Decentralized Finance (DeFi) has captured the interest of investors throughout the crypto and traditional finance world alike. By removing centralized parties like banks, exchanges, and others, DeFi has allowed users to access peer-to-peer economies functioning on automated smart contract functions and protected by the immutability of the Blockchain.
Since the DeFi boom witnessed at the start of 2020, the total value locked (TVL) in DeFi projects has grown massively and currently sits at $70.85 billion. The growth of the DeFi industry has been widely attributed to the advent of yield farming activities with the creation of the Compound (COMP) governance token and later creation of automated Yield Farming platforms like Yield.Finance.
While DeFi has generated mass interest from investors across the board and has generated innovative subsets like Non-Fungible Token (NFT) and GameFi platforms, interest in Yield Farming remains strong in 2021. It is essential to define yield farming and explore the best ways to take advantage of this profitable activity.
What is Yield Farming
What exactly is Yield Farming? While widely popular, the term is highly ambiguous, with many contradictory sources failing to provide an accurate definition of what Yield Farming is. Contrary to popular belief, simply using any yield generating product in the DeFi ecosystem is not considered Yield Farming.
Decentralized exchanges, lending protocols, and insurance platforms allow users to provide liquidity and to earn yield on their deposits from trading fees and user-generated interest on the borrower side. Furthermore, some projects will encourage this activity, known as liquidity provision, with additional governance or utility token rewards allocated for extra yield. The latter activity is known as liquidity mining.
While both of these can generate high APYs for DeFi investors, they are only steps that are leveraged in the process of Yield Farming, which can be defined as a complex investment strategy that takes on varying degrees of risk to maximize the user’s passive income activities actively.
Automated Yield Farming
Yield farmers will often use leverage products to increase their liquidity and take advantage of several decentralized platforms to compound interest. These activities come with different degrees of risk and rewards, which we will discuss further below.
While it is possible to participate in Yield Farming manually, these processes are often cumbersome. They require a high level of technical and financial expertise and extensive research for the best strategies.
Automated yield farming platforms allow users to take advantage of these strategies without investing time and research in manual participation. Centralized examples include platforms like Swissbord, and decentralized ones include the popular Yield. Finance dApp.
These platforms pool users’ funds and use them for these strategies. While centralized platforms usually provide a more user-friendly experience, they also limit the amount of risk (and profit) that the user can undertake. On the other hand, decentralized platforms provide multiple vaults (where users’ funds are pooled to save on gas fees) with varying degrees of risk, according to the degree of leverage and number of smart contracts interacted with.
Understand the Risks
To start using these platforms or to engage in Yield Farming manually, it’s imperative to understand the risks of investing in this activity. As we’ve mentioned above, Yield Farming usually takes advantage of leveraged positions, which means the user has a higher chance of being liquidated if the value of an asset changes abruptly.
Additionally, there are security risks involved with compounding profit across multiple platforms., given that smart contracts may contain unknown vulnerabilities or attack vectors, especially those that haven’t been publicly audited. As so, the risk increases with the number of platforms interacted with.
An additional risk to stay on the lookout for is impermanent loss created in the process of liquidity provision and liquidity farming and is the result of the volatility of the assets in which the user provides liquidity.
The best way to mitigate all of these risks is to use CeFi platforms like Swissborg and others, which employ risk management strategies and allow users to stake single assets like established cryptocurrencies or stablecoins.
With that being said, it’s always important to never invest more than what you can afford to lose, especially when it comes to experimental and nascent industries like DeFi.