Every now and then the crypto space starts buzzing about something new, in recent times it was the start of the decentralized finance movement (casually called DeFi), but since this has escalated further into an unusual trend called yield farming. While high risk a significant number of traders seem to be taking the risk to see how much profit they can potentially gain from this new practice. However, if you are first to hear of this unusual practice, you likely have many questions, read on to learn a little more about this escalating cryptocurrency trend in this beginners guide to yield farming.
What is Decentralized Finance?
While this term can be pretty broadly used, in this context it will be used to describe many of the recent DeFi projects launched on the ethereum network. While all these projects vary in a multitude of ways, there are some reasonably common similarities, primarily in that, they offer both loans and benefit those that provide loans or collateral for these loans. While similar projects have existed in the past, and some have grown to be quite significant, there has been a recent boom of new projects pushing the boundaries further than before and gaining quite a lot of attention in some cases.
What is Yield Farming?
Yield farming is somewhat a natural progression of the availability of several different DeFi projects. When carefully planning and stringing together various types of loans among different projects, multiple levels of returns can potentially be achieved with interest returned in various tokens and cryptocurrencies from multiple sources. Interestingly yield farming has brought liquidity providers on a significant scale to many of these projects which in-turn providing liquidity for them to grow further. At its core, the process is about putting digital assets "to work" which in turn provides both risks, and if all goes well rewards.
Example of Yield Farming
Investing in ethereum is not really an example of yield farming. However, if you took that ethereum, lent it to a DeFi project, received a loan, lent that to another project and started stacking loans from various projects gaining incentives along the way, this would become yield farming. It's quite surprising how deep some of these yield farmers are taking this, some stacking quite a few levels of loans to get as much as 100% annualized yields thanks to various types of cashback, bonuses, and other loan incentives.
The Problem with Yield Farming
If you've reached this point you had to wonder if there was a catch, and yes there absolutely is, and a significant one at that. The biggest concern with yield farming is when the stacks start to collapse. Unlike investing ethereum in an ICO or buying some coins or tokens that are involved in one project, when farming yield you are relying on multiple projects to function well, not get hacked, and not to have any issues that affect your liquidity stacking. Like a game of Jenga one wrong move can have your whole stack tumbling down, you can run low on collateral for your loans and in short simply get rekt.
If you are expected to pay back a loan in a specific token, but it's pumped in value 200%, you can quickly start running into problems. If anyone was to tell you liquidity mining and yield farming was a foolproof practice, this is merely not the reality. While the crop yield for careful farmers can be quite significant, this is absolutely no sure thing. With the many recent issues that have occurred with some DeFi projects that have sent waves through the ethereum community, odds are sooner or later, this practice could hurt those that partake in it. Is the risk worth the reward? That's for everyone to decide for themselves.
Money Markets & Liquidity Pools
Some projects allow for the staking of tokens to, in turn, receive rewards; this is one of the ways a yield farmer utilizes loans. Whether they are governance tokens, stablecoins, or anything else, if they have a market value, then they are a prime candidate for many yield farmers to target. Recently some tokens have boomed as soon as a way to add them to yield farming stacks which produce further risks.
Many projects have started offering rewards in their native token for using their platform or engaging with the services they provide, these liquidity incentives have turned from a nice return or reward to liquidity mining potential. Some recent launches have seen millions of dollars roll into DeFi projects in the first week alone. While some cryptocurrency traders are opting simply to lend money to these money markets and sit back, many are using money markets as just a stepping stone to more returns on their tokens and other digital assets.
Yield Farming Tools
You may be wondering how people are keeping track of some of their larger scale farming efforts, and it seems a few developers were too. Quite quickly yield farming tools are starting to appear offering dashboards to help monitor various metrics useful to yield farmers and liquidity providers. Many websites have sprung up as well offering a range of resources and yield farming news. While many of us have only heard about this trend in recent weeks, it seems to be escalating with significant speed.
It seems every day there are new yield farming strategies and different crypto assets prime for farming, but is this the peak of the hype or are more projects, tokens, and high-risk investment opportunities are going to continue to roll out, only time will tell.
Loan providers in the DeFi space typically expect you to over-collateralize for any loans you are taking. If the value of the collateral you have provided falls below a certain threshold, you are at a high risk of being liquidated so that the loan can be repaid to lenders. Like leverage trading, money markets and liquidity providers in the DeFi space do carry a significant risk for liquidation if you stretch your resources too far. Sudden changes in market conditions also pose a significant threat as they can affect the value of your collateral or your ability to pay back that collateral if you are having issues deeper into your stacking for one reason or another. With all the risk involved in yield farming, you may find it better to keep your ether in your hardware wallet, and your farming to the outdoors.
Whether you think yield farming is here to stay, a dangerous gamble, or a peculiar economic behaviour forming in the cryptocurrency space, it is nonetheless an interesting trend. If it is here to stay or not only time will tell. If you prefer to keep things simpler and safer, you can head over to LocalCoinSwap and buy or sell major cryptocurrencies like bitcoin and ethereum. Peer-to-peer (P2P) trading offers the ability to turn cryptocurrency into your business by exchanging with various payment methods and profiting from arbitrage opportunities, without having to rely on the fast-paced and high-risk world of yield farming.