In the world of decentralized finance (DeFi), yield farming can be extremely lucrative. But if you want to be successful, you need to understand the pros and cons. That's why we've broken down some common strategies—and pitfalls—that you should know before you pick up your plow.
What exactly is yield farming?
Yield farmers seek to generate as much income – or yield – as possible from their digital capital by switching between different DeFi platforms and strategies. Think of it like a farmer rotating crops in a field to get the most yield out of the soil.
There are different ways to “earn returns,” so to speak, but the idea is the same: you want to earn a return on your cryptocurrency by locking it in the smart contracts of DeFi platforms. Now let’s look at some common yield farming strategies.
Provision of liquidity
When you deposit coins and tokens on a decentralized exchange (DEX), you provide the platform with liquidity – that is, cryptocurrencies with which you can transact. Exchanges require a supply of crypto for users to trade. And in return, liquidity providers earn a portion of these trading fees.
Traders on Uniswap, for example, could exchange DAI for Ether. And as a liquidity provider, you must provide the DEX with DAI and Ether in equal values. By providing 1% of the DAI-Ether liquidity pool, you earn 1% of the fee every time a trader swaps between the two assets.
But this reward is not risk-free: you are exposed to what is called a temporary loss. Calculating temporary loss can be complex. But without going into it, if the prices of coins in a liquidity pool change in such a way that it would have been better to just keep those coins in your wallet instead – and not make that liquidity available to the DEX.
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Loans and credits
Just as you earn interest when you deposit money into a savings account, you can earn returns when you lend your cryptocurrencies to borrowers on DeFi lending platforms. It's just that the return you get with DeFi is usually much higher than what you get from a bank – but there is also much higher risk.
As a lender, your biggest risk is that your smart contract has a flaw in the code – allowing hackers to break in and siphon your money. So make sure you use reputable DeFi platforms and spread your cryptocurrencies across several different platforms.
Yield farmers could also borrow from one platform and lend the same funds on another. In other words: lending with leverage. Your potential return is very high, but so is your risk: it's a double whammy, not for the faint of heart.
This guide was created by Finimize in collaboration with Ledger.
Check out Ledger's Mini website on finimize.com.
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