Yield Farming or Liquidity Mining is a developing mechanism of earning rewards from cryptocurrency capital investments. Yield farming follows the staking concept where funds are held in a crypto wallet to facilitate the transactions in a blockchain network. The digital funds held in the wallet can earn returns through a process of locking them. Liquidity mining funds are held in liquidity pools by liquidity providers (LP). They earn rewards for their investment in that exchange interface.
Yield farming is one of the popular DeFi solutions and allows investors to receive an interest for lending out their tokens. Its mainly used on the Ethereum blockchain.
The Role Of Liquidity Providers (LP)
Yield farming is not possible without LPs who stake their funds in liquidity pools. The collection of orders in such trade networks facilitates trading in cryptocurrency by creating a market. In business, they are colloquially known as market makers because they supply what buyers and sellers want to trade.
How is this achieved? You may ask. By putting up money pools, buyers and sellers can transact conveniently. Locating an individual buyer or seller may prove challenging and perhaps risky. A collection makes it possible for buyers and sellers to loan or request credit. Moreover, these exchange platforms also facilitate the swapping of tokens.
The pool acts as a smart contract where a buyer-seller agreement is coded and made available on the decentralized blockchain platform. Some of the leading mining platforms include Compound, Yearn Finance, Aave, Aleph.im, Serum, Uniswap, Curve Finance, and Maker DAO.
Yield Farming ROI: How Are Returns Calculated?
The most common computing methods of the expected interest from a farming investment use the annual basis in working out the gain.
Annual Percentage Rate (APR)
APR (Annual Percentage Rate) refers to the yearly rate of return imposed on borrowers, but paid to capital investors.
This methods most distinct feature is that the interest earned is not plowed back in the investment scheme to make more interest.
Annual Percentage Yield (APY)
APY (Annual Percentage Yield) is an annual rate of return charged on capital borrowers and subsequently paid to the capital providers. APY is distinct from APR only by the fact that latter allows compounding of interests to bring in more returns to the investor.
What are the risks of Yield Farming?
Farming is not immune to capital losses. The farming transaction involves surrendering of funds to a smart contract. The process involves virtual transaction protocols between two anonymous parties without a central enforcement body. If the protocols that access a given blockchain fall victim to a system error, then the financial information, including the contract codes, are lost. That means that the funds invested are also lost. If at all the blockchain blocked all forms of system delegation, then the records would be safe.
The smart contracts are mostly developed by anonymous developers who hold a substantial quantity of their own token. There will be a time where they will dump their tokens on the market.
Another risk is that the farmed token decreases in value. During the DeFi hype we see a lot of tokens promising high yearly returns. It looks very promising to investors, but nobody wants a 100% yearly interest on a token that plunged to $0,000001.
Like any other business person, a yield farmer needs absolute ingenuity to make high profits. A conglomeration of several mining strategies can make attractive profits: searching for the healthiest APR, farming with WBTC and USDT, swapping and borrowing many tokens in a single transaction, and striving for governance tokens.
The popularity of Yield Farming resulted in very high Ethereum gas prices. It isn’t profitable anymore to lend “small” amounts (1000 USD or lower).
We do think that there are currently more (long term) risks than profits to be made with yield farming.