DeFi or decentralized finance is an emerging sector in the digital ecosystem that inflated amid the global COVID-19 pandemic. The sector is referred to the variety of financial products that have been built on top of some major blockchains.
One type of feature in the market that is growing among enthusiasts and investors is yield farming, which turned out to be a goldmine for them. Which provides the holder with periodic payments from the revenue generated by the underlying asset. Yield Farming is currently one of the best techniques that helps manage crypto assets. Ultimately, the feature of the industry is giving a chance for automated revenues.
According to data from CoinMarketCap, at press time, the DeFi industry is valued at $44.94 billion. The trend of yield farming showed a surge since the beginning of this year. Yield farming involves lending or staking digital currencies or tokens, for which users receive a reward.
Fundamentals of DeFi Yield Farming
DeFi Yield Farming is one of the epochal growth propellers of the industry. Here, investors are giving their crypto to secure them from inside liquidity pools. As their cryptocurrencies are used in the market, they receive a reward. Providing our crypto holding helps in the functioning of the platforms.
The providers of the funds are known as Liquidity Providers (LPs), and where they pour their funds are entitled to a Liquidity Pool, which is a smart contract-based dApp. Investors can lock their digital tokens in a pool and receive rewards that are generated from the underlying platform on which the Liquidity pool is built.
How is the entire system of DeFi yield farming work?
Talking about DeFi yield farming, the most common question that arises is how this decentralized system rewards investors. To understand this, we need to go through the working principles of yield farming.
To put it simply, we can explain that investors lend their cryptocurrencies through a decentralized application. Every process is conducted through a smart contract with no middleman or intermediary.
After receiving the funds, the pool then powers a marketplace where everyone can lend, borrow, swap, or exchange digital assets. While processing these transactions, the platform incurs a charge from the users.
These fees, that are received by the platform, are distributed among the LPs for staking their holdings. In contrast, these automated decentralized systems are working because the investors are staking their funds.
Yield Farming is operated with a request matching framework that is known as the Automated Market Maker (AMM). AMM is a model that controls a major portion of the decentralized trades available. This market maker essentially invokes the pools by using predefined calculations. The entire system relies on LPs to store assets within pools.
Staked funds of investors then provide the subsidized framework through which decentralized clients borrow, lend, and trade. For this purpose, the clients must have to pay a fee, and ultimately, these fees are then distributed among the users.
How does DeFi yield farming calculates the rewards?
Usually, the anticipated yield repays are annualized. Latent rewards to the LPs are calculated over the course of a year. Notably, to reckon the rewards, two often-used touchstones are Annual Percentage Rate (APR) and Annual Percentage Yield (APY).
It is observed that the APR does not account for compounding or reinvesting gains to generate larger returns, but APY does that. Investors or stakers should keep in mind that both APR and APY are merely predictions and estimations only.
In this decentralized system, even short-term advantages are challenging to forecast with accuracy. This is because the passive income generation here is a highly competitive in a fast-paced industry with rapidly changing incentives. If a strategy succeeds, other yield farmers will flock to take advantage of the same strategy, and ultimately it will halt its power to yield significant returns.
Thus, as the measurements are outmoded market metrics, the industry has to develop its own profit calculation algorithms. Indeed, weekly or daily rewards calculations would make more sense in place because of the rapid pace in we witness in the industry.
Is it worth staking our crypto assets?
The primary benefit of DeFi yield farming is the sweet reward that we receive. The earlier we get into a pool, the more we may end up witnessing more rewards as the value of the tokens will increase. We can then either sell off to take the profit or reinvest the proceeds.
However, the DeFi industry is also popular for being one of the hot markets in the digital ecosystem. If we are in the decentralized industry, which is yet in the nascent stage, then there are definitely risks involved. This means loans cost can be volatile, making it difficult to predict what your rewards will look like in the coming year. Following this, many are concerned about whether it is truly profitable to stake in DeFi protocols.
The profit-making scenario here depends on, like most things in digital assets. Sometimes, yield farming allows investors to generate 1,000% APY. However, for freshers in the market, there is no way to account for the market volatility. The value of our pegged funds could fluctuate and affect the entire income. Besides, we also witness a lot of rug pull and scam news that makes things riskier.
On the other hand, everything here is depending on smart contracts, that is also susceptible to bugs and hacks. Although some early DeFi protocols have integrated some significant security measures, most platforms are risky.
Being a perplexed operation that unwraps both borrowers and lenders to financial risk, yield farming is challenging for many. Mostly, when the prices in the digital currency industry is highly volatile, users face an increased risk of price slippage and fugacious loss. This appears when the price of any cryptocurrency in a liquidity pool changes, it, ultimately, alters the ratio in the pool to fortify the stakes.
Moreover, regulatory risk is another element that is shrouded in uncertainty. Financial watchdogs have issued terminate and abstain orders against centralized protocols. Thus, it is ambivalent, when DeFi would take a striking from the regulators. Still, the industry is designed to be resistant to any central authority, including government regulations.
Popular DeFi yield farming protocols
Uniswap (UNI)
Uniswap is a decentralized exchange (DEX) platform, that allows its users to exchange and trade digital assets. Acting as a symbolic exchange platform, its frictionless nature is one component that draws numerous brokers. LPs help the platform by contributing and staking their funds, which measures up to two tokens. The cryptocurrency liquidity pools are then listed on the platform and allow the traders to exchange the digital assets and reward the LPs.
Notably, the frictionless nature of the platform has helped it become one of the most popular DEX platforms for trustless token swaps.
Furthermore, the DEX is useful for high-yield farming systems. Besides, the holders of Uniswap’s native crypto token, UNI can also take part in the governance system of the exchange and vote on upcoming upgrades.
According to data from DappRadar, Currently, more than $4.5 billion worth of funds are locked in the protocol.
Aave (AAVE)
Aave is a DeFi protocol that specializes in offering stable crypto pairs yield farming. Cryptocurrencies that are pegged in the ratio of 1:1 with some government-issued fiat currencies are known as Stablecoins, as they are very stable in nature and do not fluctuate significantly.
The protocol also has its own native cryptocurrency, AAVE. Holders of this crypto token can incentivize users to use the network and offers numerous benefits. These benefits include free savings and governance voting power. When it comes to DeFi yield farming, it is common to find liquidity pools working together. On Aave, the Gemini dollar has a deposit APY of 6.98% and borrow average percentage yield of 9.69%. Notably, this is the highest-earning stablecoin that is accessible on the protocol.
According to data from DappRadar, Aave has a total value locked of more than $5.27 billion.
Curve Finance (CRV)
Curve Finance is one of the largest DeFi platforms in terms of TVL. Notably, the protocol makes greater use of locked funds than any other platform in the sector. Curve brings a beneficial strategy for both swappers and liquidity suppliers.
The protocol aims to create deep on-chain liquidity using advanced bonding curves. Currently, the project is providing the largest list of stablecoin pools with great APRs that are tied to government-issued currency. Stablecoin pairs are more likely for investors as, until the peg of the tokens is safe, these pools are quite risk-free.
Furthermore, because of the low volatility of cryptocurrency, the temporary loss may be entirely debarred because their prices will not redact drastically in relation to each other. However, still, the protocol carries few risks similar to other platforms like temporary loss and smart contract failure.
According to data from DappRadar, Curve is the fifth largest DeFi protocol, with a looming $4.54 billion in TVL.
PancakeSwap (CAKE)
Similar to Uniswap, PancakeSwap works similarly as a decentralized exchange. The protocol runs on the Binance Smart Chain (BSC) rather than the largest altcoin network, Ethereum. In contrast, PancakeSwap has some extra gamification-focused features. Users can witness a variety of cryptocurrencies that includes BSC token exchanges, interest-earning staking pools, NFTs, and even a gambling game that is also available on the exchange.
PancakeSwap is susceptible to the assonant risks as Uniswap, such as fugacious loss due to ample price irregularities. Simultaneously, several users have faced losses because of smart contract failure.
Many of the digital assets in the platform’s pools have a minor market cap, gauging them in danger of temporary loss.
According to data from DappRadar, PancakeSwap is currently the 9th largest DeFi protocol, with more than $2.3 billion in TVL.
Conclusion
Smart contracts in the decentralized ecosystem are not infallible as they seem, as the industry is yet in its nascent phase. Today, as the digital ecosystem is emerging, we can witness many protocols rising by some small teams and limited budgets, which could attract bugs on the platform.
The prime measure to any decentralized finance investors or yield farmers is to scrutinize the most trusted and reliable protocols.