What is Yield Farming?
Yield farming is a method of generating profits through the use of decentralised finance (DeFi). On a DeFi platform, users can lend or borrow cryptocurrency and get cryptocurrency in exchange for services rendered. More involved planning can be used by yield farmers who aim to boost their yield output. Yield farmers, for example, can continually shift their cryptos between several loan platforms in order to maximise their profits.
Why has Yield Farming become so popular?
The creation of the COMP token, a Compound Finance ecosystem governance token, is attributed with the surge in the use of yield farming. Holders of governance tokens can partake in the governance of a DeFi protocol.
To start a decentralized blockchain, governance tokens will regularly be issued algorithmically with liquidity incentives. This simply encourages future yield producers to add liquidity to a pool.
How does Yield Farming Work?
Yield farming is inherently connected to an automated market maker structure (AMM). Liquidity providers (LPs) and liquidity pools are usually involved in this. But how does it work?
Funds are transferred into a liquidity pool by liquidity providers. This pool is used to support a marketplace where users can lend, borrow, and trade tokens. Fee applies for using these platforms, which are then redistributed to liquidity providers according to their portion of the liquidity pool. This is the foundation of an AMM’s operation. However, because this is a comparatively novel technology, the methods can be substantially distinct. There’s no doubt that new ways will arise that will improve on current implementations.
Apart from fees, the distribution of a new token could provide a supplementary incentive to add funds to a liquidity pool. For example, a token may only be available for purchase in miniscule amounts on the open market. It can be acquired, on the other hand, by giving liquidity to a certain pool.
The distribution rules will be established by the protocol’s unique implementation. In the end, liquidity providers are reimbursed depending on the proportion of liquidity they contribute to the pool.
What are some risks of Yield Farming?
Beyond the regulatory dangers that most digital assets face due to the lack of defined policies addressing cryptocurrencies around the world, cyber theft and fraud are significant concerns. All of the transactions entail digital assets that are preserved via software. Hackers are proficient in finding loopholes and exploits in software programmes in order to steal money.
Then there’s the question of token volatility. Typically, cryptocurrency prices have been known to be erratic. Short bursts of volatility can emerge, causing the price of a token to rise or fall even though it is locked in the liquidity pool. This may result in unexpected gains or losses, and you may be better off if you kept your coins open for trading.