Governance tokens can help users to have better control over their assets. Such a utility has greatly increased the popularity of governance tokens and DeFi over the last year or so.
Yield Farming: The Crowd-Puller for DeFi
Yield farming has been a crowd-puller for DeFi. In this article, we try to explain what is yield farming and its role in DeFi.
In terms of growth achieved in the shortest possible time, DeFi has surpassed the predictions of most.
In the last few months, DeFi has undeniably made a name for itself in the crypto industry, triggering a surge of momentum for the whole cryptocurrency market.
DeFi may be the closest form of decentralization that the crypto space has ever produced. Moreover, DeFi has removed the need for location-based censoring and emerged as a truly borderless financial ecosystem.
Technical aspects such as these have greatly contributed to this astonishing growth of DeFi.
However, purely from a user perspective, one of the commercial factors which have really fueled the growth of DeFi is the concept of yield farming.
In this article, we’ll take a closer look at what yield farming is and how it can benefit the average user.
To better understand yield farming, one has to understand some of the basic concepts associated with DeFi.
Services offered by DeFi
Anyone who is remotely interested in crypto will have heard about the different services offered by DeFi platforms, such as lending, borrowing, or savings accounts.
Hence, the working principle of DeFi is similar to that of some of the traditional financial institutions like banks. A person depositing money in the bank gets a return on their deposit because the deposited amount will be lent out by the bank to another customer.
Since banks use a centralized business model, they provide the return in such a way that it is hugely profitable for the banks themselves, which is one of the main reasons why most traditional banks are currently offering less than 1% in APY (or annual percentage yield).
DeFi platforms may be regarded as the decentralized version of banks, and this enables DeFi platforms to give returns a level of magnitude higher (>10% APY) than what banks are currently promising.
Yield farming allows users to compound yields provided by the DeFi platforms by using a combination of different services offered by the platforms.
Liquidity pools are one of the fundamental concepts associated with decentralized exchanges and DeFi tokens and are fast gaining popularity in the crypto space. Centralized exchanges have long been scrutinized for two things in particular:
- Liquidity of coins/tokens.
- Manipulation of markets by market makers.
Liquidity pools are devised to address both these issues. Liquidity pools are pools of tokens created to eliminate the issue of liquidity. Any user can deposit tokens in a liquidity pool, and once deposited, these tokens are bound by a smart contract.
Users that have deposited to a liquidity pool will receive a proportionate percentage of the total trading fees charged on all the trades that have happened in that particular pool.
Let’s take the example of a user deciding to provide liquidity to an ETH-USDT pool by investing US$1,000. Assuming the total liquidity of that pool is US$100,000, and the trading fee charged on each trade is 0.3%, a trade amounting to a total value of US$10,000 would earn the user 1% of US$30 (0.3% trading fees).
Thus by eliminating the need for centralized groups as market-makers, liquidity pools have enabled the platforms to be more decentralized and have effectively rectified two of the major issues of centralized exchanges.
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Furthermore, a user adding the tokens to a liquidity pool will receive the platform’s native token or liquidity pool token in exchange for the service provided. During the period of the smart contract, the user is free to use this native token. However, if the user needs to remove their token from the liquidity pool, they will have to burn this native token.
Yield farming can be defined as a method to maximize return on investment using a combination of different products in the DeFi ecosystem.
Users have generally combined the lending services or liquidity pools offered by different DeFi platforms – as well as the native tokens offered by them – to maximize yields.
There are a variety of ways to earn through yield farming from a DeFi platform. One of the most common methods used by users is by using the lend option available in a DeFi platform.
Let’s assume that a user has lent a certain amount of USDT at a 4% interest rate. This whole transaction is governed by a smart contract that ensures the resoluteness of the transaction.
Once the transaction is complete, and the smart contract is active, the person receives a native token, in this case, something like cUSDT or yUSDT in exchange for using the service.
Users can transfer or deposit the received native token in a different DeFi platform that accepts the token. Let’s assume that the native token earns an interest of 4% on the second platform.
Now, at the end of the lending period, the user will receive the interest on the original amount that was lent, along with that the person would have received interest on the liquidity pool token deposited in the second platform. This has the potential to considerably increase the user’s final yield through the compounding of interest rates.
Considering the example interest rates mentioned above, a user at the end of the lending period who had performed the yield farming would have gained an interest rate of 8.16% by compounding the 4% interest from both the platforms.
Moreover, a user could also earn from yield farming by depositing in the liquidity pool of decentralized exchanges as well.
Furthermore, a user can repeat this with any number of platforms and any number of native tokens – that is, if the platform accepts the native token.
There are many more complex ways of increasing the yields through yield farming even further. However, the risk involved in such investments also increases exponentially along with each degree of complexity.
Yield farming has certainly driven the attention of the DeFi community in a new direction. DeFi is still in its early stages, and it will need time to mature. Similarly, yield farming is an even less mature concept and will need more time to develop into something with less risk.
Nevertheless, DeFi is the red-hot topic right now in the crypto space, and it is fair to say that the innovations happening in the space will ultimately produce better platforms that users can more efficiently utilize for yield farming, and ultimately for maximizing their gains.