We’ve run through liquidity pools and staking in recent weeks. Another useful tool in the world of DeFi is Yield Farming. The total value of DeFi jumped from $18.71 billion on January 1st 2021 to nearly $260.12 billion on the first of December later that year. With a majority of the leading DeFi protocols being centered around lending, it shows there’s plenty of opportunity in yield farming.
WHAT IS YIELD
Before we break down yield farming, we first have to understand yield. Yield is the return on investment over a set period of time, most often annually. Yield usually requires price increases, dividend payouts, or interest rates to return more money than previously lent or invested. Trading fees can also serve as a payout to lenders or holders in crypto.
INTRO TO YIELD FARMING
Yield farming is one way for cryptocurrency holders to earn more while idly holding their coins. In DeFi, cryptocurrency and tokens are given to the liquidity providers for investing and holding their tokens, thus adding to the liquidity pool. These holders allow for stabilised trade and other protocols to commence by providing to the liquidity pools through lending, which adds value to the market. The next thing to know about earning in yield farming is that it can be done in several ways:
- Staking
- Providing Liquidity (for Liquidity Pools – LPs)
- Lending / Borrowing
Staking is usually seen as the safer play of the three, where people lock up their crypto to help a network secure transactions, earning them rewards through the network. Staking has an average annual yield of 4-10%.
You can earn through the second way by providing liquidity for LPs and in turn, since you have ownership of whatever percentage you provided, you’ll receive a payout of that total percentage in LP swap fees.
Lending can be a hybrid that dabbles in both of these two. These loans – be it lending or borrowing – are backed by collateral. This means you must lend your own coins before borrowing against them, and if you don’t end up returning the borrowed amount, you’ll be liquidated (lose possession of your original coins). So how can this yield money in a different way than staking or pools?
HOW TO EARN : THE CORE OF YIELD FARMING
Yield farming, to be precise, is when you take an investment and use it to gain annual interest on, but also grow that initial investment without having to add any new coins out of your own pocket. Let’s explain this real quick. Keep in mind that you can lend and then borrow from a variety of different coins.
Now say you lend $1000 of ABC coins out of your own wallet to a DeFi lending platform in order to earn the 20% APY (annual percentage yield) for holding ABC tokens. The collateral factor of ABC coin is 70%, so even though you’re technically staking ABC coin, the collateral allows you to take up to 70% of your lendings out to borrow another coin. You take $700 out on collateral and borrow some XYZ coin, either swap it for ABC coin on the same platform or on a DEX, and then add the freshly converted ABC coin to your lending supply. You can then use that $700 worth of ABC coin to take out a further 70% of the freshly added supply. By strategically recycling this process, you’re able to gain a substantial sum of ABC coins without using your own tokens. But, you can only borrow so much against your position as the borrowed amount gets lower and lower.
THE RISK
The amount you borrow must ALWAYS be paid back, as you risk your entire position being potentially liquidated if you’re not careful. Sometimes you will simply incur a penalty fee or lose a portion of your position, but depending on the circumstances, being fully liquidated due to under collateralization is possible. Most user-friendly platforms will have an interface that displays how risky your collateral / loans are at any given moment.
It is of course ideal to be fully aware of your limits and how stretched or risky your position is. Just because you can borrow up to 70%, doesn’t mean you should. It’s not a bad idea to borrow a portion of that 70% instead and remain over collateralized. Being over collateralized is the safer way to play it in case of any severe volatility in price or sluggish trade volumes could lower the coin’s value and leave you in a vulnerable position.
A guideline to follow in most cases would be to only lend / borrow coins you would actually hold.