DeFi, a financial technology that aims to eliminate intermediaries in financial transactions, has opened up many opportunities for investors to earn passive income. One of them is yield farming. This new concept of decentralized finance allows you to maximize your return on capital by using various DeFi protocols. So how to make money with yield farming? What are its advantages and disadvantages? Let’s check it out!
What is yield farming?
Yield farming, also known as token farming or liquidity mining (LM), is a strategy of investing in DeFi decentralized finance. It involves borrowing or betting on cryptocurrency tokens to earn a predetermined reward – the so-called “stabilization fee”, depending on which contract and how much we freeze our funds in. Users can earn fixed or variable interest by investing in cryptocurrencies in the DeFi markets. Their role is to provide the liquidity necessary to facilitate the transaction of a specific token pair on the platform.
In the case of many DeFi projects, in addition to the profits drawn from cryptocurrency deposits themselves, customers can count on additional earnings in the form of tokens of a particular protocol. The solution, which is yield farming, resembles a bank deposit – in the case of which by depositing money in the bank and “freezing” the capital for a specified period, we allow the bank to turn our money. The reward for this is the interest paid to us. Yield farming is currently the most critical growth engine of the decentralized finance sector.
How does yield farming work?
Users who provide their cryptocurrencies to DeFi platforms are liquidity providers (LPs). They guarantee the coins or tokens that go into a liquidity pool – an innovative decentralized dApp-based application that pools all funds. The yield farming functions are based on the Automated Market Maker (AMM) model. The locking of said coins and tokens results in paying a fee or interest to investors. The entire lending process is done through smart contracts without any intermediaries. Most of the farming is done on the Ethereum platform. The rewards paid out are a type of ERC-20 tokens. Lenders make money from the price fluctuations of these tokens.
Yield farming versus staking – making money with cryptocurrencies
There are several popular ways to earn a significant passive income in the cryptocurrency market. Yield farming is an exciting alternative to staking. It is defined as earnings from blocking cryptocurrency on a particular network to ensure the security and operation of the blockchain network. While both methods can generate profits for the investor, yield farming is considered riskier than staking, yet more profitable than it.
Popular yield farming protocols
Yield farmers can maximize returns on invested funds by using various DeFi platforms. They offer multiple options for incentivized lending and borrowing from the liquidity pool. The most popular yield farming protocol is Compound, used to lend and borrow assets. Investors earn money from it by receiving interest for the funds they lend. MakerDAO is also a well-known protocol. It allows users to lock up cryptocurrencies as collateral assets to borrow DAI, a USD-settled stable token. Other noteworthy yield farming protocols include:
The different protocols offer different levels of risk and reward. Experienced DeFi market users can use other platforms to reap maximum profits. While earning the passive income, they can further reinvest the profits, gaining more and more.
Advantages and disadvantages of DeFi farming
Farming is undoubtedly one of the most exciting concepts to earn passive income on the cryptocurrency market. The critical advantage of farming is the possibility of attractive earnings. The amount of profit earned depends primarily on the type of tokens we decide to provide liquidity. If you want to multiply your funds this way, it is worth choosing popular tokens, which will allow you to earn commissions related to trading. Average profits from farming may vary from a few to a dozen or so per cent – it is much higher than traditional bank deposits. At the same time, investors support the whole cryptocurrency and DeFi sector because many entities receive favorable trading conditions thanks to the liquidity provided.
Despite its advantages – mainly tempting profits, yielding farming is not without disadvantages. Resembling bank deposits, DeFi farming is more unstable and complicated in comparison. It also involves the risk of loss, which may result from the change in the ratio of tokens in a given pool in relation to each other. Liquidation of collateral is also a significant risk, which can happen if an asset loses value. When borrowing funds, we must be able to cover such collateral. Otherwise, the collateral can be liquidated, and you will lose money. For these reasons, yield farming is not recommended to beginners for too complicated and unintuitive.