What Is DeFi Yield Farming?: A Guide To Cryptocurrency Passive Income

Before the emergence of DeFi, we had the traditional Financial institutions and banks to oversee our finances.

The arrival of Decentralized finance (DeFi) has changed the way people manage their financial assets and investments.

Traditional banks offer their customers interests on their savings but after the stipulated period, the profits on those savings are too meager compared to what most DeFi protocols offer their investors.

This Post Contains

• What Is DeFi Yield Farming?
• Is Yield Farming Profitable?
• Is Yield Farming Risky?
• Best Yield Farming Platforms.

DeFi involves Decentralized Applications (DApps) that are used to carry out financial activities, through distributed ledgers (Blockchains), without the need for an Intermediary such as banks or other financial agencies.

What Is DeFi Yield Farming?

DeFi yield farming involves lending, liquidity mining and staking your digital assets (Cryptocurrencies) on DeFi platforms to earn rewards in exchange for your investments. Similar to traditional banks, DeFi yield farmers put their cryptocurrency to work in exchange for interests and rewards.

Liquidity providers (Users providing their cryptocurrencies for the functioning of the DeFi platform) provide their cryptocurrencies to a liquidity pool, a smart contract-based Decentralised Application (DApp) that holds all the funds. 

When the Liquidity providers stake their coins or tokens on the liquidity pool, they earn rewards in  transaction fees paid by users, interest generated from the underlying DeFi platform they provide liquidity on or the platform’s governance token.

The Return On Investment (ROI) is calculated using an Annual Percentage Yield (APY) method to estimate the profit the user makes on their stakes over a year.

Is Yield Farming Profitable?

Yield farming is profitable if you have a good strategy.

To illustrate, Yield farmers move their cryptocurrencies between different lending marketplaces to maximize the profits on their investments. 

For a Liquidity provider who has knowledge of the best yield farming strategies yield farming is more profitable than for others. However, as more people join a Liquidity pool, the APY reduces.

 For example the potential Annual Percentage Yield (APY) of a Yield farming protocol may be 10000% at launch but as more people join the protocol the number of tokens awarded as a reward by the smart contract may be the same but the percentage each person gets will reduce.

If you invest your funds in a good Yield farming protocol you can maximize your returns and earn good passive income.

Is Yield Farming Risky?

While yield farming may promise higher potential Return On Investment (ROI) than saving with a bank, more risks are associated with the DeFi investment protocols than with using traditional banks.

Here are some of the risks liquidity providers face.

1. Impermanent Loss

Simply put, Impermanent loss occurs when the price of the tokens you deposited into a pool changes compared to when you deposited them in the pool. It is the major risk that Users face when providing their funds on exchanges as Liquidity providers.

For example Harry invested 2 BNB & 20 BUSD in a liquidity pool, as the value of both deposited tokens need to be equivalent, Harry has invested $40 in total. 

Other users have also invested a combined 18 BNB & 180 BUSD in the pool which means there’s a total of 20 BNB & 200 BUSD in the pool (of which Harry owns 10% of the shares in the pool).

Later on the price of 1 BNB changes to 40 BUSD, despite the change, there’s still 20 BNB and 200 BUSD now in the pool. 

Remember the value of both deposited tokens need to be the same whereas 20 BNB is now worth 800 BUSD meaning we now have 800 BUSD worth of BNB against 200 BUSD.

When this happens, arbitrage traders will add BUSD to the pool and remove BNB from it until there’s a balance in the ratio of both deposited tokens therefore leading to a reduction in BNB and an Increase in BUSD in the pool.

 This results in a change in the ratio of both deposited tokens, there’s now 10 BNB (remember BNB was reduced from it’s initial 20 BNB to add more BUSD) and 400 BUSD in the pool.

If Harry decides to withdraw his own 10% shares from the pool he’ll get 1 BNB and 40 BUSD which is valued at $80 Harry made a profit of $40. However, if he had simply held on to the tokens in his wallet and not invested it, Harry would have $100 (2 BNB worth $40 each + 20 BUSD) instead of $80 and made a profit of $60 instead of $40. That is what Impermanent Loss is all about.

To tackle this risk, you can deposit two different Stablecoins (Stablecoins such as USDT and DAI are immune to Impermanent loss as their value is stable) in the pool. This will eliminate the risk of impermanent loss.

2. Too Dependent On Smart Contracts

Automated Market Makers use smart contracts to execute their transactions. Meanwhile smart contracts are not free from malfunctions and bugs which can easily be exploited by hackers who may still Investors funds from the DeFi yield farming platform.

Related: Advantages Of Decentralized Finance Over Traditional Finance

Best Yield Farming Platforms 

Despite the risks associated with staking and lending on decentralized applications (dapps), Yield farming is still a lucrative means to earn passive income and maximize the return on your investment if you use established exchanges and DeFi protocols as they’re more secure.

Here are the best platforms for DeFi Yield farming.

• Compound Finance

Compound is an algorithmic autonomous DeFi platform that offers users the opportunity to lend and borrow assets via the liquidity pool and earn rewards in return.

Compound allows users to deposit tokens such as Dai (DAI), Tether (USDT), Ether (ETH), USD Coin (USDC), Wrapped BTC (WBTC), Ox (ZRX), Basic Attention Token (BAT), and Sai (SAI) e.t.c. and earn rewards in the same tokens they deposited.

Lenders and borrowers on the Compound protocol also earn COMP (the governance token of the Compound protocol) which is distributed every day.

The DeFi platform currently has millions of dollars worth of cryptocurrency deposited on the platform.

• MakerDAO

MakerDAO is a decentralized autonomous organization (DAO) that allows people to Lend and borrow cryptocurrencies through smart contracts on the Ethereum blockchain without the need for an intermediary. 

Users can use DAI (MakerDAO’s stablecoin used to determine lending rates and rewards), MKR (MakerDAO’s governance token), ETH and other cryptocurrencies to lend on the platform and also use them as collateral to apply for loans. 

• Synthetix

Synthetix is a decentralized exchange (DEX) and a platform for users to exchange cryptocurrencies and also stake their SNX (Synthetix Network Token) tokens or ETH on the staking pool and mint synthetic assets (Synths) through their stake.

Liquidity providers are also rewarded on a weekly basis, with a share of the transaction fees on the Synthetix Exchange.

• Aave

Aave is an open-source autonomous protocol for users to Lend and borrow Cryptocurrencies. The protocol also has a Flash loan feature (A loan in which the borrowed amount is expected to be repaid in one transaction rather than in installments).

Lenders earn interest by depositing Cryptocurrencies into specially created liquidity pools and earn aTokens in reward from interests and transaction fees. Borrowers can also use their crypto as collateral to take out a flash loan with the platform allowing them to borrow upto 80% of the value of their collaterized assets.

Uniswap

Uniswap is the leading Decentralized exchange (DEX) on the Ethereum blockchain. Apart from ERC-20 token swaps, Liquidity providers can also deposit two tokens that are equal in value in the liquidity pool and provide liquidity for traders.

In exchange they earn interests and fees from trades on Uniswap.

Conclusion

DeFi yield farming is a profitable method of earning income, however you need to learn first and gain knowledge about the best strategies and platforms to maximize returns on your investment.