Understand yield farming in just 3 minutes

It is during the summer of 2020 that yield farming becomes one of the most popular trends in the industry. Challenge. The issuance of Compound and Aave governance tokens started a craze that has not waned. From now on several other farming protocols coexist with their own rules and risks. These include MakerDAO, Uniswap, Curve or PancakeSwap.

What exactly is yield farming?

When we talk about yield farming, we are actually talking about “yield farming”. It is therefore a question here of cultivating your own cryptocurrency in order to ultimately generate passive income.

Via a pool of liquidity, this takes the form of a loan of cryptocurrencies to DeFi (Decentralized Finance) protocols in return for the collection of interest.

Thanks to relatively complex combinations and strategies, a “farmer” can increase his yield by moving his cryptocurrencies between several lending platforms. But these “farmers” rarely divulge their strategies, which makes things even more difficult for beginners to understand.

How does it work ?

Very schematically, we find the same operating process as in a banking institution. The money (here the cryptocurrencies) held in an account is used in the global liquidity reserve (liquidity pool) of the bank. The latter will therefore use this windfall to in turn lend cash to other customers.

In the cryptocurrency ecosystem, all loans are in a “smart contract”. This notably obliges the borrower to put up a guarantee before the loan is accepted. In this system, the borrowers themselves have a say in both the amount and the duration of their payments.

How is yield farming different from staking?

Yield farming requires users to deposit their cryptocurrency funds on DeFi platforms while with staking investors use their funds to support the blockchain and validate blocks on the network and transactions.

Staking is the easiest strategy to earn passive income and can be done with minimal initial investment.

Read also 3 minutes to (finally!) understand DeFi, Decentralized Finance!

the yield farming is more complex, but also more risky since it exposes investors more to a loss related to the volatility of the price of digital assets. Staking is therefore a more interesting option for users who are new to DeFi.

What are the advantages and disadvantages of it?

Yield farming has become an essential tool that offers many advantages for the lender. However, the risks inherent in its use should also be noted.

  • Generate interest and therefore passive income through cryptocurrency lending.
  • It allows to distribute capital directly to investors without going to investment funds or banks.

On the side of the disadvantages, we find mainly:

  • The expected profit will usually require very complex strategic planning.
  • It’s necessary hold significant capital to hope to deploy different investment tactics in order to obtain the best results.
  • On the side of the borrower, the latter may be required to provide excessive guarantees. This is because of the need to facilitate market position adjustments in the event of a sudden market crash.
  • The “farmed” token can take a lot of value, just like it can sink.

Conclusion: what future for yield farming ?

Yield farming is very promising and one of the most popular ways to generate rewards with cryptocurrency holdings. This tool is still in its infancy, but will continue to impose itself with the technological advances and the evolutions of the DeFi infrastructure.

Moreover, it is a catalyst that has already allowed the emergence of many crypto projects and which is capable of both increasing liquidity and ensuring a fair distribution of tokens.

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