Yield farming is a branch of DeFi or decentralized finance referring to users generating rewards or a ‘yield’ from their cryptocurrency holdings passively. DeFi applications use smart contracts and other permissionless protocols to enable these facilities without any middleman.
Yield farming involves an elaborate process of locking up one’s coins for a specific period. By the end of this time, the investor will hopefully earn more crypto than they began with initially. This article will cover, in more detail, this type of investment, what exactly is involved, and all the pros and cons.
What is yield farming?
Yield farming can serve a few purposes. The first is what analysts refer to as liquidity mining because whether a person or lends their coins directly to an exchange, and they are providing liquidity.
The incentives are clear; exchanges require as much liquidity as possible; for users to provide this, they are rewarded. Liquidity is the facility for a broker or an exchange to buy and sell a specific instrument in the market without bringing about significant changes to their prices.
A lack of this attribute comes with many problems, namely slower transaction speeds, increased likelihood of slippage, and a less deep order book.
Thus, the higher the liquidity, the faster transactions can occur, the cheaper the spread, and the more prices become stable. Another purpose for lending is for individuals and institutions to receive credit without going through the rigorous traditional financial system.
Another motivation for yield farming is staking. Countless cryptocurrencies rely on the proof-of-stake consensus mechanism to keep their networks secure and confirm transactions. Therefore, the two most well-known methods investors can partake in yield farming are staking and lending.
Despite seeming like simple concepts and passive investments, like any financial market, yield farming is not without risks.
Staking
Staking involves locking or freezing coins for a fixed period to support a blockchain network’s operations utilizing the proof-of-stake consensus mechanism to verify transactions.
After this time, the users receive a reward in the form of more coins. Unlike proof-of-work, which is essentially mining, there are no miners with staking because the blockchain prioritizes rewarding those with the largest stake in the protocol.
There is no process of computers solving mathematical equations for the right to add blocks. Developers of a particular cryptocurrency may provide staking directly from their wallets, or exchange will offer the service.
The potential earnings from staking depend primarily on the size of the stake from the user.
Pros
- Staking is a less energy-consuming endeavor compared to traditional mining with coins. It also requires far fewer physical resources.
- Staking makes confirming transactions on blockchains far more scalable. This attribute is one of the reasons why Ethereum, a project that was long associated with proof-of-work, is currently transitioning into proof-of-stake.
- A cryptocurrency using proof-of-stake is less susceptible to vulnerability attacks because of the enhanced security. It is also less vulnerable to bad actors because there are consequences of potentially losing the stake for any maliciousness.
- Staking allows for the luxury of receiving more crypto and still being able to profit from its potential future appreciation.
Cons
- Some projects using staking require a high minimum amount of coins for the eligibility to stake. Therefore, it can somewhat favor more affluent investors.
- Some cryptocurrencies will need the investor to stake for a specific period. Furthermore, once they’ve accumulated the rewards, there could be an ‘unbound period’ ranging from 7 to 21 days before they can withdraw.
In some cases, an investor may have gained bigger profits by simply buying the asset instead of staking it.
- Any investment in cryptocurrencies is not entirely devoid of risk since prices could fluctuate wildly, potentially making the coins less valuable for an indefinite period.
Lending
Lending is the other subset of yield farming where cryptocurrency holders lend out their holdings to lending platforms and exchanges to earn interest. These services then connect the lenders to ordinary folk and institutions looking to borrow coins outside of the traditional credit system.
Alternatively, as briefly mentioned previously, an exchange would benefit from lenders to provide liquidity in their platforms. Like staking, lenders enter into a contract to lend out for a particular period, usually starting from a week.
Depending on the platform, they could access the accrued interest daily or realize the total after the lending time is over.
What makes lending with cryptocurrencies less risky than lending fiat money is although no credit checks apply for borrowers, they will put up collateral in the likelihood of defaulting on the loan.
Of course, there is still the threat of price volatility as with any coin. However, becoming a lender through this channel is not as burdensome as lending real money in unsecured credit.
Pros
- Like staking, lending is a far less physical and complex method of earning with digital currencies. Aside from the financial commitment, it merely involves conducting proper research on a specific asset, having a wallet, and registering with a platform.
- It is a less risky way of putting one’s crypto holdings to work, making it a truly passive investment.
Cons
- Again, price volatility with cryptocurrencies is one of the main disadvantages.
- Although the annual percentage yields through lending can vary and are generally better than what a bank would offer for saving, an investor may need a more considerable investment to realize a significant gain.
Depending on the project in question, it could be more profitable to simply buy and hold a particular coin.
Final word
It’s incredible to think such complex financial procedures are occurring without any third-party authorities. The model of DeFi is truly disrupting the traditional industry, thanks to the beauty of cryptocurrencies.
As with any investment, one should never forget all the possible dangers one could encounter. Yield farming is one of the largest sectors in this space, with CoinMarketCap estimating that DeFi tokens currently boast a market cap of around $110 billion (at the time of writing).
There is presently little evidence that this will decrease anytime soon.
