The emerging advancements in the world of crypto have created many new opportunities while leaving beginners in awe. If you want to navigate the crypto world, then you should be familiar with the newly arriving buzzwords and trends. Many people don’t have a clear idea of how crypto can offer promising ways for earning value with their crypto assets. This is where you could find the continuously rising popularity of yield farming making formidable highlights in the present times.
At the same time, the growth of decentralized finance or DeFi is also indicating favorable implications for yield farming in crypto sphere. Are you excited to learn about the “yield” in the case of crypto and how you can farm it? The following discussion offers you a detailed overview of the concept of farming yield in the case of crypto. You can learn how it works, what it offers you, and the risks involved with it.
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What is Yield Farming?
One of the first things that would come to mind during discussions on yield farming in crypto, especially the definition. Let us take a look at the background before moving towards the definition of farming yield in crypto. According to various credible sources, the Total Value Locked or TVL in DeFi ecosystem has surpassed $200 billion.
At the same time, cryptocurrency holders have been contributing additional value to various DeFi applications, with special emphasis on generating yields. As a matter of fact, yield farming is probably one of the formidable reasons that draw people to DeFi. However, the concept of yield generation could be a bit confusing topic for beginners, just like other crypto and blockchain concepts.
The beginning of the concept of yield generation found new directions with the arrival of the COMP token with Compound Finance. COMP token is basically an ERC-20 token, which can provide authorization for community governance in the Compound Finance protocol. The owners of COMP tokens could make suggestions and vote on any changes desired in the protocol. The governance coins help in passing the ownership rights to different asset holders.
It is reasonable to wonder about the possibilities of leveling up the decentralization in the network. The most common approach, in this case, would refer to the algorithmic distribution of tokens alongside liquidity incentives. As a result, it is more attractive for market makers as it can offer prospects for the creation of new tokens and offering liquidity. Since the launch of the COMP yield farming token, many new DeFi platforms have come up with new ways for encouraging liquidity in DeFi.
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Understanding Yield Generation
The background of yield farming clearly shows some details about what it is and how it works. At the most fundamental level, yield generation or farming is basically a process in which crypto holders have to deposit their assets for procuring rewards on the same. The process could help crypto holders in earning fixed or variable rates of interest through crypto investments in the DeFi landscape.
It focuses on lending cryptocurrency through the Ethereum network, which is presently powering the DeFi movement. In the case of traditional banks, you must repay back a loan along with interest. You can also find a similar concept in the case of yield farming for crypto assets in the present times.
Yield generation or farming lets you make the most of your crypto assets without letting them sit comfortably. With this concept, your crypto assets would no longer rest in your wallet or an exchange. On the contrary, yield farming rates could be appealing enough to lend your crypto holdings through DeFi protocols for garnering favorable returns.
As you have noticed already in the case of Compound Finance, yield generation or farming involves the use of ERC-20 tokens, and you would get the returns in the form of ERC-20 tokens. Even if such conditions could change in the future, Ethereum is presently the playground for yield farming transactions.
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Working of Yield Farming
The discussions on yield farming rates and the process itself would be incomplete without reflecting on how it works. Yield generation starts through the addition of funds to liquidity pools, which are basically smart contracts containing funds. The liquidity pools drive a marketplace that enables users to exchange, borrowing or lend tokens. After you add your funds to the liquidity pool, you can take on the identity of a liquidity provider. Users would get the reward in terms of fees originating from underlying DeFi platforms for the assets you have locked in them.
It is important to note that investment in ETH does not qualify as yield farming. On the contrary, lending out ETH over a decentralized, non-custodial money market protocol qualifies as yield generation. Reward tokens could be deposited in liquidity pools, and people could shift funds between different protocols for chasing higher yields.
The concept of yield generation is quite complex, and farmers must need experience in the Ethereum network and associated functionalities. Subsequently, they could transfer their funds across different DeFi protocols for achieving the best returns. Yield farming in crypto is not an easy concept, and people offering liquidity receive the rewards according to the amount of liquidity. Therefore, the farmers who have huge amounts of capital backing their ability to offer liquidity are likely to earn more profits.
Types of Yield Farming
You can discover two distinct variants of yield farming with liquidity pool or LP farms and with staking farms. In the most basic sense, the farming opportunities in these variants focus on users having to deposit cryptocurrency in smart contracts. However, the difference is largely evident in the type of smart contract. A deeper insight into the types of yield generation or farming approaches could help in understanding yield farming comprehensively.
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Liquidity Pool or LP Farms
In the case of a liquidity pool farm, users have to deposit crypto assets in a smart contract that has been programmed for offering a liquidity pool. You can find the functionality of such pools similar to a decentralized trading pair involving two or multiple cryptocurrencies.
Trading is possible in the LP farms only with the cryptocurrencies offered by the liquidity providers. Decentralized finance or DeFi apps provide rewards to the liquidity providers with LP tokens in return for their deposits. The yield farming token could help in retrieving the deposits underlying the liquidity pool at any particular time, along with the added interest in terms of trading fees.
The liquidity provider tokens are significant since DeFi apps operating liquidity mining programs establish staking interfaces to deposit the liquidity provider tokens. As a result, you can lock in your liquidity, followed by automatic and continuous governance token rewards for lock-in.
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Stake Farms
Stake farming is another yield-generation approach that has been gaining the attention of investors. The approach involves a user depositing crypto assets in a smart contract that has been programmed to offer a staking pool. However, the staking pool is not similar to a decentralized trading pair. On the contrary, it is more like a decentralized vault for a specific type of asset.
The stake farming approach in yield farming does not offer flexibility for trading and focuses on securing the deposits. The stake farms could facilitate a streamlined experience for users in comparison to liquidity pool farms. Stake farms only demand that users must deposit a single asset to earn passive income as compared to working in the role of a liquidity provider on a decentralized exchange. Subsequently, they also focus on staking the liquidity provider tokens.
Other Yield Generation Variants
When you need to find out more about yield farming in crypto, you don’t have to settle for liquidity pool and stake farming only. Many new DeFi projects have introduced new liquidity mining programs, with new variants of DeFi activities being associated with incentives in the form of governance tokens. Here are some of the other types of yield generation that can help you understand ‘how yield farming works’ in a comprehensive manner.
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Insurance Mining
Insurance mining focuses only on yield farms to reward users who have to deposit assets in the decentralized insurance funds. The decentralized insurance funds are highly risky as the successful insurance claims would be taken from them. Depositors in such type of yield generation could enjoy yielding farming rates on the funds they put on the line for safeguarding projects.
You can find a clear example of such a system in the case of the liquidity stability pool. Then, people would supply the LUSD stablecoin in the pool as the backdrop for the lending protocol of liquidity. Users receive the yield farming rewards in the form of LQTY tokens, the native token of Liquity.
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Arbitrage Mining
Another emerging example to show ‘how yield farming works’ from a different perspective is arbitrage mining. The process of arbitrage mining focuses on yield farms that provide incentives, particularly for arbitrage traders. Arbitrage traders leverage market discrepancies throughout the DeFi ecosystem.
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Trade Mining
You could also understand ‘how yield farming works’ in a different way by reflecting on trade mining. It is basically the same process as arbitrage mining. However, the formidable difference in this case directly points out to undertaking simple trades for earning token rewards.
A clear example of an early player in the domain of trade mining would point towards Integral. It is a hybrid AMM/order book decentralized exchange, which has the potential to revolutionize yield farming. After its launch in March 2021, the platform has awarded ITGR governance tokens to traders who use the incentivized pools.
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Special Highlight of Yield Farming
The concept of a yield farming token itself is unique and groundbreaking in the DeFi space. Yield generation has become a go-to term for many people trying to explore the DeFi ecosystem right now. One of the foremost benefits of yield farming is directly evident in the lucrative prospects for profit. If you are an early player in a new project, then you could procure token rewards, which can escalate in terms of value. You could sell all the rewards for a profit or opt for reinvesting your rewards.
Presently, yield farming could offer more attractive returns in comparison to traditional banks. However, there are many other risks associated with yield-generation activities. You can discover variable yield farming rates as one of the foremost risk factors in the case of yield generation. As a result, you could discover many difficulties in forecasting the type of rewards you can expect over the next year. As a result, you can clearly notice that yield farming in crypto comes with a certain share of risks. Furthermore, you should also note that the DeFi space inherently presents many formidable risks that could affect your yield generation pursuits.
The Prospects with Yield Generation
While it is clear that yield farming offers a plausible set of advantages as well as risks, many people would reasonably wonder about the prospects of yield generation. What is in there for you to care about yield generation? Look back one year, and you could find that the Ethereum network was a thriving playground for earning profits through yield farming in crypto. The majority of DeFi platforms have been developed on Ethereum. As a result, one can clearly notice the lucrative promises people have perceived with the DeFi landscape.
Yield generation is highly significant as it could offer substantial levels of liquidity in the initial stages. However, it is highly suitable for lenders as well as borrowers as it can enable easier facilities for taking out loans. The people who make massive profits in yield farming generally have a substantial amount of capital backing them up.
On the other hand, people wishing to take any loan could have crypto with low yield farming rates going as down as 1% APR. Borrowers could also lock their funds in an account offering higher interest with improved simplicity. Now, there are still some possibilities for earning massive yields on assets in comparison to traditional financial services.
It is also important to note that yield generation is still a debatable topic in crypto. Some sects of the crypto community do not perceive yield farming as a significant intervention. Interestingly, some experts in the crypto space have also requested people to refrain from yield generation. For instance, flash farms are one of the notable objects of critique for Ethereum developers due to higher risk levels.
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Associated Projects
You can find a wide variety of DeFi projects presently associated with yield generation. Presently, Aave is the biggest DeFi protocol in terms of the value locked in smart contracts. Aave helps users in lending and borrowing various cryptocurrencies. You can also find another notable DeFi protocol for yield farming in crypto with Yearn Finance.
The protocol can work for moving the funds of users among various lending and liquidity protocols for earning prolific interest rates. The most distinct example of a DeFi project associated with yield generation would refer to Compound. It works as a DeFi platform where users can procure favorable returns on the crypto assets locked in them.
Best Practices for Yield Farming
The next important factor in understanding yield farming tokens and their usage refers to the best practices. It is important to note that yield generation is not an easy affair, to say the least. Many projects such as Compound and Aave have been working on improving the accessibility of borrowing and lending in DeFi. The best yield farmers could earn lucrative interest rates at par with 100% APR for renowned stablecoins, with varying strategies. Here are some of the most important highlights among DeFi platforms that show the best practices for yield generation.
Borrowing funds could help you earn the yield farming token as a reward, and you get more tokens as you borrow more.
If the rewards surpass the cost of borrowing fees, then you can continue borrowing for farming rewards.
Another best practice for yield farming crypto assets would rely on the compensation of liquidity miners for borrowing and lending. In this case, you can lend the asset with the highest interest rate and then borrow the amount you want in return for the tokens. Subsequently, you should also return the remaining assets to the lending pool.
All of the best practices point out the need for keen observation of the value of assets. At the same time, you should also take note of the market trends and emerging practices in yield farming for the best returns.
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Bottom Line
The concluding note about yield farming in crypto would refer directly to the simple nature of the approach. However, it is too soon to develop accurate predictions about the future of yield generation approaches with such dynamic advancements. For instance, some people have been pointing out the possibilities of bursting the bubble at a particular point in time.
One thing you can note in particular in this case would refer to the anticipation and hype associated with yield generation. The high risks in yield farming, along with the high rewards, present a balanced impression of its future. Learn more about yield generation and how it plays a crucial role in the DeFi sector now.
*Disclaimer: The article should not be taken as, and is not intended to provide any investment advice. Claims made in this article do not constitute investment advice and should not be taken as such. 101 Blockchains shall not be responsible for any loss sustained by any person who relies on this article. Do your own research!
