What is Yield Farming Offering Passive Income?

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Interest in the DeFi industry showed itself especially in 2020. The amount of DeFi tokens locked on the platform exceeded $ 40 billion. As decentralized applications and stock markets rose rapidly, the search for alternative income among users also increased. Yield farming is preferred precisely for this need.

Yield farming is token lock to the system in exchange for various rewards. In this way, both liquidity is provided and returns are obtained at varying rates. Similar to staking, yield farming has a fundamentally different operating principle. Yield; While it is used in terms such as yield, yield, production, farming means farming and agriculture.

What is Yield farming and how does it work?

Yield farming refers to the reward DeFi users earn for locking tokens into their liquidity pools. These liquidity pools are controlled by smart contracts and are important for the trading of tokens in the market. Providing passive income, yield farming provides users with income while providing liquidity to the cryptocurrency pool.

Tokens locked to the system through networks such as Ethereum provide users with returns. This return is similar to receiving interest income from deposit accounts at banks after a certain period of time. The importance of this process is that it serves as a tool to ensure that a newly released DeFi protocol gain liquidity and test the reliability of the protocol.

How does it work?

Users can start yield farming by selecting a liquidity pool based on their capital and risk appetite. The working principle of Yield farming is as follows:

  • The token is locked into a liquidity pool.
  • The locked token is usually a stablecoin. For example; USDT, USDC, DAI, etc.
  • After the token is locked, the user becomes a liquidity provider.
  • The user is rewarded for locked tokens.
  • The awards given can be locked back into the liquidity pool. Experienced users can try to increase their income by moving the locked tokens to different liquidity pools.
  • The rewards can vary depending on the amount of token deposited or the platform being traded.

For example; If a user deposits ETH in Compound, he will receive Compound ETH (cETH). CETH, which will be deposited into a different liquidity pool, means the emergence of a third token. Therefore, yield farming can become a difficult process to follow.

Yield farming protocols

The popularization of Yield farming is based on the Compound (COMP) protocol. The Compound protocol announced that it will distribute a certain amount of tokens to users daily until all tokens are exhausted in 2020. The new system worked for Compound and the value of the token began to rise. Investors were able to earn COMP as a daily return in line with the amount of token they locked into the system and continued to receive high amounts of COMP. Following the success of the Compound, Balancer, bZx, Ren, Curve, Synthetix started to implement a similar system.

Yield farming capable platforms; Compound, MakerDAO, Aave, UniSwap, SushiSwap, Balancer, Synthetix, Yearn.Finance, PancakeSwap, Venus and Curve Finance. These platforms generally act on the principle of enabling people to enter the DeFi market comfortably and enabling everyone to make transactions.

What are the advantages and risks of Yield farming?

The advantages and risks of Yield farming can be summarized as follows:

Advantages:

  • Yield farmers provide liquidity to the network.
  • In order to diversify the cryptocurrency portfolio and balance risk, yield farming can benefit investors.
  • With the right strategy, there is a good chance of making a profit.

Risks:

  • DeFi applications are open source and can therefore be vulnerable to attacks. As a result of the hacking attack, the DeFi ecosystem may collapse and the yield farming token may lose value.
  • High reward can mean high risk. There is no institution that can protect deposited tokens. Tokens may be lost if the highly rewarding and token locked protocol suddenly disappears from the DeFi ecosystem or faces major trouble.
  • Rates of return can vary. The now high rate of return may drop in the coming months. This situation prevents the predictability of the gain that can be obtained from yield farming.
  • Problems that can be seen in smart contracts can affect the amount of reward awarded as a result of farming.
  • When doing yield farming processes should be reviewed frequently. There is a risk of loss if possible errors in the system are overlooked.
  • Everything works as a whole in the DeFi ecosystem. For this reason, the disruptions to be seen on the platform where the token is deposited and the network to which that platform is connected have the potential to affect yield farming rewards.

Differences between yield farming and staking

Staking and yield farming can be compared at times. Staking, which is defined as locking crypto coins to the network, is a different process from yield farming. Staking is done on blockchain networks where the PoS mechanism is located and requires a validator. A token that can be staked is kept in the cryptocurrency wallet for a certain period of time, and users receive rewards at expiry. The rate of reward given after staking may also vary depending on the staking period and the volatility of the token. During this process, the user takes the role of authenticator and verifies blocks in the network. Thus, both the security of the network is ensured and the operation of the network continues.

In Yield farming, the processes are a little more complex. In this process, users can transfer deposited tokens between pools and get lower transaction fees or new tokens. Unlike staking, users are not authenticating in this process. They can continue to produce yield farming by depositing the rewards they earned in a pool into the same or a different liquidity pool.

While the amount of tokens to be deposited for staking can be high, this amount is lower in yield farming, and users can increase their rate of return by obtaining large amounts of tokens with yield farming.

Although Yield farming is a preferred passive earning method in the DeFi ecosystem, it is necessary to consider the risks and take action accordingly.

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