Yield farming in decentralized finance explained

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Cryptocurrencies provide an opportunity for investors to earn high returns on their investments. In this article, we’ll explain yield farming and how it works.

Introduction

Yield farming, also known as rent-seeking, is a decentralized finance practice involving investors who buy tokens of other decentralized financial platforms to profit from their efforts. As the name suggests, this process involves renting your tokens – or lending them out – to others willing to pay you an interest rate for access.

The goal of this process is not only to make money but also to help drive the decentralized finance movement forward. It creates value for its participants and helps grow communities around different projects.

There are many benefits associated with yield farming:

  • increasing liquidity
  • reducing volatility 

However, there are also risks involved with this practice. Here’s what you need to know before getting started:

Definition and explanation of yield farming

Yield farming is a term used in cryptocurrency to describe the practice of high-yield lending, where a borrower pays a lender an interest rate higher than the market average or even rates offered by peer-to-peer (P2P) loans. Additionally, the process pertains to providing trading liquidity through decentralized platforms. Vitalik Buterin coined the term years ago.

The DeFi-focused process is profitable because it allows you to make money off someone else’s loan without taking any risk yourself. That can be very attractive for lenders who want to earn extra income with their idle funds. For liquidity providers, it is a passive income stream.

Other investments, like real estate or stocks, have more volatility and are subject to market conditions one may not understand well enough. Yield farmers connect borrowers looking for high-interest loans and lenders willing to provide those loans at lower rates. 

How does yield farming reward users?

By providing liquidity, you will earn a portion of the fees paid by those who trade on the exchange. For instance, by dealing directly with other users on the platform and earning their respective commissions to facilitate trades. 

For example, suppose there are no open orders for you to fill at an acceptable price and volume on an exchange. In that case, it may make sense to set up your order to facilitate another user’s trade request at a better price than they would have received elsewhere. 

In this scenario, both traders will pay commissions based on your contribution towards facilitating their transaction. You earn more than one-half of that commission fee because you provided liquidity. Additionally, you accepted the risk of holding onto other people’s funds while waiting for them to fill out their order (in our example above).

What are the requirements for yield farming?

  • It would be best if you had a token that has access to the DEX.

  • It would help if you had a trading bot.

  • You need to know how to trade.

  • Knowledge of the market and prices of various tokens on that particular DEX is beneficial. Any other factors potentially affecting those prices (such as an upcoming announcement from a large company) must be considered.

The risks of yield farming

The risks of yield farming are the same as any other investment, and many people don’t realize that. That is because many average investors don’t understand what it means to invest in yield farming. 

They explain that they’re investing money in a peer-to-peer lending platform, but then they sell their notes at a profit after one year. That sounds like an investment. So why would there be any risk?

Liquidity provision is a lower-risk option, although it can lead to impermanent loss.

How to get started with yield farming

The first step to getting started with yield farming is to select a Dapp that you want to use. You can find the list of current yield-farming-enabled Dapps on various data aggregators. 

The best way to get started is by exploring user experience and some of the most advanced yield-farming features today. After choosing a Dapp, you can start depositing funds into your wallet and sending them out again. Or lending out your crypto assets for interest payments on deposited funds (this is called “some kind of interest” because we don’t know what kind yet).

Yield farming essentially offers high rewards for users participating in it, but it can be risky. In addition, yield farming is a way to earn money by lending your cryptocurrency. However, the method is risky because all of the following are true:

  • You’re lending out your cryptocurrency, so if you don’t have any more of it and the borrower doesn’t pay back their debt, you won’t have anything left.

  • You’re lending to strangers (an unknown party), so if they default on their loan, there’s not much recourse in getting compensation or justice.

You can mitigate the risks by going through a reputable yield farming platform. Such projects have built-in systems protecting lenders’ assets and guaranteeing repayment of loans.

Conclusion

All in all, yield farming seems like an excellent way to earn more money. While some risks are involved with doing this, the rewards seem to outweigh the potential losses.

We hope this brief introduction helps clarify some uncertainties or concerns you may have regarding this novel concept.


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