After the massive ICO frenzy of 2017, the cryptocurrency market plunged into a prolonged bear market, but the hype of 2017 caught the general public’s attention. Investors, developers, traders, and others have flocked to the segment as the remainder of the capital from the ICO bubble has been used as a source of funding for technological innovation along with growing venture capital investment.
Much of this drive and capital has gone towards the creation of Decentralized Finance (DeFi), a broad term that encompasses a set of DeFi protocols, applications, and financial instruments that run on layer-one protocols such as Ethereum.
It’s hard to have any short conversation about cryptocurrencies right now without the topic of DeFi appearing in the dialogue. So, what exactly is DeFi, and why should you be interested in a new popular trend – profitable yield farming?
What Is DeFi?
DeFi refers to a thriving ecosystem of applications and DeFi protocols focused on modernizing existing financial infrastructure.
In general, DeFi can be seen as the creation from scratch of an alternative financial infrastructure in relation to the traditional system.
DeFi platforms include everything from decentralized exchanges (DEXs like Uniswap) to synthetic assets (like Synthetix), liquidity pools, insurance products, payments, borrowing/lending protocols (like Compound), stablecoins, and much more. These platforms function similarly to existing financial services, but in most cases, replace existing institutions (such as exchanges) with a series of smart contracts running on networks such as Ethereum.
The Uniswap DeFi protocol uses automated market makers (AMMs), which are essentially robots that quote prices between two trading assets.
DeFi and Centralized Cryptocurrency Exchanges
Centralized exchanges can process trades using a centralized order book significantly faster than their DEX counterparts. For many traders, the performance limitations of the DEX are unacceptable, and they prefer centralized exchanges.
The immediate issue that crops up on many DeFi platforms (like the DEX) is liquidity. DeFi protocols have realized that financial instruments and trading will be the first major technological lure of the cryptocurrency market, but securing liquidity remains a challenge.
How to Encourage Investors to Contribute Assets to Liquidity Pools or DeFi Platforms?
In the case of Uniswap, the fees generated from each trade in the liquidity pool are paid to investors who contribute their digital assets to the protocol’s liquidity pools. By liquidity providers to the protocol, they are rewarded in the form of a passive source of income.
However, for more sophisticated DeFi protocols, the answer to the question of providing liquidity has evolved into another form known as liquidity mining or “yield farming.”
What Is Yield Farming?
Yield Farming is a way of earning on cryptocurrency, which is often confused with liquidity mining. However, they note that they matter from each other. Profitable farming has detected such a movement that has already become available to the cryptocurrency trader so that the emergence of new units will arise. To this end, participants in the cryptocurrency market implement many processes that allow the most efficient use of cryptocurrency, and not just buying and selling it. It should be noted that Yield Farming is the most profitable and liquid source of income if there are problems with some areas of the financial market.
It is no longer a secret to anyone that cryptocurrencies and earnings on them are one of the most interesting and urgent tasks of the future. Let’s take a closer look at what Yield Farming is and how to make money on it.
Yield Farming works through the applications of the DeFi system, and, in general, the result depends on it.
Previously, crypto traders received a small percentage of the commission for each transaction in order to increase the liquidity of one application or another (for example, Uniswap or Balancer). But the method of liquidity mining tokens using DeFi applications has become the most popular. In fact, with the help of Yield Farming, you can earn money by investing in certain projects receiving cryptocurrency in return.
Income farming boomed in summer 2020. At the same time, the release of an application governance token called COMP was announced, which will be able to be used by borrowers and lenders of the program. The experience of COMP tokens has shown a good annual percentage yield. However, it is worth noting that each next launch of the token requires more and more new solutions so that users can compete with each other and at the same time earn.
It is worth noting that the more complex the strategy for placing tokens in the chain of application protocols for yield farmers, the more profit he receives.
Today, the Yield Farming chain traders choose virtual currencies such as Tether, Dai, USD Coin, or Ether. Experts justify this choice by saying that using these stablecoins and tokens allows you to track profits in the easiest and most profitable way. Cryptocurrency ETH, in turn, maximizes profits.
Now, most yield farming protocols reward liquidity providers with governance tokens, which can usually be traded on both centralized exchanges like Binance and decentralized exchanges like Uniswap. The governance tokens will often be algorithmically distributed with liquidity incentives to launch a decentralized blockchain.
To help beginners avoid typical mistakes, we recommend that you study the detailed instructions for profitable farming.
Here are a few important points to take into account:
- Profitability of yield farming pools is constantly changing and depends on the policy of DeFi services, the amount of liquidity, and the exchange rates of assets in the pool.
- Intermittent losses and the active emission of tokens in which rewards are issued are the main factors that reduce the profitability of yield farming.
- Of the hundreds of decentralized finance services that reward liquidity, decentralized exchanges are the most trusted.
- The best way to mitigate the risks of income farming is to diversify across different ecosystems, DeFi services, and liquidity pools.
Where Does the Yield Farmers’ Income Come From, and How Is It Calculated?
To begin with, let’s recall that profitable farming means receiving rewards for liquidity providers to DeFi services — decentralized exchanges that use the automated market maker mechanism (AMM-DEX).
Yield farming strategy consists of two components:
- shares of trading commissions for buying and selling assets in this pool;
- rewards from the liquidity pool paid in the exchange’s governance tokens.
And usually, the second component in terms of profitability is several times higher than the first.
A certain number of tokens are allocated per day for each of the pools in accordance with the exchange’s need for liquidity for certain pairs of assets. The reward is divided among all liquidity pool members in proportion to their contribution.
For example, the pool accounts for 10 tokens per day. If you own 10% of the value of this pool, then you will receive 1 token per day of farming. But if the liquidity pool attracted a lot of investors and its size increased 10 times due to new deposits, then your share was reduced to 1%, and you will receive 0.1 tokens per day. Accordingly, the profitability of farming will decrease by 10 times.
At the start of new pools, while they are almost empty, you can see incredible returns of thousands and tens of thousands of percent per annum. This makes a strong impression on beginners.
But as the amount of liquidity blocked in the liquidity pool (Total Value Locked – TVL) grows, its actual profitability decreases sharply.
Another common reason for a decrease in the indicator is a drop in the exchange rate of the tokens in which the reward is issued. This may be due to the high rate of issuance and the constant sales of farmers seeking to withdraw income. As a result, the price chart of such tokens may look like a free fall.
As a result of the combination of these two factors, in a matter of days, the attractive 1000-1500% per annum can decrease tenfold, to the average of 20-50%.
Thus, the profitability of pharming pools is constantly regulated not only by the amount of remuneration but also by the inflow/outflow of liquidity and market mechanisms. In many ecosystems, transaction costs are a few cents. Therefore, investors’ capital is constantly in search of optimal profitability and flows into promising pools in a matter of minutes.
What and Where to Farm?
Literally every day, new DeFi services appear that promise rewards for providing liquidity. But you should not trust your funds to the first pool that comes across.
You can get a general impression of the variety of DeFi services with farming pools in the corresponding sections of digital assets aggregators CoinMarketCap and CoinGecko. Here you can find out the TVL of hundreds of pools’ current returns and sort them by various parameters. It is worth paying attention to the presence of audits of smart contracts, which significantly reduces the risks of hacking and theft.
One of the complete aggregators for yield farmers’ liquidity pool in several ecosystems is the VFAT.Tool service. Despite the ascetic design, it provides the most up-to-date list of DeFi services for each network.
And when connected to a Web3 wallet, the service allows you to find out the TVL of each pool, its current profitability, as well as manage investments: add and withdraw liquidity, and receive rewards.
What Is Apy in Income Farming?
Users involved in income yield farming, like most protocols and platforms, yield farming returns calculated the estimated profit in the form of an annual percentage yield (APY). APY is the rate of return earned during the year on a specific investment. Annual percentage yield considers the amount of interest calculated on a regular basis and applied to the total amount of the investment.
The boom in the income yield farming market that began in the DeFi Summer 2020 has led to the fact that the most perspicacious yield farmers could sometimes extract income of up to a thousand percent per annum. However, the procedure itself, its protocols, and coins can be risky and susceptible to pooling. In addition, the income received in the form of protocol tokens is subject to very sharp price fluctuations.
Top 10 Income Farming Protocols
To optimize the return on investment, yield farmers often use different DeFi platforms at the same time. Different platforms offer different options for incentivized lending and borrowing from liquidity pools. Here are seven of the most popular income yield farming protocols:
Aave. Open-source, non-custodial decentralized and borrowing protocol. Users can borrow assets and earn compound interest for lending in the form of an AAVE (formerly LEND) token. Aave has the highest amount locked up (TVL) of any DeFi protocol.
Curve Finance. DEX allows users and other decentralized protocols to exchange stablecoins with low transaction fees and low slippage.
Uniswap. One of the most popular DEX and AMM allows users to swap almost any pair of ERC20 tokens without intermediaries. Staking for liquidity providers is designed in such a way that they must invest their funds on both sides of the liquidity pool in a 50/50 ratio and, in return, receive a part of the transaction fees, as well as UNI protocol control tokens.
Instadapp is the most advanced DeFi platform. It gives yield farmers the ability to create and manage their DeFi portfolio.
SushiSwap is a fork of Uniswap that generated a huge wave of community support during the liquidity migration process.
PancakeSwap. It is a DEX built on the Binance Smart Chain (BSC) network for exchanging BEP20 tokens.
Venus. This protocol is based on an algorithm short-term capital markets system on Binance Smart Chain.
Balancer is an automated portfolio manager and trading platform. Its liquidity protocol features staking flexibility. Lenders are not required to add liquidity evenly to both pools. Instead, liquidity providers can create custom liquidity pools with different tokens in the desired proportion. As of August 2021, it has over $1.8 billion locked up.
Yearn.finance. It’s an automated decentralized aggregation protocol that allows yield farmers to use various lending protocols such as Aave and Compound to maximize profits.
Risks of Income Yield Farming
Income-generating farming can be incredibly complex and involve significant financial risks for both borrowers and lenders. This is usually associated with high transaction fees and only makes sense if the amount of capital is thousands of dollars. Users are also exposed to the additional risk of recurring losses and price slippage during times of market volatility.
Firstly, profitable farming is not protected from hacks and fraud due to possible vulnerabilities in the smart contracts of the protocol. Bugs in the code can simply appear out of the blue due to a fiercely competitive race between protocols, where release speed is most important. New contracts and features are often not tested.
You don’t need to look far for examples of vulnerabilities that led to serious financial losses: the Yam protocol raised more than $400 million in the days before the critical bug was discovered, and Harvest.Finance lost more than $20 million in liquidity as a result of a hack in October 2020.
DeFi protocols are public, but they depend on several applications to run smoothly. If any of these core apps are being used or not working properly, it could impact the entire app ecosystem and result in a permanent loss of investor funds.
We recommend approaching profitable farming. As the existing protocols are not code tested, the promised profitability goes hand in hand with the risk of liquidation due to price volatility. Many of these liquidity pools are scams that end up in a rag pool where the developers take all the liquidity from the pool and run away with the money.
The blockchain is immutable. Most often, the losses in DeFi become irreversible. Weigh all the risks associated with income farming before making investment decisions and fraud due to possible vulnerabilities in the smart contracts of the protocol. Bugs in the code can simply appear out of the blue due to a fiercely competitive race between protocols, where release speed is most important. New contracts and features are often not tested.
First of all, you need to calculate yield farming returns and only then make a decision.