The year is 2020, and the cryptocurrency market is adding one more use case to its growing ecosystem of tokens and DeFi operations–yield farming. The yield farming concept solved the liquidity issue in crypto exchanges, especially on decentralised exchanges. The concept also provided users with a means to multiply their crypto assets by locking them in liquidity pools and drawing rewards from the interest and transaction fees on the exchanges.
Yield farming entails crypto users depositing their tokens or assets in the form of staking or lending to liquidity pools on exchange protocols to receive token rewards from the exchange operations on the platform. While it is an excellent investment option for users with idle funds, it can also be pretty risky, considering the market volatility.
Here's a guide to yield farming and how to start before we get down to impermanent losses.
How Does Yield Farming Work?
Decentralised exchanges use liquidity pools as a source for funds with which other users swap their tokens. These liquidity pools provide the base for token swapping, and it is crucial that they continuously contain assets to serve users. Smart contracts govern the liquidity pools, using algorithms to set the prices of cryptocurrency pairs and facilitate faster and more accurate transactions between users.
When decentralised exchanges started, they were faced with significant challenges in getting liquidity for their operations. It was a major reason many DEXs couldn't scale up as the cryptocurrency market expanded, which necessitated the introduction of centralised exchanges.
Eventually, yield farming was developed to acquire liquidity from users with idle crypto assets. These users, regarded as liquidity providers, stake their crypto coins in liquidity pools on the DEX, and earn rewards in the form of more tokens (usually the native token of the DEX). The rewards come from transaction fees that the exchange charges on every token swap, as well as interest on crypto loans if the DEX also offers lending services.
The process of earning passively from the liquidity provided is called liquidity mining, which is essentially yield farming. Compound brought the idea into the limelight, and before long, many other DEXs adopted it for use on their platforms.
Liquidity providers on such exchanges earn based on percentages called Annual Percentage Yield (APY), which is calculated differently by individual DEXs. The platform's algorithm calculates the interest during the year in a compounded manner.
Where Can I Start Yield Farming?
Like we said, yield farming is available on decentralised exchanges and protocols that provide lending/borrowing services. These platforms are always in need of liquidity to sustain the swapping process, and reward their liquidity providers with governance tokens. You can trade these tokens on the market or swap them on the DEX.
Some of the most popular yield farming platforms in the cryptocurrency market include:
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Aave:
Aave offers lending and token exchange services to crypto users. It is especially famous for its flash loan feature, which enables users to take emergency loans without collateral.
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Uniswap:
One of the largest DEXs in the cryptocurrency market, built on the Ethereum blockchain. The exchange allows for any swapping between tokens on the Ethereum network.
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Compound:
Compound is one of the top yield farming protocols, holding the one of the largest amounts of liquidity among the other exchanges. The platform boasts advanced security that ensures it remains secure against hacker attacks.
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Curve Finance:
allows other users to exchange stable coins at relatively low slippage. The platform holds the highest trading volume presently, set at about $9.7 billion.
How to start your yield farming journey today: acquire some tokens from any exchange, and access the yield farming site through a DApp browser. There, you can deposit your tokens, locking them in the liquidity pools, and recieve rewards from the swap operations.
What Are Impermanent Losses On Yield Farming Projects?
When you invest in a yield farm, your assets are displayed via a dashboard, where you can view your current portfolio even though you can't access all the tokens. As the platform adds your token rewards, the figure on the dashboard changes.
The cryptocurrency market is highly volatile, as token prices can change in a blink without any prior signs. It's one of the attributes that increase the risk in opportunities like yield farming, since a dip in token value leads to loss for the investor.
Now to impermanent losses. To start an investment on a yield farm, you buy stable coins, which are fairly resistant to price fluctuations. You then use stable coins, such as USDC, USDT, and DAI, to purchase the specific tokens you wish to invest in.
Now, when the price of that token, say Ethereum, goes down against the stable coin's price, the liquidity provider is at a loss. The amount of Ethereum staked doesn't change, but the value of the assets in the liquidity provider's dashboard reduces. That loss is referred to as an impermanent loss.
How to Avoid Impermanent Losses?
You can avoid impermanent losses by investing in stable coins, which are not as volatile as other tokens.
If you have to invest in other kinds of tokens, you can stake your assets in two correlated assets, where profits in one coin can cancel out losses in the other. This doesn't totally eliminate the possibility of a loss; it only minimises the effects of a loss on your overall crypto portfolio.
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This article is intended for educational purposes and is not financial advice.
