What Is Yield Farming?
Yield farming is the cryptocurrency equivalent of earning an annual percentage yield on deposits with banks. When investors participate in yield farming, their cryptocurrency value grows over time. Unlike APY with a bank, yield farming isn’t passive. At the most basic level, yield farming is a way of earning fees by lending cryptocurrency through smart contracts. It may sound simple, but there’s a lot to it.
How Does Yield Farming Work?
To be a successful yield farmer, investors have to understand the complex strategies behind the process. Earning a yield on cryptocurrency isn’t as simple as loaning money out one time. Instead, investors have to move their cryptocurrency around almost constantly.
The world of cryptocurrency is still young, and yield farming is even younger. Many yield farmers don’t share strategies with others, since more people practicing yield farming may lead to greater competition, decreasing overall revenue.
Cryptocurrency Lending Platforms
As cryptocurrency becomes more prevalent, additional financial tools for the niche emerge. Yield farming happens through decentralized finance lending platforms that are specific to cryptocurrency. Some of these platforms have algorithms designed to facilitate yield farming.
Users can lend or borrow any cryptocurrency on these platforms. They set ranges for rates so that cryptocurrency moves around automatically to “chase” the best opportunities. For example, users can set algorithms to automatically borrow cryptocurrency at low rates and automatically lend cryptocurrency at higher rates.
As long as they are earning more than they are spending, users can accrue cryptocurrency. This is a strategy that some people use with traditional money, too. They borrow at low rates and lend the money out to others at higher rates. While traditional currency offers the stability of set rates, cryptocurrency offers the potential for more lucrative earnings.
Earn Yields for Borrowing and Lending
Stablecoins are a type of cryptocurrency that is tied to a currency or other physical asset. Stablecoins get their name because they tend to hold a steady value instead of fluctuating dramatically. Trading in stablecoins offers specific incentives. For instance, users can earn an APY on stablecoin deposits.
Second, some lending and borrowing processes offer an additional coin or token of cryptocurrency for a transaction. Even borrowers receive incentives in the forms of coins and tokens – not just lenders. Users can then reinvest these bonus coins or trade them for cash.
Rewarding borrowers and lenders is a way of encouraging cryptocurrency users to stay active on a platform. The most active users have the opportunity to earn the highest yields. Platforms use coins and tokens to decentralize ownership, strengthening the cryptocurrency in the process. Stronger cryptocurrencies increase in value, attracting more users and repeating the cycle.
What Is Decentralized Financing?
Most people know that banks and credit unions use technology to facilitate financial transactions. What they don’t know is that there are restrictions on how technology can be used within banks and credit unions. Financial institutions have to stay within the boundaries of restrictions and regulations as well as meet service standards for customers. Lending and borrowing, in particular, are heavily regulated processes.
The Federal Reserve oversees all the money that is in circulation within the United States. Cryptocurrency is different because it does not have a centralizing entity. There are thousands of cryptocurrencies available with much fewer restrictions and no legal oversight to navigate. Because of this, cryptocurrency is often called decentralized finance, or DeFi.
Instead of limiting technology, decentralized financing embraces it. That’s part of what makes yield farming such a lucrative business for many cryptocurrency investors. The security of blockchain technology makes cryptocurrency easy to track from transaction to transaction and the freedom of DeFi places few, if any, limitations on borrowing and lending transactions.
Risks of Yield Farming
Before cryptocurrency investors begin yield farming, they should consider these key factors:
- Do they fully understand the cryptocurrency they want to lend or borrow?
- Is the coin stable enough to maintain a steady value over time?
- If the cryptocurrency loses value, are the earnings enough to cover the loss?
- If they lose a lot through yield farming, is it devastating to their overall financial portfolio?
Tips for Smart Yield Farming
Hacks are always possible, especially with smaller decentralized financing platforms. Because yield farming is relatively new, the risks are high as wrinkles get ironed out. Cryptocurrency investors can take on less risk with yield farming by:
- Borrowing and lending with the primary cryptocurrencies – Bitcoin and Ethereum
- Creating an account on the exchange for trading
- Only taking advice from trusted cryptocurrency sources
- Partnering with a firm that specializes in cryptocurrency to benefit from cryptocurrency expertise
- Understanding, and mentally preparing for, market fluctuation
- Treating yield farming as a long term commitment
Yield farming is currently experiencing growing pains. Some experts compare the state of yield farming to the beginnings of the internet. However, many of the struggles facing yield farmers are temporary. In the future, yield farming will likely be a much smoother process with clearer expectations for investors.
Yield Farming FAQHere are the answers to some of the most frequently asked questions about yield farming.
- Is yield farming safe?
- Everything comes with risk. Greater rewards often pair with higher risk, and the same is true with yield farming. Staying on the "main track" of established yield farming practices will prove safer than chasing the latest tactics, but may not be as profitable.
- Is yield farming different from staking?
- The two are similar, but staking is different. When investors stake cryptocurrency, they lock in coins as a way of supporting the security of the cryptocurrency as a whole. Staking is similar to purchasing shares in a business because investors get rewarded for staking coins based on the coins' market performance.
- What are the decentralized platforms that support yield farming in cryptocurrency?
- The primary platforms and protocols that investors use for yield farming include:
- -Compound Finance
- -Curve Finance
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- Binance. "What Is Yield Farming in Decentralized Finance (DeFi)?"
- Harvard Business Review. 2021. "What Happens When Cryptocurrencies Earn Interest?"
- Forbes. 2021. "Decentralized Finance Is Building A New Financial System."
- Forbes. 2021. "DeFi ‘Yield Farming’: How To Get DeFi Yield, And Why Invest In It."
- Business Insider. 2021. "Crypto ‘Yield Farming’ Is Reportedly Booming, and Investors Could See."
- Binance. "What Is Staking?"