Any method that locks in cryptocurrency assets to generate passive revenue is known as yield farming and is measured in terms of APY (annual percentage yield) or sometimes known as APR (annual percentage rate).
However, they are not the same thing as compound interest, which is simply a rate that accrues on both the initial deposit and the periodic accumulated interest, is not really factored into APR calculations, in contrast to APY.
All that matters in traditional banking (centralised finance) is making a deposit and receiving an interest rate. The bank will then have the final say over how to spend those funds for their range of financial goods.
There are no banking institutions in decentralised finance (DeFi). Smart contracts saved on blockchain networks have taken their place, and there are numerous potential for yield farming activities such as Staking, Liquidity Mining, and Lending/Borrowing.
Staking
Proof-of-stake (PoS) consensus algorithms are used by smart contract blockchain networks like Ethereum, Cardano, Algorand, Solana, Fantom, Polygon, and Avalanche to protect and validate their networks.
Staked cryptocurrency funds are used by each validator operating a PoS node (a computer storing the complete blockchain record) to validate transactions. As a result, validators profit from traders using the blockchain, a practice known as yield farming.
Liquidity Mining
A liquidity provider can lock up funds for either side of a trading token pair if someone wants to swap tokens. For example, ETH for USDT. USDT might be added to a liquidity pool by visiting Uniswap. Liquidity pools work as banking vaults but are also smart contracts. As a result, to exchange tokens, one would use this type of liquidity pool, generating revenue for liquidity providers (LPs). Liquidity Mining has been explained in detail below.
Lending/Borrowing
Traders who wish to borrow cryptocurrency instead of swapping tokens might lock in their liquidity providers’ cash into pools. Several DeFi protocols, such as Aave, Maker, Compound,dYdX, and SushiSwap, provide yield farming revenue to lenders.
Yield farmers frequently act as both lenders and borrowers. This is a much favoured activity because it allows users to yield-farm with borrowed money, relying on the appreciation of volatile assets to offset the cost of borrowing
Because of this, up to 90% of borrowed assets are stablecoins, but up to 75% of collateral is typically made up of volatile cryptocurrencies.
Yield farmers who lend and borrow would thus be able to maintain their initial deposits.
Naturally, the holders would have to liquidate if the value of the volatile asset decreased. APY yields on stablecoins are often the highest because demand is high and supply is limited.
A closer look at Liquidity Mining
The depth of market (DoM) is a metric used to quantify the tradability of particular asset. It is merely an illustration of all pending buy and sell orders compared to one another and organised inside an order book.
When the buy and sell walls are both high, it indicates that there are a sizable number of available orders that can be filled. A high level of market liquidity results from this.
The ask (red) and bid (green) walls are displayed in the visual order book. Strong DoM assets usually exhibit approximately equal wall heights, a sign of great liquidity. This is particularly valid for assets like Bitcoin (BTC) that have a high market capitalization (see image above).
On a decentralised exchange (DEX), investors may swap tokens in the same way that they would in a bank or forex market. A decentralised exchange such as Uniswap is also a decentralised application (dApp), which is only a user interface connecting the user to the smart contract on the blockchain. Uniswap’s smart contracts are specifically liquidity pools. They include trading pairs of tokens that other traders have contributed. On a centralised exchange, market makers provide liquidity.
Since, on a DEX, liquidity is provided by traders themselves, they accomplish this by locking up their assets in a liquidity pool of a specific trading pair. Afterwards, other traders can access that pool whenever they utilise the services of the DEX for trading, which compensates liquidity providers (LPs) for their decentralised service.
The above operation is carried out via a protocol known as Automated Market Maker (AMM). Apart from the funds, there are no prerequisites to become a liquidity provider (LP). Anyone having a MetaMask wallet can quickly and easily connect it to the Uniswap dApp, which connects to the smart contracts on Ethereum.
In case of lending protocols such as Curve, Aave or Compound, liquidity pools are available from which investors can borrow (to access liquidity pools) or lend (to lock in assets). Liquidity providers are also referred to as yield farmers or liquidity miners.
Through direct communication between traders and liquidity providers, DeFi establishes a whole new financial dynamic. Borrowers can pay off their loan at any moment, to start. Just this translates into leveraged longs and short sales, which is a common investing technique. Borrowing riskier cryptocurrency assets to be purchased later or borrowing stablecoins to purchase more volatile cryptocurrency assets.
When market downturns occur or in times of low liquidity, this can lead to liquidation events because of the volatile nature of cryptocurrencies, which is precisely what has occurred during many DeFi protocol crisis leading to their closure.
Apart from the liquidity crisis, there is also the issue of hacking. The DeFi market has suffered a lot due to frequent hacking events. Manipulative whales can also sometimes trigger a cataclysmic event when they decide to pull out assets leading to depegging of a stablecoin protocol (Terra Classic LUNC failure).
Offering liquidity carries a risk because it may result in impermanent loss. Once more due to cryptocurrency volatility, the token’s price can diverge from its locked-in liquidity pool price. The more the price difference, whether it is higher or lower, the more the transient loss (Impermanent Loss).
Disclaimer: This article was created for informational purposes only and should not be taken as investment advice. An asset’s past performance does not predict its future returns. Before making an investment, please conduct your own research, as digital assets like cryptocurrencies are highly risky and volatile financial instruments.
