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What is Yield Farming in Crypto?

DeFi yield farming explained

With the fast-growing DeFi (decentralized finance) industry, the term “yield farming” is becoming increasingly popular among people that seek to invest in the world of cryptocurrencies. Considering that money markets and liquidity pools are the main places where an investor can earn yields by adding or lending crypto, yield farming refers to a process that will provide capital returns by putting tokens to productive use.

Yield farming and DeFi

Decentralized finance or DeFi opened up plenty of new opportunities for crypto investors and since record-breaking funds are now locked into DeFi projects, yield farming has become an attractive investment opportunity. Basically, investors are able to earn fixed or variable interest by investing crypto in a DeFi market.

Although most of the projects are operating on the Ethereum blockchain, simply buying ETH does not equate to yield farming. However, protocols like Aave or Compound for lending ETH, both being the primary lending and borrowing protocols accounting for more than $1 billion of lending, are the main methods investors use to “farm yields” or generate a return.

Money markets and liquidity pools

Investors are now able to lend capital on money markets by depositing stable coin to protocols like the ones previously-mentioned, benefiting from multiple features like better rates (stable or variable) or extra rewards. Over-collateralization is one of the key qualities of DeFi money markets, which means a borrower will need to deposit assets with a value greater than his loan.

In case the collateralization ratio (value of collateral divided by the value of the loan) drops below a certain level, the collateral is liquidated, and lenders get repaid. Based on this setup, some investors are able to use leverage and at the same time, ensure that money won’t be lost in case borrowers default. Still, it is important to note that there are hacking risks associated with smart contracts, even though some of the leading lending projects had not yet experienced such issues.

The second main area where crypto investors are farming for yield is in the liquidity pools. In this case, liquidity providers (LPs) are earning fees and rewards for adding their assets to a pool. Keep in mind liquidity pools can be configured in many ways, depending on the asset ratio. At present, Uniswap and Balancer and two of the largest liquidity pools in the DeFi industry.

With the rise of crypto trading apps and decentralized exchange platforms, an increasing number of trades are placed via a liquidity pool and all investors contributing earn a fee for facilitating the well-functioning of the market. Same as with the money markets, there are risks that should be considered, mainly the impermanent loss, occurring with liquidity is provided for an asset that grows in value rapidly.

Investors are favored by recent DeFi developments, considering a lot of new investment opportunities are arising along the way. Yield farming will continue to be their main objective, as interest rates in the traditional financial industry are projected to remain at ultra-low levels for several years.

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