Staking or lending crypto assets to produce high returns or incentives in the form of additional cryptocurrency is known as yield farming, an emerging concept in the space of cryptocurrency exchange development and smart contract solutions. Thanks to new technologies like liquidity mining, this revolutionary but risky and unpredictable application of decentralized finance (DeFi) has exploded in popularity recently. Yield farming is currently the most important growth factor in the still-developing DeFi sector, helping it to expand from $500 million in market capitalization to $10 billion by 2020.
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Yield farming protocols, in short, encourage liquidity providers (LPs) to stake or lock up their crypto assets in a smart contract solution-based liquidity pool. A proportion of transaction costs, interest from lenders, or a governance token may all be used as rewards. These returns are calculated as a percentage yield on an annual basis (APY). The value of the released returns rises as more investors allocate funds to the associated liquidity pool.
The majority of yield farmers initially staked well-known stablecoins such as USDT, DAI, and USDC. The most common DeFi protocols, on the other hand, now run on the Ethereum network and offer governance tokens for liquidity mining.
What Sparked the Rise of High-Yield Farming?
The introduction of the COMP token – the Compound Finance ecosystem’s governance token – has sparked a surge of interest in yield farming. Token holders get governance privileges for governance tokens. However, the question is the distribution of these tokens happens while keeping the network decentralized?
Distributing these governance tokens algorithmically with liquidity bonuses is a common way to kickstart a decentralized blockchain. Liquidity providers are enticed to “farm” the new token by providing liquidity to the protocol.
Although the COMP didn’t invent yield farming, it did raise the popularity of this form of token distribution model. Other DeFi ventures have also devised creative ways to draw liquidity to their ecosystems.
What are the Advantages and Disadvantages of Yield Farming?
Profit is one of the most obvious advantages of yield farming. Yield farmers who are among the first to implement a new project may be rewarded with tokens that rapidly appreciate. Huge gains can be made if they sell certain tokens at the right time. Those profits can be re-invested in other DeFi projects to increase yield even more.
Yield farmers must typically invest a substantial amount of money upfront to make any significant profits — even hundreds of thousands of dollars may be at stake. Yield farmers face a major liquidation risk if the price drops unexpectedly, as it did with HotdogSwap, due to the highly volatile nature of cryptocurrencies, particularly DeFi tokens.
Also, the most effective yield farming techniques are complicated. As a result, those who don’t completely comprehend all of the underlying protocols are at greater risk.
Yield farmers have put their money on the project teams and the smart contract code that underpins them. Many developers and entrepreneurs are drawn to the DeFi space because of the opportunity for profit. They start projects from the ground up or even copy the code of their predecessors. Even if the project team is trustworthy, the code is often untested and prone to bugs, making it vulnerable to attackers.
Key Challenges and Opportunities with Yield Farming
The Ethereum blockchain is used for the majority of DeFi applications, posing some significant challenges for yield farmers. The Ethereum network is experiencing scalability issues ahead of the 2.0 update. As yield farming becomes more common, the Ethereum network becomes clogged, resulting in long confirmation times and rising transaction fees.
As a result of this scenario, some have speculated that DeFi could end up self-cannibalizing. Ethereum’s problems, on the other hand, seem to be more likely to support other networks in the long run. The Binance Smart Chain, for example, has emerged as a viable alternative for yield farmers who flocked to the network to take advantage of new DeFi DApps like BurgerSwap.
Additionally, Ethereum’s existing DeFi operators are attempting to solve the problem with their second-layer solutions for the network. As a result, assuming that Ethereum’s issues do not prove fatal to DeFi, yield farming will continue to exist for some time to come.
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