DeFi is a technology at the forefront of innovation within the blockchain space. It is driving more innovation and flexibility in the financial industry compared to traditional finance. Yield farming is an emerging trend in the crypto world and is attracting the attention of cryptocurrency enthusiasts.
If you are considering investing in specific cryptocurrencies, then yield farming is a good option. DeFi sprung from the need to have a transparent financial system.
Forbes rightly points out that there is a lot to learn from the DeFi universe. This article explores the fundamentals of DeFi yield farming.
What is DeFi?
DeFi is the acronym for decentralized finance. The blockchain-enabled concept offers progressive and agile tools to users, decreasing the operational risk of the traditional finance model.
It allows entrepreneurs in crypto to recreate traditional financial tools. They can do so in a decentralized environment beyond the control of any government or company.
What is DeFi yield farming?
At its core, yield farming is a process of earning rewards using cryptocurrency holdings. The process of lending or staking assets in DeFi protocol to generate high returns is known as DeFi yield farming. According to Relite.Finance, Cross-chain Yield Farming is the next highest returns strategy.
The name farming indicates high interest generated through the liquidity of various DeFi protocols. DeFi protocols also provide tokens that indicate the user’s share within the liquidity pool. The tokens can be transferred to other platforms which increases the potential gains of a user.
Yield farming benefits both borrowers and lenders. The liquidity pool can be lucrative for borrowers keen on margin trading and lenders who wish to invest idle crypto assets to get passive income.
Within the DeFi ecosystem, the yield farmer plays the role of a bank to lend funds to yield maximum returns. The DeFi ecosystem relies on blockchain-based smart contracts to connect lenders and borrowers while rewarding investors.
Why is DeFi ideal for yield farming?
Contrary to the traditional financial system that relies on centralized infrastructure, DeFi runs by code in a decentralized blockchain infrastructure. The immutable smart contracts help run financial protocols.
Owing to the decentralized nature associated with DeFi, no centralized entities offer seed capital. Thus, all cryptocurrencies are provided by liquidity providers and lenders. DeFi platforms are software brokers that facilitate financial transactions at a fee.
Defi capitalizes on the considerable blockchain features to unlock liquidity, support standard economic systems and enhance financial security.
Features that make DeFi suitable for yield farming
Since DeFi relies on blockchain technology, all the data is unalterable. As such, financial transactions are conveniently auditable and more secure.
DeFi relies on programmable smart contracts that automate execution and create digital assets.
With DeFi, developers are at liberty to build on existing protocols, integrate third-party applications, and customize interfaces. Thus, DeFi protocols are also referred to as money legos.
Since DeFi works on blockchain technology, it offers transparency in codes, data, and transactions. The degree of transparency and authenticity around transaction data nurtures trust and guarantees the availability of the network to any user.
Participants in the DeFi market have custody and control over their data and assets. They interact with permissionless protocols and applications.
How DeFi yield farming works
Yield farming in DeFi applications offers opportunities to crypto holders to earn passive income and returns by lending their holdings through smart contracts. Each DeFi application decides how yield farming will occur on its platform.
Mostly, yield farming involves liquidity providers and liquidity pools. A person who deposits cryptocurrencies in a smart contract is referred to as a Liquidity Provider. Liquidity pools consist of smart contracts.
The pools run on special decentralized exchanges referred to as automated market makers.
Here are the steps involved:
Step 1: The liquidity provider deposits their funds in the liquidity pools through smart contracts. These funds are then locked by the smart contract and are available under the smart contract limitation.
Step 2: The liquidity pools are in charge of the marketplace where users lend, borrow, and exchange funds. Users in these platforms pay the fees. This way, liquidity providers benefit depending on the value of their holdings.
Step 3: Liquidity providers get rewarded for locking their funds in the pool depending on the amount they invest on the platform.
Step 4: All the rewarded tokens or funds are deposited in the liquidity pools. It is up to the liquidity investor to create complex investments through reinvesting.
Also, they can move the rewarded tokens to other liquid pools for more yields. Having a diverse cryptocurrency portfolio helps the liquidity provider.
How yield farmers earn a return on investment
The return on investment in yield farming falls into three categories.
1. Transaction fee income
These vary depending on the protocol and pool. For instance, the fee for pool creation varies from 0.001% and 10%.
2. Token rewards
They act as incentives to provide liquidity. The rewards are distributed over a certain period from weeks to years. You can trade the tokens on decentralized exchanges or centralized exchanges.
3. Capital growth
It helps compute the profitability associated with a challenging yield farming opportunity.
Benefits of DeFi yield farming
DeFi yield farming provides multiple benefits. These include:
- Simple user interface
Investors use various apps to monitor their investments and hardly find a learning curve in the yield farming applications. DeFi applications have user-friendly interfaces.
- Easy start
It is easy to start yield farming because of the high interoperability associated with DeFi platforms. The only requirement is cryptocurrency and cryptocurrency wallet.
The DeFi industry is very versatile. Some platforms automatically move crypto across platforms to get a better investment.
- Profit potential
Participants who stake their crypto holdings earlier into protocols can get profitable returns.
DeFi yield farming is gaining a lot of attention as one of the most profitable forms of crypto investment. With each passing day, yield farming is gaining prominence. Hopefully, the article helped you grasp what it takes to invest in DeFi yield farming.