The cryptocurrency market is full of buzzwords and trends. Crypto itself was a revolutionary, profitable idea, and new ones keep emerging within the wider industry umbrella. The most recent of these skyrocketing trends is DeFi yield farming.
DeFi, short for “decentralized finance,” applies the concept of decentralization behind cryptocurrency to financial actions like lending. It uses smart contracts to enable permissionless and trustless loaning and borrowing. The underlying platforms that make DeFi possible have led to the rise of yield farming, a way of arbitraging crypto tokens.
Yield farming, also called “liquidity farming,” helped DeFi applications grow by $12 billion this year alone. Savvy investors also stand to make considerable profits, but with a fair amount of risk.
How DeFi Yield Farming Works
DeFi is an attractive concept in and of itself, as it lets users get a loan without giving away any personal information. The thought of an intermediary having access to this data causes 39% of customers to reconsider financial services, so this privacy is a welcome change. For a distributed lending service to work, though, the platform has to attract lenders.
DeFi platforms pay out their usage fees to liquidity providers (LPs) as a reward for putting crypto into their pools. Some, like Compound, go a step further and offer LPs new tokens on top of these fees. Yield farming happens when LPs take those tokens and deposit them into other pools, getting more rewards.
Most DeFi applications use stablecoins, which all have different ways of measuring the U.S. dollar value. Yield farmers can benefit from this, profiting off the exchange rate differences by moving their funds around various liquidity pools.
Some LPs even borrow from the pool they lend to, then lend that crypto again, maximizing their rewards. While it may seem like cheating the system, DeFi platforms encourage yield farming since it makes their services more in-demand.
Limits and Risks
Different DeFi platforms have varying protocols guiding what LPs can and can’t do. Many require some kind of collateral for financial actions, most often a small crypto fee. On some, all users need to qualify as an LP is to have an Ethereum wallet.
Most DeFi activity right now is happening on the Ethereum blockchain, so they use ERC-20 tokens. This could change as DeFi becomes more popular, but for now, the most profitable yield farming utilizes Ethereum. Blockchain-agnostic applications may appear in the future, but there aren’t any major platforms with this feature as of now.
DeFi yield farming sounds like an excellent opportunity to make profits, but it’s risky. First of all, maximizing yields requires a deep understanding of the highly complex algorithms that determine exchange rates and rewards. Users that don’t understand these systems are more likely to lose money than make it through yield farming.
Like many kinds of investments, users won’t likely see high returns unless they have high initial investments. Crypto whales who have coins to spare are far more likely to profit from yield farming. Without a substantial first investment, returns will be slow and possibly minimal.
Since almost all DeFi activity runs on Ethereum, there are also reliability issues. Increased activity leads to a higher chance of mistakes in these transactions.
Is Yield Farming Sustainable?
Some crypto investors are worried about DeFi yield farming’s meteoric growth. Memories of the 2017 cryptocurrency crash reemerge as more people flock to yield farming. A DeFi bubble could be forming, making this an unsustainable and dangerous practice.
Compared to 2017, today’s cryptocurrency market is much larger and more diverse. This size and diversity will lessen the impact of sudden changes in supply and demand. Many of the creators of leading DeFi applications come from the world of traditional finance, offering assurance to some.
As improvements come to the Ethereum blockchain, DeFi’s risk will go down. Similarly, features like blockchain-agnostic services will help lessen the risk of a crash. So while yield farming is risky, it won’t likely see a similar disaster as crypto did in 2017.
All Crypto Is Volatile
The cryptocurrency market as a whole is volatile, and DeFi is no exception. Like crypto in its early days, making significant profits off yield farming seems straightforward but is unlikely. Only users with crypto to spare and in-depth knowledge of the underlying algorithms will see substantial yields.
That said, yield farming isn’t necessarily a disaster waiting to happen. If investors have patience and remember not to invest more than they could afford to lose, it could lead to positive results. Yield farming won’t revolutionize crypto, but it’s not a death sentence, either.
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