-entering the liquidation pool, there are some things you ought to put in place which include:
● Always keep a healthy borrow and collateral ratio in case market prices fluctuate, and it’s not in your favor.
● Do all your dealings, collateral, and loans in stable coins such as USDT, USDC, etc., because they are fiat-pegged.
● Ensure the smart contract is audited to give you complete information on what you need to know.
● Only engage with reputable companies.
● Be on the lookout for reviews from existing users and study the pattern.
Best Yield Farming Crypto
You should know that investing in ETH itself does not make you an investor in yield farming. There is a difference. Instead, to fully participate in crypto yield farming, you need to lend out ETH by funding a pool built on a decentralized non-custodial money market protocol, e.g., UNISWAP. It’s after you invest in a pool, that you start receiving a reward.
Some of the yield farming protocols with reputations include:
Step by step guide on how to farm yield
Different protocols can be used for yield farming. This step-by-step guide further explains how to farm yield via Uniswap on the Alpha Homora network.
● You have first to decide your role; it could be a lender, yield farmer, liquidator, or bounty hunter.
● After you decide on the role you want to play in the liquidity pool, you can now fund the pool. For instance, you can use the platform to become a liquidity provider to Uniswap by swapping the required amount to ETH for Uniswap.
● Your returns depend on the role you play. For example, liquidators earn 5% of the position value for supplying liquidity which helps to keep the protocol running. In comparison, bounty hunters who contribute to the liquidity will earn 3% of the total reward.You can check out the protocols earlier listed above in the article. Don’t think about investing because you like the names of any of the protocols or hearsays. Do in-depth research, ask questions, and then carry out a test with a few funds that you can manage if a loss occurs.