Every cryptocurrency user has encountered the term DeFi, which is an acronym for Decentralized Finance. DeFi is an ecosystem of financial applications created on top of blockchains, introducing investors’ aspect and making returns on the value of their assets via yield farming markets.
Yield farming, also referred to as liquidity mining, is where crypto holders loan cryptocurrencies and get fees and interests as returns. Similar to when an individual deposits some sum into the bank’s savings accounts and earns interest, yield farming operates on a similar principle.
We should note that investing in a crypto asset doesn’t mean you’re yield farming unless you lend out and receive interest.
Yield Farming – How it is Done
Use Money Markets
There are a few DeFi yield farming protocols you can use to mine liquidity, but the exact method of yield farming depends on the terms and functions of the particular application. This technique rewards you with the project’s token, which mostly includes stablecoins because they offer an easy way to track both profits and losses, but it is also possible to farm yield using other coins.
DeFi money markets come with the benefits of security against financial risks. The tight security is possible because of the over-collateralization protocols, – ‘the provision of collateral that is worth more than enough to cover potential losses in cases of default’ – used in the money markets.
If the collateralization ratio goes below a specific threshold set at any point, the collateral is sold, and the lender earns his amount plus interest. Over-collateralization helps to make sure that borrowers will pay the full amount.
Use Liquidity Pools
There are numerous liquidity pools in DeFi ecosystems, which offer providers rewards for adding their assets into a pool.
So how can you earn in liquidity pools? Each time an individual trades via the pools, the liquidity providers in the pool receive a small fee. In some protocols, for liquidity providers to enhance their profits, they need to consider impermanent loss, which comes with providing liquidity for a highly volatile asset. In other projects, liquidity providers can reduce their impermanent loss by setting up a certain allocation.
Curve finance also enables liquidity providers to get rid of their impermanent losses – that is done by allowing the trading between assets pegged to the same value. There is a pool that manages USD pegged stablecoins, and another that deals with stablecoins linked to Bitcoin (BTC). Because the assets are worth the same amount, there is no possibility of impermanent loss.
Risks Associated With Yield Farming
Highly profitable investments usually come with high risks – the situation is similar in DeFi yield farming. The crypto industry is already widely used, but it still has a long way to go when it comes to technology and growth.
DeFi projects are operated by smart contracts and therefore face the same risks seen in smart contracts. Some of these vulnerabilities include gas limits, reentrancy attacks, and so on, of which unreliable traders can take unfair advantage. However, a user should be aware of the risks in the market and choose to trade and move with caution.
DeFi liquidity mining is the ideal method for crypto users to get returns on their assets’ value. Still, the technology has a long way to go when it comes to growth and adoption. Liquidity pools are also a thing for the crypto big whales, who are always prepared to take high risks and get even higher returns. In comparison to fiat bank savings accounts, DeFi yield farming earns higher interest, which makes liquidity mining drive crypto adoption faster.