As more and more innovations infiltrate the cryptocurrency space, a new term is often created to identify the innovation and the practise of the innovation.
Yield farming is the hottest new term in the crypto space right now. Simply put, yield farming is a way of earning crypto with the crypto you have already. It involves lending money out to others, the lending process is backed by smart contracts and in return for the service of lending you earn crypto. There are far more complexities to yield farming but lending and commission is the whole idea behind the concept.
Yield farming grew out of the DeFi (decentralized finance), DeFi, which is also one of the relatively new buzzwords in the crypto space, brings more features of traditional banking to the digital sphere of crypto. Features like borrowing and lending are some of the upgrades in the world of crypto.
How it started
On the 14th of June, an Ethereum-based credit market called Compound, began distribution of its token known as the COMP token. The COMP token is a governance token, its live distribution was so successful that the platform reached $600 million in Total Value Locked (TVL). This made compound a big name in the world of decentralized finance. The large sale of these governance tokens got people interested in Compound. As a result, putting crypto that would have otherwise been sitting idle in a wallet, at the disposal of Compound, meant fairly high returns
What are tokens?
Crypto tokens are also digital currencies but they are quite different from actual crypto currencies. Tokens are also called crypto assets, they are special types of assets within the blockchain of a particular cryptocurrency. They can be used within the blockchain of that crypto currency. Sometimes, they are used as ICOs (Initial Coin Offering), like buying shares of a company, crypto tokens are like money that can be used for specific purposes within an application. They are like getting voucher cards on an online shopping platform, but can only be used on that platform. Just like shopping vouchers, tokens can be used as reward systems for network participants.
Tokens are built over an existing blockchain, so, unlike an independent crypto like Ethereum, tokens cannot stand alone. Whilst ETH is an independent currency of the ethereum blockchain, ERC20 is a token built on top of that blockchain.
Again, governance tokens differ slightly from regular crypto tokens. this governance tokens, give holders power to make changes to the governance parameters.
How exactly does yield farming work?
Yield farming is essentially putting your crypto in a credit based market like compound and expecting returns. Yield farming involves liquidity providers and liquidity pools. The liquidity providers are the yield farmers who put their crypto in liquidity pools where others can lend the crypto. By using this service a cost is incurred, the liquidity providers are then paid from the amount incurred by the users of the service. The payment depends on their stake in the liquidity pool.
All these activities are done with smart contracts on the ethereum blockchain. The smart contract decides the specifics of the interaction between lenders and borrowers. It decides how much interest the borrower pays.
Funds deposited into the liquidity pools are usually stable coins pegged to the dollar, as it is easy to track profit and losses with them. Cryptocurrencies like ETH can also be used. Profits on yield farming are annualized. Essentially, what has been earned can only be evaluated after a year.
Is yield farming a guaranteed profit making venture?
Yield farming is a complex process and can be very risky. Yield farming works best when there is enough capital to put in. Some suggest that it is a venture best for whales, who have a very deep supply of capital. Yield farming involves reading of smart contracts and other complex activities, a lack of understanding of these activities will most definitely lead to a loss.
Volatility could also cause losses, if there is a sharp drop in price of the stake put in a liquidity pool, the value of the stake drops lower than the initial amount put into the stake.
Yield farming is still a new niche in the world of crypto and DeFi, although it has been profitable for some, it will go through a series of evolutions before it becomes profitable for many.