Last Updated on 17 mins by cryptoevent

Yield farming has been a hot topic in the DeFi community for a while and has become one of the hottest ways to explore passive income cryptocurrency. But while it’s growing in popularity, it’s not exactly easy, and there are nuances and subtleties in the space that make it complex for traders who are entering the world of cryptocurrency and decentralized finance for the first time.

What is yield farming?

To compare yield farming to legacy financing, think about depositing money in a bank: Banks typically offer different interest rates to customers who keep their money in deposits over the years. The bank gives you an annualized interest rate on your deposits.

This is similar to yield farming in the DeFi space. Users lock their funds using a specific protocol (like Compound and Balancer) which then lends the funds to those who need credit. The platform rewards users for locking their assets and occasionally shares some of the lending fees with them.

The income that lenders receive from interest and fees is less important. When it comes to real payout, the units of new crypto tokens from the lending platform are the maximum profit. If the value of the crypto lender’s token increases, the user will make a purchase.

The Rise of Yield Farming

Locked in relation to the total value (TVL) in dollars, the DeFi space is expected to grow by 150% over the next year. In comparison, the cryptocurrency’s market cap has only grown 37% so far.

Many analysts attribute this year’s phenomenal success in the DeFi market to yield farming. It involves both investors and speculators who provide liquidity to lending and lending platforms.

Yield Farming: The Solution to DeFi’s Liquidity Problems

While banks may offer credit, there is a lot of bureaucracy and administrative logistics that must be overcome before a person can obtain credit. In DeFi, credit is much more accessible, but it requires liquidity first. DeFi &Servers around the world are the solution to provide the necessary liquidity in space. Many platforms try to recruit long-term holders (HODLers) to add liquidity pools by incentivizing them on their wealth.

Borrowing from other users is becoming more common. In the future, it could potentially compete with borrowing from lenders and venture capitalists.

What is the connection between yield farming and liquidity pools?

Fees are charged to liquidity providers through platforms such as Uniswap and Balancer. They offer rewards as an incentive for increasing liquidity in the pools.

Every time someone trades through the liquidity pool, the liquidity providers receive a portion of the platform fee. Due to the recent increase in DEX trading volume, Uniswap liquidity providers have made good gains. This liquidity pool is a way for those who lend their funds to earn rewards from the platform and a way for the platform to increase its liquidity.

Curve, finance made easy

One of the best DEX liquidity pools is Curve. It was designed to provide an efficient way to trade stablecoins. The platform now supports USDT, USDC, TUSD, SUDS, BUSD, DAI, PAX and BTC pairings and uses automated market makers to facilitate transactions with minimal deviation.

Curve is also backed by automated market makers to keep transaction fees low. In the first few months after launch, it grew into one of the largest platforms in the industry. Curve’s performance has outperformed some of the industry’s biggest brands in yield farming. Currently ahead of Balancer, Aave, and Compound Finance, Curve is popular with arbitrage traders as it offers significant savings on trades.

There is a difference between Curve and Uniswap. The Uniswap algorithm was designed to increase liquidity availability. The curve, on the other hand, is careful to allow the least amount of slip. As a result, Curve remains a preferred choice for high-volume crypto traders.

Understand yield farming risks

Temporary Loss

In yield farming, there is a reasonable chance of losing money. Automated market makers can be very profitable for certain protocols like Uniswap. Volatility, on the other hand, can cause you to lose money.

Any negative price change will reduce the value of your share compared to holding the original assets.

The concept is simple and can only be implemented when staking tokens that are not stablecoins, as they are subject to price fluctuations. Let’s say you bet 50% ETH and 50% of a random stablecoin to farm a third token, if the price of ETH falls dramatically, you can lose more money than if you simply buy the token you are cultivating in the market.

Suppose you stake 1 ETH (priced at $400) and 400 USDT to farm YFI at a price of $13,000. (The example is not based on existing liquidity pools.) Your daily return is 1%. That means for your initial $800 investment, you should be getting about $8 in YFI per day. However, due to market volatility, the price of ETH falls to $360 and you lost 10% of your ETH while making say $8 in YFI. If you bought $800 worth of YFI and the price didn’t change, you would have kept the value.

Smart Contract Risks

Smart contracts can be exploited by hackers and there have been several incidents this year. Curve, $1M at risk at bZx and lendf.me are just a few examples.

The DeFi explosion has resulted in a millionfold increase in the TVL of emerging DeFi protocols. As a result, attackers are increasingly focusing on DeFi protocols.

the pRotocol’s design

With most DeFi protocols in their early stages, there is an opportunity to gamble on the incentives. Consider the recent events of YAM Finance where a miscalculation in the rebasing method resulted in the project losing almost 90% of its dollar value in just a few hours.

High risk of underfunding

Your collateral is vulnerable to cryptocurrency volatility. Market fluctuations can potentially jeopardize your debt situation. As a result, undercollateralization may occur. You may incur additional losses as a result of inadequate liquidation procedures.

DeFi tokens are subject to change

The underlying tokens of the yield farming protocol are reflexive, which can affect volatility and their value. This is reminiscent of the early days of the 2017 ICO craze.

carpet pulls

It is important to remember that on platforms like Uniswap, which is at the forefront of DeFi, anyone can withdraw their liquidity at any time unless it is locked by a third-party method.

Additionally, in many situations, the developers hold large amounts of the underlying asset and are able to quickly launch these tokens, leaving investors with worthless assets. The most recent example comes from a promising company called Sushiswap, where the lead developer sold millions of ETH worth of its tokens and immediately dropped the price of SUSHI by more than 50%.

Is yield farming worth it?

Yield farming is bringing a large number of new people into the world of DeFi, and many are making money off their idle crypto assets while HODLing.

However, it is important to remember that there are significant dangers involved. Temporary losses, smart contract risks, and liquidation risks all need to be considered. While very profitable, it is important to research these risks and only wager funds that you can afford to lose.

The post What is yield farming in DeFi and what are the risks? appeared first on Coin Insider.