All About Yield Farming in DeFi

Imagine if COMP holders decided, for example, that the protocol needed more people to put money in and leave it there longer. The community could create a proposal that shaved off a little of each token’s yield and paid that portion out only to the tokens that were older than six months. It probably wouldn’t be much, but an investor with the right time horizon and risk profile might https://www.xcritical.com/ take it into consideration before making a withdrawal. That said, distributing governance tokens might make things a lot less risky for startups, at least with regard to the money cops. So, Compound announced this four-year period where the protocol would give out COMP tokens to users, a fixed amount every day until it was gone.

Yield Farming VS. Staking: Which Is The Better Investment Strategy?

This is what makes yield farming ideal for investors who have the necessary liquidity and risk tolerance to invest in these protocols. When yield farmers switch between liquidity pools, they need to pay transaction fees to execute those transfers. Users on the Ethereum network may have to pay high what is defi yield farming gas fees for a simple on-chain transaction.

The difference between Yield Farming and Liquidity Mining

Appealing to the speculative instincts of diehard crypto traders has proven to be a great way to increase liquidity on Compound. This fattens some pockets but also improves the user experience for all kinds of Compound users, including those who would use it whether they were going to earn COMP or not. “The idea is that stimulating usage of the platform increases the value of the token, thereby creating a positive usage loop to attract users,” said Richard Ma of smart-contract auditor Quantstamp.

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Many of these liquidity pools are convoluted scams which result in “rug pulling,” where the developers withdraw all liquidity from the pool and abscond with funds. In LP farms, trading is limited to the cryptocurrencies provided by liquidity providers. Decentralized finance (DeFi) platforms incentivize liquidity providers with LP tokens, representing their deposits in the pool. These tokens enable providers to withdraw their deposits along with accumulated interest from trading fees at any time. During a bear market, investors and farmers reduce deposits into liquidity pools, negatively affecting the potential APY earned from yield farming.

Yield generation holds immense significance, facilitating substantial liquidity and offering easier access to loans for both lenders and borrowers. Those reaping substantial profits in yield farming typically wield considerable capital. Conversely, borrowers can access loans with low DeFi farms rate, or opt for higher interest rates with greater ease. Despite sharing similarities in practical application, each method serves distinct purposes and carries unique risks and rewards.

It utilizes the popular AMM model that allows users to trade against a liquidity pool. Liquidity providers receive an LP token representing their share of the popular pools on Pancakeswap that can be staked to earn CAKE tokens. One way is distributing such tokens algorithmically, including liquidity incentives. Since COMP was launched, many different DeFi platforms have offered brand new schemes to attract liquidity to a yield farming ecosystem. The value of digital assets locked in DeFi smart contracts went up rapidly from $670 million to $13 billion in 2020.

This prevents loss of funds from technical or fraud vulnerabilities more likely across complex farming protocols. Risk-tolerant investors may still utilize farming for short-term gains while staking core holdings for long-term security. But those with lower risk appetite tend to favor staking’s history and verification protocols for longer-term, buy-and-hold crypto asset approaches.

That’s one example of how to yield farm on a specific protocol within the DeFi ecosystem. Keep in mind that multiple YF strategies exist, and new ones pop up regularly. Pool’s activity is another factor that defines how much a participant can earn. Credible sources claim that 1.9 billion dollars are currently locked in DeFi.

Rug pulls are another common risk for new yield farming projects with shady, anonymous developers at the helm. Research has shown that users lost more than $10 billion from rug pulls and DeFi hacks in all of 2021. More recently, estimates attribute $158 million to DeFi hack losses for the month of November, 2023, compared to $184 million for CeFi hacks. As a result, an understanding of the differences between yield farming and liquidity mining could help make a wise decision.

Finally, it’s likely that DeFi will integrate more with traditional finance as time goes on. More and more, crypto and DeFi are seen as attractive investment opportunities for mainstream financial institutions as well as retail investors historically interested in stocks and shares. Impermanent loss occurs when the assets in a liquidity pool become imbalanced due to a heavy sale or buy of either asset in the pool.

• Impermanent loss isn’t technically a loss if LPs haven’t withdrawn their tokens from the liquidity pool and should even out again over time.
• A decentralized trading pair and the staking pool are not comparable, though.
• Learn what makes decentralized finance (DeFi) apps work and how they compare to traditional financial products.
• As this sector gets more robust, its architects will come up with ever more robust ways to optimize liquidity incentives in increasingly refined ways.
• This could reduce the overall expense of participating in staking for certain tokens.

This benefits liquidity providers because when someone puts liquidity in the pool they own a share of the pool. If there has been lots of trading in that pool, it has earned a lot of fees, and the value of each share will grow. In order to borrow some funds from the platform, a borrower will need to deposit double the borrowed amount as a form of collateral before proceeding to the deal. Using smart contracts, the value of the collateral can be checked at any point in time. If it is less than the borrowed amount, the contract can trigger to liquidate the borrower account, and interest is paid to the lender. This means the lender will never be at a loss, even if the borrower fails with repayment.

Usage of the Ethereum blockchain is the most notorious when it comes to YF. The decentralized finance space is currently worth more than $121.5 billion. Earlier, ETH blockchain has suffered from certain scalability problems.

However, certain tokens require a staker to commit a minimum amount of tokens to stake; for example, every validator node must stake a minimum of 32 ETH. Although not required, stablecoins connected to the USD are frequently used as the deposit method. USDT, USDC, BUSD, and other stablecoins are some of the most commonly utilized in DeFi.

Over time, Synthetix’s yield farming program shifted to begin providing SNX rewards to users who deposit sUSD (Synthetix’s stablecoin) on Curve Finance, alongside other popular stablecoins. Investors deposit their tokens into liquidity pools on dApps, providing the capital needed for lending, borrowing, and swapping on-chain. They receive LP tokens as receipts for their deposits, which entitle holders to fees and other rewards in proportion to their share of the liquidity pool. These LP tokens allow investors to withdraw their original deposits plus any rewards earned whenever they like. The amount an investor can earn by leaving their positions in the liquidity pool for a year is measured by the APY (annual percentage yield). It’s important to understand that yield farmers can increase their returns by leaving their capital and rewards in the pool to compound, boosting future earnings.

The bottom line is that liquidity providers get a return based on the amount of liquidity they provide to the pool. Besides fees, releasing a new token may play a role in encouraging money to be contributed to a liquidity pool. For instance, a token might only be available in modest quantities on the open market. On the other hand, it can be generated by giving a certain pool some liquidity. The purpose of this article is to explain what yield farming and liquidity mining are and how they work, the main differences between them as well as their upsides and risks.

Given the rollout of Kamino Lend V2, the protocol may scale aggressively over the coming months, penetrating previously untapped markets in Solana DeFi. If the price of ETH starts to drop, that means traders are selling ETH for DAI. This causes the ratio of the pool to shift so that it is more ETH heavy. Alice’s share of the pool would still be 25%, but she would now have a higher ratio of ETH to DAI. The value of her 25% share of the pool would now be worth less than when she initially deposited her funds because traders were selling their ETH at a lower value than when Alice added liquidity to the pool. Some fresh fields may open and some may soon bear much less luscious fruit.