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Yield farming: Beginners guide

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DappRadar

Learn more about putting your cryptocurrency to good use

Unless you have had your head under a rock for the last 2 weeks you should have heard the term ‘yield farming’. The latest hype bubble to hit the blockchain and crypto space is making a lot of noise right now. But what is it, how can people benefit, and how much risk is really involved?

It is vital at this point for readers to know that the amount of competition between investors coupled with high gas prices means that yield farming is only profitable when using a significant amount of money.

Yield farming with $50 in cryptocurrency will definitely result in a loss. For those that want to dip a toe in and try it, that’s not a problem. But be aware that this strategy will not be profitable.

What is yield farming?

Yield farming is nothing more than putting cryptocurrency assets into use by earning a return on the capital invested. There are numerous money markets. Such as Compound, Curve, and Aave, and these provide the most straight forward road to earning a yield.

For those looking to earn more. Liquidity pools such as those available on Uniswap can provide more flexibility as they provide better yields but come with increased risk.

Using money markets

Compound and Aave are DeFi’s top lending and borrowing protocols and both have witnessed an explosion in activity over the last few weeks. Mainly due to the release of Compound’s COMP token.

Borrowing capital from a money market is the simplest way to earn a return on your cryptocurrency has proved to be a popular method in 2020. In order to participate users need to deposit a stablecoin in their chosen platform and start earning returns immediately.

Money market platform Aave offers borrowers the ability to choose a stable rate of interest. Rather than a variable rate so is generally able to offer better rates than Compound. The stable rate tends to be higher for borrowers than the variable rate, thus increasing the marginal return to lenders.

As discussed, Compound recently introduced its own native token COMP and is trying to incentivize users to utilize the compound platform as a pose to taking their business elsewhere.  

Anyone that lends or borrows on Compound earns a certain amount of COMP. 2,880 COMP is issued to Compound users per day. At $250 per COMP at press time, this translates to $720,000 in extra rewards per day.

Money market risks

DeFi money markets function by offering over-collateralization. Meaning that the assets deposited by a borrower must have more value than their loan. To calculate the collateralization ratio an equation of – the value of collateral/value of the loan can be used.

When the collateralization ratio falls below a certain threshold, the collateral is liquidated and repaid to lenders. This setup provides an optimal situation for speculators that want to gain leverage. It also ensures that lenders don’t lose their money if borrowers default.

One other factor to consider is smart contract hacks, but Aave and Compound have avoided this risk to date.

Liquidity pools

Uniswap offers one of the best liquidity pools in DeFi. Effectively luring liquidity providers with rewards for adding their assets to a liquidity pool. It is important to note that liquidity pools on Uniswap are configured between two assets in a 50-50 ratio.

Every time a user makes a trade through a Uniswap liquidity pool the liquidity providers that contributed to that pool are rewarded through earning a fee for helping to facilitate this.

Uniswap pools have traditionally offered liquidity providers fairly healthy returns over the past year as DEX volumes increased dramatically. However, it is important to note that optimizing profits requires investors to consider impermanent loss.

Impermanent loss is the loss created by providing liquidity for an asset that rapidly appreciates. Something that can happen in this industry without warning and often.

One dapp offering liquidity pools that circumnavigates impermanent loss by facilitating trades between assets pegged to the same value is Curve Finance.

For example, there is a Curve pool containing USDC, USDT, DAI, and sUSD: all USD pegged stablecoins. There’s also a liquidity pool with sBTC, RenBTC, and wBTC: all pegged to the price of BTC. Since all of the assets are worth the same amount, there’s no impermanent loss to concern users.

However, it’s worth noting that trading volumes will always be lower than other liquidity pools like Uniswap. In summary, Curve Finance eliminates impermanent loss, but Uniswap will result in a higher fee collection.

Choosing a farm

For those reading this that are risk-averse who just want to earn a yield on their stablecoins, money markets or providing liquidity on Curve Finance is the best option for lower-risk interest.

For those who have large cryptocurrency holdings and want to put them to productive use, liquidity pools like Uniswap are a good choice.

Not financial advice

The information provided here is for reference and informational purposes only. This information is not intended as financial advice and readers understand that all risks associated with DeFi and yield farming are taken on by the user themselves.

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