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What Is The Yield Farming in Decentralized Finance (DeFi)

BitForex Editor
Sep 11, 2020

Yield farming is a process of putting your crypto funds to work to earn interest. It is also known as liquidity mining and is a method for users to create more assets through their own cryptocurrency. To put it simply, it is a process of depositing cryptocurrencies and getting rewards.

While yield farming and staking might appear similar, their differences become apparent when you begin to see the inner workings of yield farming.

One defining factor is that, as opposed to staking (buy & hold) your funds, yield farming interacts with participants also known as liquidity providers whose primary function is to add funds to liquidity pools.

What Is A Liquidity Pool? 

It is a smart contract that has funds locked in it. When liquidity providers fund a liquidity pool, they get rewarded either in single or multiple tokens and if the liquidity provider prefers, the reward can be refunded into other liquidity pools in order to earn rewards there too. Both the transactions and the rewards in Yield farming are ERC-20 tokens on Ethereum.

How Did It All Begin?

Yield farming beginnings can be traced to when the COMP token was launched.

When the COMP TOKEN (the token of the Compound Finance platform) too off, it granted governance rights to everyone who owned or held a token. However, the prevalent question was, how these tokens could be distributed in such a way that the network upon which it functioned could be further decentralized.

A method that was employed early on was the algorithmic dispersal of the highlighted tokens with the added incentive of liquidity. What this did was attract liquidity providers to 'farm' the governance token by depositing their funds and thereby adding liquidity to the pool.

This might not have created the process of Yield Farming, however, it was specifically the launch of COMP governance tokens that brought some fame to this method of distribution. After that incident, other projects and protocols under the DeFi ecosystem have all come up with inventive processes through which they have introduced liquidity to their individual and collective platforms.  

How does Yield Farming Works?

 The automated market maker provides a template through which we can understand how to Yield Farming works. At the basic level and like we mentioned earlier, it is a transaction between liquidity pools and liquidity providers.

First, a liquidity pool is funded when a liquidity provider puts in money/crypto and this gives the marketplace the required boost through which the users can either borrow, exchange, or lend tokens. Naturally, this will incur charges that are then transferred to the LP (liquidity provider) in relation to the amount they invested into the pool.

The way this works however still differs across boards considering the novelty of the tech itself. There will be other methods through which users will interact with the service in the coming years.

How To Earn Yield Farming Rewards

There is no hard-fast rule for earning with yield farming, the truth is that the methods are unstable and change very frequently with every platform having its own unique risks and rules. However, if you are still interested in the process then you must have a firm understanding of the processes of decentralized liquidity protocols.

The fundamental method of yield farming has already been treated in this article; a smart contract, deposit funds in it and earn on the funds deposited. However, as you begin to delve in, the methods begin to diverge into new territories. This is why the idea of putting in your hard-earned assets is strongly discouraged.

A rule of thumb to curb your overall risks; no matter what platform you utilize for 'farming', always have control over your investment.

There are a number of different platforms that are used for yield farming, they include Maker DAO, Compound Finance, AAVE, C.R.E.A.M,  UniSwap, and more

Yield Farming Risks

Yield farming itself is a very risky venture and it requires steps that are so complex, if you are a beginner in the world of DeFi, it is advisable not to engage. The truth is this, it is better suited for individuals with a lot of capital to deposit. While yield farming might sound simple on the surface, that is a smokescreen. If you venture into it without proper knowledge, you will lose all your money. Below, we deal with the risks associated with Yield Farming.

Smart contracts

Flaws and bugs in the smart contracts through which transactions are processed are one of the biggest risks of yield farming. A lot of different protocols on the platform are open source and so they were created by either individual users or teams on a shoestring budget.

This is, however, not a thing that is exclusive to yield farming because bugs are found everywhere. Even bigger organizations with all the resources at hand still have issues with defects and bugs in their system. It is just a risk that a user needs to be aware of.

Composability

DeFi protocols are designed in such a way that there is the ease of integration between themselves and are therefore permissionless. What this implies is that its total ecosystem is cradled entirely on its structure. This is what composability means; all elements within the system work together as a unit with parts.

The reason why this poses a risk is that since everything works together and all elements of the ecosystem are essentially reliant on one another, the whole ecosystem would be affected if just a single part of its structure were to malfunction. This is a serious threat to both yield farmers and the liquidity pool they interact in. Your trust has to be two-folds directed towards both the protocols that hold your assets and the other protocols that it works with that might not be directly related to how your asset is utilized.

Closing Thoughts

Yield Farming has taken the crypto community with a storm and it is the latest fad in 'town'.

Every day, the DeFi tech seems to be bringing newer and more mind-blowing innovations to the table and at this rate, it is difficult, if not impossible to determine what new applications will prop up moving forward. However, DeFi products and all its protocols have not and will not stop leading the fort in the crypto world of finance, science, and economics.

It is only a matter of time before users, developers, and money markets totally revolutionize the financial system to the point where it is more accessible to the world and completely in the hands of the people.

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