Understanding Yield Farming

by | Jul 1, 2021

Disclaimer: Posts on the HyperTrader blog and associated HyperLinq websites are for educational and informational purposes only. These posts should not be taken as financial advice, nor are they meant to be viewed as trading advice. HyperLinq Inc. or the authors take no responsibility for any damages or losses.

The exponential growth of DeFi has opened a door to a lot of opportunities for crypto investors around the globe. The rise of DeFi has made it possible for everyone to participate in a financial market regardless of geographical location, availability of credit score, or identity information. 

With this new borderless and open financial system, anyone can participate and capitalize the numerous opportunities across various DeFi protocols. However, for a newcomer, DeFi can be complicated at first and requires a basic knowledge of interacting with blockchain applications. 

Therefore, today, we’ll delve into one of the techniques called Yield Farming through which investors can earn a passive income using their crypto funds. 

Further Read: What is DeFi?

What is Yield Farming? 

Yield farming is a practice of locking up crypto assets in order to earn a passive income. In DeFi, there are three major ways to lock your crypto assets to earn rewards  – lending, staking, and participating in liquidity pools. 

Lending: Crypto lending is quite similar to traditional finance. All you have to do is – provide your crypto funds to lending protocols such as Compound and in exchange, you earn a fixed or flexible yield on your funds. 

The flexible interest, however, can depend upon the demand for lending against borrowing on the specific protocol. 

Staking: Staking is a process of locking your crypto assets in a PoS (Proof of Stake) blockchain network to secure the network and earn a fixed reward on your funds. 

Investors can either choose to run a node by themselves and become a validator by staking their funds. On the other hand, users can also earn a reward by simply delegating their funds to a choice of their validator on the network. 

Further Read: What is Crypto Staking?

Liquidity Pools: Depositing funds in a liquidity pool to earn a reward can be said to be the most complicated process among all three ways mentioned here. To understand the concept of liquidity pools, we need to first delve into decentralized trading. 

A liquidity pool is a smart contract intended to lock a collection of funds to facilitate decentralized trading. Liquidity pools can also be called the backbone of decentralized exchanges. DEX platforms leverage liquidity pools to enable users to trade crypto assets while doing away with the need for centralized order books. 

Now here comes the opportunity for users to earn yield by participating in liquidity pools. Users can become a liquidity provider (LP) by depositing a pair of crypto tokens in a pool to facilitate token swapping for traders. In exchange for facilitating trading of those given pairs of tokens, users can earn a part of trading fees for each token swap.

For example, users can become a liquidity provider in ETH/DAI pool on a decentralized exchange such as Uniswap by depositing equal value of both tokens in this given pool and earn a steady yield on every ETH <-> DAI transaction on Uniswap.

Besides earning a part of trading fees, most protocols also reward liquidity providers with governance tokens, enabling users to not only earn additional rewards but also participate in the protocol’s governance.

Conclusion

To sum up, learning DeFi can be tricky, but the best way to learn about something is by actually interacting with it and doing things. Hence, I’d recommend the same for getting yourself acquainted with DeFi. To learn more about yield farming and other ways to earn a passive income with DeFi, check out top DeFi protocols such as Compound, Yearn Finance, Aave, MakerDAO, Uniswap, Balancer, etc. 

However, it’s worth noting that the DeFi is currently at a nascent stage and can be risky at times. Therefore, it’s recommended to start small and focus on learning potential rather than earning.

Head of Content Marketing @ HyperLinq. His love for Chai and mountains precedes everything. Often wonders about things like, "why $1 earned through leverage feels 100x better than $1 earned selling your time?"
Head of Content Marketing @ HyperLinq. His love for Chai and mountains precedes everything. Often wonders about things like, "why $1 earned through leverage feels 100x better than $1 earned selling your time?"

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