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Yield Farming

| May 14, 2024

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Right after staking took off, the concept of making passive income or earning rewards by coming together to support a token or protocol got big.

Yield Farming is one such concept that is very close to staking but differs in its fundamental approach of generating rewards for users, which is riskier than traditional staking. 

What does Yield Farming Crypto Mean?

Yield Farming, a fascinating yield-generating process, is a key feature of native DeFi protocols. It offers investors a unique opportunity to pool their assets, potentially earning above-average returns. Typically, these rewards are distributed in the form of the protocol’s governance token, adding an exciting element to the yield farming experience.

Yield Farming typically helps a protocol cap its circulating supply, engage the holders, and supply them with the native protocol token to hike the price and increase the overall holders of the token. 

At the heart of Yield Farming are the Liquidity Providers(LPs), the individuals who enter these farming pools. Their participation is crucial, as it helps maintain the protocol’s liquidity and ensures the farming process’s smooth operation. In exchange for liquidity, LPs earn APY rewards in real-time. 

Yield Farming works completely on an incentivization technique, inviting all who wish to take bigger risks to earn bigger rewards. This also allows token holders to easily continue their long-term holding and accumulate extra tokens by putting their tokens in a locked pool. 

How does Yield Farming Crypto Work?

Yield Farming is done a few different ways, mainly through a DEX, a CEX or a dedicated yield farming platform. Let’s break down how yield farming works step by step:

  1. First, you need to pick a yield farming protocol. For example, you could select an AMM DEX like PancakeSwap.
  2. Look for the ‘ Liquidity ‘ section once you’re on the decentralized trading platform. This is where you’ll become a liquidity provider.
  3. Now, decide which particular asset you want to add liquidity for and select that asset pool. For example, you might choose to deposit BNB and CAKE tokens into the BNB/CAKE pool.
  4. You’ll receive your LP token in return once you deposit the asset in your chosen pool.
  5. Now, take that LP token and head over to the ‘Farms’ section. Here, you can deposit your LP token into the BNB/CAKE yield farm to start earning your yield farming rewards. Furthermore, you’ll also be rewarded with a transaction fee from the liquidity pool you participated in.

Benefits and Risks Involved in Yield Farming

Even though Yield Farming is a new and better way of earning rewards, it comes with its own set of benefits and risks. Whether you are looking to participate in a Yield Farming pool or simply analyze its pros and cons, this list will help you make better decisions. 

Benefits of Yield Farming

  1. Passive Income: Instead of just holding onto your crypto, you can make it work for you and earn extra tokens and fees without needing to trade actively.
  2. Liquidity Boost: Yield farming helps keep decentralized exchanges (DEXs) running smoothly by providing liquidity, which means better trading experiences and less slippage for users.
  3. High Returns: Some DeFi projects offer pretty sweet returns that can beat what you’d get from traditional investments. You could make some serious gains with your capital, depending on the market.

Risks of Yield Farming

  1. Impermanent Loss: In automated market makers (AMMs), there’s a risk of “impermanent loss.” This happens if the prices of the tokens in the pool change a lot after you’ve added liquidity. The system might rebalance the pool, and you could end up with less value than if you’d just held onto your tokens.
  2. Smart Contract Bugs: DeFi protocols rely on smart contracts, and if the code has bugs or weaknesses, hackers can exploit them to steal funds.
  3. Uncertain Yields: Yields can be unpredictable because they depend on the number of people supplying assets. If lots of people start farming, the rewards might shrink.
  4. Price Volatility: Crypto prices can be wild, and if the token you’re earning rewards in suddenly drops in value, you could lose all your profits.

Should you Participate in Yield Farming?

Yield Farming is most definitely a new trend in the crypto market. It is notorious for providing extraordinary returns to leverage retail investors to lock up their tokens and avoid sell pressure for protocol tokens. 

Although the tokens collected in a yield farming pool are governed by a smart contract, this does not automatically make it an on-chain activity. Some intrinsic factors make it more of a side activity than a full-fledged activity for active traders. 

In addition, the potential profits you make from yield farming largely rely on the price of the protocol token you earn as your reward. If the value of this token decreases, your yield farming earnings could significantly decrease as well.

Let’s break it down. Imagine you’re farming on a DeFi platform and earning rewards in a specific token. If the price of that token suddenly goes down, the value of your rewards also decreases. So, while yield farming can be lucrative, keeping an eye on the token prices to ensure your earnings stay robust is important.

If you’re up for taking on some risk, yield farming can be a thrilling opportunity to earn returns on your crypto. But remember, it’s crucial to do your homework and never invest more than you’re willing to lose.