Crypto brings with it the promise of breaking the standards set by traditional finance. This includes being able to earn a higher APY (Annual Percentage Yield) on assets than something like normal savings accounts with banks.
What is Yield Farming?
Yield farming is the process of lending or staking crypto assets to receive rewards or high returns. These returns are calculated in the form of APY.
Essentially, liquidity providers, or LPs, stake or lock their tokens into liquidity pools run by smart contracts. Liquidity pools are simply collections of tokens that are locked into a smart contract.
Depending on the platform, users can earn a percentage of transaction fees, governance tokens, interest from borrowers, or some combination of the three. Governance tokens, as the name suggests, give holders the power to vote on the future of a blockchain project.
This booming sector of DeFi (decentralised finance) has seen exponential growth over the past few years as people seek to get the most bang for their buck.
Often times a lender's share is represented by LP tokens. These tokens can be used to reclaim the original amount lent plus any yield, or just the yield. For example, if someone lends using PancakeSwap, they'll receive FLIP tokens as an LP token.
Be Aware of the Risks
There are three main risks to be aware of when lending out assets for yield farming.
The first is impermanent loss, which occurs when an asset in the liquidity pool sees a significant price change compared to the other assets in the pool. If 100SOL = 1ETH when the liquidity pool opens and a couple of days later 50SOL = 1ETH, an impermanent loss will be experienced by the depositor. With drastic price changes, the yield earned does not make up for the impermanent loss.
Second, we have flash loan attacks. This is a process where scammers borrow piles of money to manipulate the market and DeFi protocols. A prime example of a flash loan attack is the one suffered by Cream Finance in 2021.
Lastly, rug pulls are an exit scam seen in the DeFi space. In this type of scam, developers will create a new token and pair it with leading crypto, like ETH or USDT, to create a liquidity pool. They use a combo of astronomically high yields and marketing to entice people to deposit assets into the pool.
Once their target is achieved, the scammers will use a 'back door' coded into the smart contract to make tons of new coins to sell for the leading crypto, draining the liquidity pool in the process.
As always, make sure to research and practise due diligence before lending to any DeFi or yield farming protocol.
Popular Yield Farming Protocols
The number of yield farming protocols grows by the day, so it can be difficult to pinpoint which are the best. Five of the most popular platforms for yield farming are Aave, Compound, Uniswap, and Instadapp.
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