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A straightforward way of getting APY on your capital is through lending and borrowing. For example, the farmer can supply a stable coin like DAI on a lending platform and start to get some returns on their capital. With liquidity and leverage, they can then take that to the next level. However, the second wave of DeFi enabled by the Ethereum blockchain added another layer of programmability to the technology. Almost all DeFi applications are built on the Ethereum blockchain, what is defi yield farming a network that maintains a shared ledger of digital value.
What are the different types of cryptocurrencies? Understanding token types
Yet another way to generate extra returns on your crypto assets is by becoming a liquidity provider for a decentralized exchange. When someone goes to Uniswap to exchange their Ether for DAI, for example, Uniswap will take some DAI from the liquidity pool and add the Ether the user is exchanging. That allows Uniswap to offer exchanges for just about any cryptocurrency pair you can imagine without having to hold any crypto itself. There has been a rise in risky protocols that issue so-called meme tokens with names based on animals and fruit, offering APY returns in the thousands. It is advised to tread carefully with these protocols, as their code is largely unaudited and returns are whim to risks of sudden liquidation due to price volatility.
Risks and challenges of DeFi yield farming
- Liquidity providers can also do this by adding their yields to the pool, adding more liquidity.
- A turbulent asset can have a significant price swing in a short moment.
- Derivatives like perpetual futures and options are widely used in crypto.
- In the future, it will probably6 be standard to buy property or land using dApps using smart contract agreements.
Examples of decentralised finance (DeFi) protocols for yield farming include Uniswap, Aave, PancakeSwap, and Crypto.com. The main types of yield farming include providing liquidity, lending, borrowing, and staking. Losses could occur due to price fluctuations of tokens, including impermanent loss, when the price of one token changes in relation to the other during the time that the coins are locked in a liquidity pool. Instead, they earn a percentage of network fees when they validate transactions. When compared to liquidity pools, staking has much lower maintenance costs. Yield farmers must consider the possibility of paying high gas fees when determining whether to shift assets between liquidity pools.
For the purposes of crypto, liquidity most often refers to financial liquidity and market liquidity. Security products and services are offered by Galaxy Digital Partners LLC, a member of FINRA and SIPC. For more information about Galaxy Digital Partners LLC, please see our Form CRS and additional disclosures related to Regulation Best Interest.
Of course, you should be aware of the drawbacks and risks to yield farming and liquidity mining. Liquidity mining is an excellent way of earning passive income for the LPs, similar to passive stakeholders within staking networks. Rug Pulls are an exit scam where a cryptocurrency creator collects money from investors for a product, abandons it, and keeps the investors’ money. Rug pulls and other scams, to which yield farmers are especially sensitive, are responsible for almost every significant fraud that took place in the last couple of years.
WBTC can be traded back for BTC at any time, so it tends to be worth the same as BTC. DeFi, however, offers ways to grow one’s bitcoin holdings – though somewhat indirectly. These initiatives illustrated how quickly crypto users respond to incentives. Every day, the Compound protocol looks at everyone who had lent money to the application and who had borrowed from it and gives them COMP proportional to their share of the day’s total business. Users making big bets on these products turn to companies Opyn and Nexus Mutual to insure their positions because there’s no government protections in this nascent space – more on the ample risks later on.
Making investment decisions should be based on an investor’s risk tolerance. The truth is that the higher the potential of rewards in the cryptocurrency world is, especially on DeFi, the less likely the project will be workable for a long time. Identify the factors most important to you, such as security or passivity, and build a strategy around them.
Any individual with access to the internet and a supported crypto wallet may interact with DeFi applications. Curve also has its own token, CRV, that is used for governance for the Curve DAO. Keep in mind that the two measurements are merely projections and estimations. Yield farming is a highly competitive, fast-paced industry with rapidly changing incentives. MakerDAO had one so bad in 2020 it’s called «Black Thursday.» There was also the exploit against flash loan provider bZx.
Many DeFi protocols reward yield farmers with governance tokens, which can be used to vote on decisions related to that platform and can also be traded on exchanges. These risks include impermanent loss, smart contract vulnerabilities, market volatility, liquidity risks, regulatory uncertainties, overleveraging, and unknown protocol risks. It’s essential to understand these risks and practice proper risk management when participating in yield farming.
On the other side, there are borrowers—market participants who use one token in a pair as collateral and are lent the other token of the pair. This activity allows the users to farm the yield with the borrowed coin(s). This means the farmer retains their initial holding, which could rise in value, and earns yield on their borrowed coins. In June 2020, the Ethereum-based credit market known as Compound began offering COMP, an ERC-20 asset that empowers community governance of the Compound protocol, to its users. To show the process of yield farming on DeFi protocols, we’ll use Compound as an example of how yield farming works. Curve Finance is a decentralized exchange protocol designed specifically for efficient stablecoin swaps.
They also present different risks, which should be considered before either strategy is pursued. Similarly, EOS is a blockchain where transactions are basically free, but since nothing is really free the absence of friction was an invitation for spam. Some malicious hacker who didn’t like EOS created a token called EIDOS on the network in late 2019.
Impermanent loss as a liquidity provider is a key concept to understand. If the price of one part of the pair moves significantly relative to the other part, you will face impermanent loss. The last way we’ll discuss is becoming a liquidity provider for a decentralized exchange — such as Uniswap (UNI -5.98%) or Pancakeswap (CAKE -1.41%). Providing a pair of crypto tokens in equal amounts to a decentralized exchange allows it to perform swaps for investors looking to exchange one cryptocurrency for another. As a liquidity provider, you’ll earn a portion of the fees collected by the exchange in return. Blockchains that use a proof-of-stake system — such as Solana (SOL -2.81%), Cardano (ADA -1.27%), and Polkadot (DOT -4.74%) — reward stakeholders for confirming transactions on the blockchain.
If users decide to withdraw their assets when token prices have deviated from their time of deposit, impermanent loss becomes permanent. Yield farming requires a pair of tokens like USDT-USDC or ETH-DAI for providing liquidity to liquidity pools. Users can provide a flexible ratio of these tokens to the trading pair for customizable pools. However, they must supply tokens in a ratio to equilibrium pools with trading pairs holding equal value. The smart contracts of staking protocols programmatically ensure users cannot withdraw funds before the unbonding period ends.
An example is Bob, who, by using a stop-loss order, can automatically take his liquidity out of a pool if the value of his assets drops below some threshold. In this way, he tries to minimize potential losses in every circumstance. However, some drawbacks to consider are the high Ethereum transaction fees and network congestion, often making gas costs on DeFi prohibitive for small investors.
Liquidity tends to draw in even more liquidity, much like centralized exchanges. Yield farmers are willing to take high risks to hit double or triple digits APY returns. The loans they take are overcollateralized and susceptible to liquidation if it drops below a certain collateralization ratio threshold.
Instead of letting these assets sit idle in their crypto wallet, they can put their coins to work by lending or depositing them on various DeFi platforms. These DeFi platforms can be decentralized exchanges (DEX), lending and borrowing platforms, yield aggregators, liquidity protocols, or options and derivatives protocols. Users who do not wish to trade crypto may be able to generate revenue on their holdings through yield farming and staking. Although each strategy offers different benefits and risks, both can be used to generate returns. Yield farmers don’t need to lock their crypto in a liquidity pool for a set period of time to earn rewards from yield farming protocols.
Let’s take a look at yield farming risks you have to be aware of before depositing your first tokens in a yield farming DApp. The farming transaction includes virtual transaction protocols between a couple of anonymous parties with no central enforcement body. In the case of blockchain blocks all shapes of system delegation, the records would be secure.
