Yield farming is a DeFi concept in which you can earn passive income by owning cryptocurrencies. It can provide good returns to investors while also supporting the blockchain ecosystem. Farming is the cryptocurrency equivalent of earning an annual percentage return on bank deposits.

Yield farming is also known as farming. It was originally designed for Ethereum’s blockchain, but it is now available for a variety of other blockchains as well.

PancakeSwap and Binance are two well-known platforms where you can use yield farming.

What’s the distinction between farming and staking?

Farming is similar to staking in that both allow you to actually earn passive income from your cryptocurrency. The difference is that farming employs two or more different cryptocurrencies.

Staking entails depositing a specific cryptocurrency in a liquidity pool in order to earn cryptos. You will receive Ethereum if you stake it.

For farming, two cryptos are placed in a pool. You will then receive a certain percentage annual return in some form of cryptocurrency. Which cryptocurrency you would receive is determined by the platform used. Farming typically yields a higher percentage return than staking, but the risk is higher.

What are the risks of yield farming?

Although yield farming can provide a good return, it is not without risks. There is no such thing as a risk-free investment.

Before considering yield farming, an investor should answer the following four questions:

  1. Do you fully understand which cryptocurrency you want to lend?
  2. Is the coin stable enough to maintain a stable value over time?
  3. If the cryptocurrency loses value, is the revenue enough to cover the loss?
  4. If you lose a lot through yield farming, is it going to impact your overall portfolio?

These questions can give you a quick overview of the risks associated with yield farming. The risks stem primarily from the fact that the cryptocurrencies you lend to a liquidity pool can fluctuate in value. This means that even if you’ve made money from farming, you can still make more if you keep your cryptocurrency. This is known as impermanent loss.

Impermanent loss is the profit you would have made if you had simply kept your cryptocurrency rather than putting it in a liquidity pool. Impermanent loss occurs when the value of the assets in the pool fluctuates and rises or falls.

Using so-called stack coins is one way to eliminate much of the risk. These are designed to have the same value as a specific currency, such as dollars or euros. With stack coins, however, you should expect a lower return.

What kind of return can you expect?

The return you can expect is determined by the cryptocurrency you choose to farm and the level of risk you are willing to take.

The yield from farming is typically expressed in APR or APY. APR stands for annual percentage rate, and APY stands for annual percentage yield, with APY accounting for interest on interest.

The rate of return also varies depending on the cryptocurrency and platform used. In most cases, the compensation you receive from farming is also paid out in the platform’s own cryptocurrency.

CoinMarketCap displays a list of expected returns for various cryptocurrencies, as well as the cryptocurrency you will receive as a reward.

How to maximize profits

The first step is to select a secure and well-known farming platform. The platform should have its own cryptocurrency with a large market cap and trading volume, as this increases security. Although crypto is generally volatile, such crypto is often more stable.

You can then choose to stake your profit to increase your potential profit. This allows you to generate two distinct cash flows. If, on the other hand, the market tanked, it might be more profitable to exchange the crypto you’ve been farming for a stack coin. This ensures that the profit you have made is secure.

Profit maximization also implies minimizing the risk of loss, such as by protecting yourself from impermanent loss. You can accomplish this by including a stablecoin as one of the cryptocurrencies you farm. If you farm two stack coins, you will almost eliminate the risk of permanent loss, but you will receive a lower APY.

How Yield Farming Generates Yields
One of the biggest questions that DeFi newbies ask is how yield farming sites are actually able to pay you interest. After all, the generation of interest cannot appear out of thin air.

  • As noted earlier, when you lend tokens to a farming pool, this will provide the respective exchange with sufficient levels of liquidity.
  • Meaning traders can use the exchange to swap tokens in a decentralized manner.
  • And in doing so, the trader will pay a small fee on each swap that they execute.

In terms of specific yields, this depends on two things in particular:

  • The share that you have in the liquidity pool
  • How much the exchange collects in trading fees

To illustrate the above, let’s look at a simple example:

  • Let’s say that you provide liquidity for the pair BNB/BUSD
  • You provide $1,000 worth of each token – so your total outlay is the crypto equivalent of $2,000
  • In total, the liquidity pool on your chosen DeFi platform has $200,000 worth of liquidity
  • This means that your stake in this liquidity pool is 1%

Now that we know what your stake in the farming pool is, we can then calculate the fees that you earn:

  • Over the course of one year, the BNB/BUSD liquidity pool collects $120,000 in trading fees
  • This means that on a stake of 1%, your share of collected trading fees amounts to $1,200
  • On an initial investment of $2,000 – this amounts to a yield of 66%

However, it is once again important to highlight that your rewards will be paid in crypto tokens. As such, the monetary value of the respective tokens that you receive will depend on market prices.

Of course, one such way to counter the volatility risk associated with yield farming DeFi pools is to opt for a stablecoin pair. On the other hand, as we saw with the recent TerraUSD crash, even stablecoins are not free of risk.

Is DeFi Yield Farming Safe?

DeFi yield farming services give you the opportunity to earn significantly more interest than you will get with traditional financial providers. However, this also means that you will be taking on additional risk.

Before you proceed with a DeFi farming investment, be sure to consider the risks outlined below:

Impairment Loss Risk

To recap, this refers to the opportunity cost that you will face if you make less from a yield farming pool than you would have done simply by holding the tokens in an exchange or wallet.

For example, if you make gains of $300 from yield farming but the respective tokens have increased by $500 during the same period, then your impairment loss amounts to $200.

Volatility and Price Risk

It goes without saying that unless you are farming a stablecoin, you will need to factor in the risks associated with volatile and market pricing. After all, crypto tokens will go up and down in value throughout the day.

This means that while your tokens are locked in a farming pool, their market value could decline. If this happens, there is every chance that you lose money.

For example, let’s suppose that when you deposit BNB into a farming pool, it is worth $500 per token.

Over the course of three months, you generate 5% in interest.

However, BNB has since declined by 20%.

As such, although you have made 5% in interest, your overall BNB portfolio is now valued at a lower amount.

This is why you need to consider the reputation of the tokens that you are looking to farm. In other words, while large-cap tokens are less prone to huge volatility spikes, up-and-coming projects are a lot riskier.

Platform Risk

You also need to consider the risk associated with the DeFi platform itself. Crucially, in order to generate a yield, you will be required to deposit funds into the platform’s liquidity pool.

And in doing so, you need to trust that the platform is legitimate. If you end up depositing funds into a shady DeFi platform, you might never see your tokens again.

Smart Contract Risk

Smart contracts are billed as being immutable. This means that once the smart contract has executed your yield farming transaction, the underlying terms cannot be amended or manipulated.

However, we often hear about smart contracts that are poorly designed. If this is the case and somebody finds a flaw in the smart contract, they might be able to steal your tokens remotely.

Conclusion

To summarize, yield farming DeFi platforms allow you to earn an attractive APY on your crypto holdings. After all, why keep your crypto tokens idle in a private wallet when you can profit from them?

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