What is Yield Farming in Decentralized Finance?
Although it started in the United States, the impact of the 2008 financial crisis was felt by the entire global economy. The Occupy Wall Street movement and Bitcoin were born just a year later. Both cryptocurrency and the social movement have been a reaction to the excesses of central finance (CeFi).
After Bitcoin, it took about six years for another blockchain to emerge: Ethereum, which paved the way for what we know today as decentralized finance (DeFi).
So, what is decentralized finance, and how does DeFi work? Read on to find out why rescued banks are talking about DeFi as riskier than Bitcoin…
Decentralized Finance (DeFi) in a nutshell
One of the areas of cryptocurrency that is attracting a lot of interest is DeFi or Decentralized Finance, which is financial services that use smart contracts, which are automated, enforceable agreements that do not need intermediaries such as banks or lawyers and happen over the Internet instead, and are based on the use of blockchain technology. (blockchain), which is a system for recording information in a way that makes it difficult or impossible to change or hack the system.
If there is no trust, how can the trading parties guarantee that the other party will delay the end of the transaction?
By payment to the arbitrator or executor as a cost of doing business. However, what happens if this arbitrator is purchased? Thereafter, the only remaining remedy is that it is in the best interest of the arbitrator to preserve his reputation.
Therefore, in the best case scenario, the business parties have to pay the fee, and in the worst case, one party is harmed in the event of corruption. DeFi eliminates both scenarios by using untrusted smart contracts. However, not all blockchains have it. For example, the Bitcoin blockchain was developed with the sole purpose of offering a deflationary cryptocurrency.
More general blockchains, such as Ethereum, Cardano or Algorand, are programmable chains. That is, developers can codify any contract that exists in the real world as a smart contract and place it within data blocks. They are smart contracts because they are automatically executed when pre-programmed conditions are met, and they are decentralized because there is no moderator in the midst of play.
How do smart contracts work?
Also called decentralized applications (dApps), smart contracts encode and execute any logic you can think of. This reasoning can be legally binding or for commercial purposes. For example, exchanging one currency for another, processing transactions, creating title deeds, tracking products, digitizing (tokenizing) real world assets (NFTs), etc.
Now, what really gives smart contracts/dApps their power is Blockchain. If you’ve ever played a first-person shooter, you’ll notice that it has a kind of economy. When you trade something in it, either between human players or NPCs, the software carries out that trade without an intermediary. Technically, this is a smart contract.
However, a hacker can easily corrupt this game to misrepresent the trade or steal the entire in-game money.
This is almost impossible for dApps, as they are stored within the Blockchain. Every time a record is created, for example, a smart contract is executed, that record is synchronized across the entire Blockchain network. Therefore, for this record to be forged, one would have to control more than 50% of the network first.
Automated market makers are the most popular decentralized applications
In centralized finance, market makers, such as the Nasdaq, Citadel Stock Exchange, or the New York Stock Exchange, are important for the stock and forex markets to function. If you want to buy an asset at a certain price, there has to be someone on the other end to sell it to, and vice versa. Without market makers, it would be very difficult to do so without much delay.
In turn, market makers introduce liquidity into the markets by covering both the “asks” and the “bids”. For example, if you want to sell 50 shares of Tesla (TSLA) stock, the market maker will buy it for you even if there is no seller available at the moment. In this way, market makers ensure that investors can exit and enter the market whenever they want, taking advantage of the asset’s price movements.
In decentralized finance, automated market makers perform the same role. Instead of centralized exchanges like the NASDAQ, a decentralized exchange (DEX) uses AMMs to introduce market liquidity. This is possible thanks to liquidity aggregators and liquidity providers.
Liquidity Pool + Liquidity Provider = Yield Farming
For a cryptocurrency pair to be tradable, there must be a token reserve so that there are no delays. This reserve is the liquidity pool. Let’s say someone wants to exchange a DAI stablecoin for ETH or vice versa. For this exchange to be possible, the liquidity provider locks its crypto assets in the DAI/ETH liquidity pool.
For his service as a liquidity provider (LPs), he receives a reward which depends on the amount of crypto assets stacked and the demand for the token pair. Therefore, the provider of liquidity is known as a crop farmer, and the provision of liquidity on a decentralized exchange is known as yield farming. The same principle applies to borrowing and lending as well.
The most popular types of DeFi dApps for yield farming are the following:
1. Aave — lending
2. Compound — lending
3. Maker — lending
4. Uniswap — DEX
5. PancakeSwap — DEX
Almost all DeFi dApps are hosted by Ethereum, while PancakeSwap is hosted by Binance Smart Chain. Which has gained popularity by providing faster transaction speeds and lower fees, which are commonly called “gas fees”. In total, crypto assets locked in the DeFi ecosystem have grown exponentially since last summer, reaching $80.42 billion (total value locked).
Why this obsession?
The number one reason for the De-Fi boom, is that while regulators have been lagging behind in the development of DeFi, De-Fi has been able to thrive in the void. For example, in conventional unsecured lending, there is a legal requirement that the lender and borrower know each other’s identities and that the lender assess the borrower’s ability to repay the debt. While in DeFi there are no such requirements, rather everything revolves around mutual trust and privacy.
That said, the regulator must delicately balance stifling innovation with failing to protect society from the dangers of individuals putting their money in an unregulated space, or of banks and other financial institutions being unable to make a living as intermediaries. But it makes sense to embrace change and it seems to be happening.
Other types of DeFi dApps and how to get started
Yield farming can be simulated just like any other activity. The best example of this is Axie Infinity, a very successful Blockchain game where one can farm Small Love Potions (SLP) and NFTs. Then, you can turn it into a passive income stream. Since the beginning of 2021, Axie’s revenue has increased by more than 6,000%!
For the best overview of available dApps, visit dappradar. You will quickly notice that for most transactions, you need ETH or BNB tokens. Of course, to get them, you first have to buy them with fiat money.
The easiest way to connect with dApps and top up your funds is to install a MetaMask wallet, which is available for all major platforms. With the MetaMask wallet installed and integrated into your web browser, every time you visit the dApp it will automatically attempt to connect you to the DeFi protocol. After that, it’s up to you to decide which pair of symbols to choose for yield farming.
Whichever option you choose, your profit rate will likely be much higher than what you could earn on your bank savings account. However, just like calculating interest on stocks and common stocks, your investment may decline, and you may not get back the money you put into a DeFi dApp to be with. Check out ways to avoid cryptocurrency scams: Beware of Bitcoin Scams.