Nowadays, DeFi is changing finance. Unlike a few years ago, a central party was required for every transaction, but that is no longer compulsory. Consequently, you no longer need a third party to lend, borrow or transact. However, those would be impossible without Defi, a product of Blockchain that enables distribution and self-banking. Therefore, that brings us to newer concepts in finance like Yield Farming, Flash loan, liquidity mining, etc.
Meanwhile, we will focus on understanding Yield Farming, while mentioning other concepts and how they relate to it.
Nonetheless, this article goes beyond the background of Yield Farming, highlighting how to farm, the benefits of farming, and its opportunities and its risks.
Who are Yield Farmers and Liquidity Providers?
Let’s start with the definitions of Yield Farming and liquidity mining. Although there are lots of exciting things happening in the Open finance space, however, Yield Farming is one of the latest memes. Concurrently, Yield Farming is the newest method of earning and investing in Crypto. Likewise, liquidity mining is a market-making approach by token issuers to reward the community.
In simple terms, Yield Farming is a clever strategy to earn more with your Cryptocurrencies. Hence, it is an act of putting your Crypto to work by keeping Crypto temporarily at the disposal of some startup’s application to earn you more Cryptocurrency. Concurrently, Leeor Shimrom, a contributor at Forbes, defined Yield Farming as:
“The act of leveraging DeFi protocols and products to generate high rates of return, in some cases reaching over 100% annualized yields when factoring in “cashback” bonuses and incentives.”
Consequently, Yield Farming is a form of liquidity mining because both refer to how investors or protocols get rewards or provide rewards for the community. You provide liquidity to a project and earn interest as defined by the smart contract.
Therefore, a yield farmer or liquidity provider is someone who puts tokens or provides liquidity to a DeFi protocol to earn interest, while hoping to secure and decentralize the system. That being said, it provides protocol governance rights to the farmers.
For instance, Compound, a decentralized money market upon distribution of COMP token enabled liquidity providers to govern how the protocol works by voting with the COMP token while earning interest.
Other Projects Implementing Yield Farming.
Although Compound may not be the first platform to implement Yield Farming, it popularized the concept. It was after Compound’s success when it used yielding to outperform MakerDAO as the dominating DeFi platform that some other DeFi platforms like Curve, UMA, Balancer, KittieFight, and others started adopting its reward and governance model. For instance, KittieFight, a gamified DeFi lending platform, is using Yield Farming to attract liquidity providers, as well as improving the system government pending full operation of the gaming and lending platform.
Is There Any Risk to Yield?
Whenever you are yielding, it is helpful to remember that the higher the profit, the higher the risk.
Consequently, below are the various risks in Crypto farming and accompanied yield safeties.
While supplying liquidity or borrowing collateralized assets, make sure to caution volatile assets. What are the volatile assets? Volatile assets are assets that are not easily affected by market dynamics. Unlike stablecoins, like Dia, WBTC, USC, etc., liquidation of volatile assets are bound to affect farmers.
Liquidation occurs when there is a market swing. Therefore, assuming that you provided liquidity or borrowed volatile assets, be sure that you might lose some investment values.
However, you can reduce volatility risks in two ways:
Investing, borrowing, or supplying liquidity with stable assets. Although every asset responds to market scenarios, stable assets reduce liquidation risks.
Integrating DeFiSaver, a one-stop management app for DeFi that allows you to automatically keep your position at a certain ratio to protect it from liquidation or increase leverage based on market movements is something you should implement. However, there could be limitations, regardless.
There is usually interoperability between DeFi protocols. Hence, that could pose a risk to farmers when a protocol has some concerns like security. For instance, a gamer who borrowed from MakerDAO to supply liquidity to KittieFight may lose both sides when any protocols are exploited.
Smart Contract Exploitation.
In recent flash loans, assumed hackers siphoned over 50 ETH. They exploited the smart contract of the Aave protocol to obtain a flash loan, a zero collateral loan executable by the smart contract.
Therefore, such hackers could compromise the system you yielded on.
Although auditing by reputable firms are advised, there could still be possibilities of bugs. Hence, it could pose a Yield Farming risk to the community.
Ethereum Transaction Risk.
The price of supplying liquidity to a protocol often becomes high, therefore, leaving the farmers with the option of delaying the transition to a later date with a lower gas fee or bearing the high cost of the transaction.
Consequently, this risk is predominant because most DeFi protocols operate in Ethereum Blockchain. However, if there will ever be a solution, DeFi protocols should look for their Blockchains as well as Ethereum, finding a way to solve high transaction fees.
Yield farming is a rewarding opportunity for liquidity providers, as it helps improve protocol governance and decentralization. However, farmers should take measures to avoid the associated risks.
Okereke has a passion for researching blockchain and cryptocurrency. He enjoys creating long form educational content to inform others on the opportunities in this space.