1. Definition of Yield Farming
Yield farming, or liquidity mining, is the process of locking your crypto assets as a liquidity provider on decentralized exchanges to profit from transaction fees and rewards. Although the definitions of staking and farming are similar, they are actually two completely different processes. We will discuss this in another post.
2. The History of Yield Farming
There are different opinions about when Yield Farming was born. However, many believe it started in 2018 when FCoin – a now defunct Chinese exchange – started rewarding people who trade in crypto. The FCoin team invented the transaction fee mining model. In short, the platform will return users’ transaction fees in FT tokens. FCoin also distributes 80% of its revenue to those who trade each day, giving them an amount corresponding to the number of FT tokens held.
Farming has become more popular lately thanks to the Compound protocol and related crypto tokens called cToken. Compound appeared on the crypto market in 2017, but people only started receiving tokens in June 2020. Since then, farming has become a hot topic with crypto investors.
Let’s start with simple statistics. In 2020, the DeFi market is so far growing at a rate of 150% in terms of total value locked (TVL) in dollar terms. By comparison, the crypto market capitalization has so far only grown at a rate of 37%.
TVL (Total Value Lock) in DeFi, including Yield Farming within a year (until May 2021) reached 60-90 Billion dollars at one time. Source: Defi Pulse
3. What is Total Locked Value (TVL)?
Simply put, the total lock value represents the value of all the assets locked in a particular protocol. This value does not represent the outstanding balance, but the total underlying supply that is being fully secured by a particular DeFi application.
TVL is a metric used to measure the financial health of a DeFi application.
One of the easiest ways to apply the TVL ratio is to determine if the DeFi platform is undervalued or overpriced.
To calculate the TVL ratio, we divide the total market cap (calculated by multiplying the current circulating supply by the current price) by the total TVL of the DeFi platform. Usually it is undervalued in most cases below 1 and vice versa.
4. How does Yield Farming work?
Yield Farming is closely related to Automated Market Making Mechanism (AMM). This is the “red wire” connecting liquidity providers (LP) and liquidity pools (Liquidity Pools).
Liquidity providers deposit funds into a liquidity pool that provides liquidity to the market. Users can lend, borrow or trade tokens from this pool. The use of the platforms incurs a fee, which will be paid to the liquidity providers in proportion to their share of the liquidity pool. This is the basic process that forms the foundation of AMM.
In addition to fees, another incentive for liquidity providers to deposit funds into a liquidity pool is to distribute tokens. For example, tokens can be accumulated by providing liquidity to a particular pool. Liquidity providers receive profits based on the amount of liquidity they are providing.
5. How is Yield Farming profit calculated?
Usually, people will estimate the profit from farming that you can get in a year’s time.
APR / APY
Some commonly used metrics are the Annual Percentage of Return (APR) and the Annual Percentage of Double Return (APY). The difference between them is that APR does not take into account the effect of compounding, while APY does. Compound interest, in this case, means direct reinvest profits to generate more profits.
Here’s a specific example: You have 100 BTC and you’ve found two lending programs that seem like a good fit.
Option A – 10% APR if you lock your BTC for a year with 52 periods of the year (weekly).
Option B – 10% APY if you lock up your BTC for a year with 52 periods of the year (weekly).
The output will be different:
Option A – This lending option will return 110 BTC after one year.
Option B – This lending option will return 110.51 BTC after one year.
The reason Option B is better is that APY has reinvested the interest paid in previous periods.
Yield Farming can be extremely complex and carries significant financial risks. Farming often incurs high Ethereum gas fees and is only worth the investment if you have a large capital. Users also face other risks such as impermanent loss and slippage when the market fluctuates. CoinMarketCap has the Yield Farming ratings page, which is a casual loss calculator, to help you spot your risk – CoinMarketCap also has a page that tracks the prices of top Farming tokens.
Since the nature of the blockchain is immutable, DeFi losses are permanent and often cannot be undone. Therefore, users should familiarize themselves with the risks in Yield Farming and conduct thorough research on the project before making an investment decision.
Smart contract bugs / hacked
Most notably, Yield Farming is vulnerable to hacking and fraud due to vulnerabilities in the smart contracts of the Defi protocols. These bugs can be caused by fierce competition between Defi protocols, where time is gold, new contracts and features are often not tested or even copied from previous projects or competitors.
7. Rug pulling
There has been an increase in risk in exchanges as there are many issuers of meme tokens with names based on animals and fruits, delivering huge APY returns. We advise you to be careful when investing in these tokens, as their code is largely untested and returns often come with the risk of sudden liquidation due to price fluctuations. In addition, there are quite a few liquidity pools that are scams with a complicated method that leads to “rug pulling”, which is when the token issuer withdraws all liquidity from the pool and takes the cash away.
After a significant number of investors trust, exchange their UNI for the listed token. The issuer will then withdraw everything from the liquidity pool. Insufficient liquidity causes the price of the token to easily be pushed to 0. A common sign of these Rug Pull creators is creating a flood of hype for the project of social media platforms and initially pumping. A significant amount of liquidity is deposited into their liquidity pool to nurture investor confidence.
Rug pulling is a malicious practice that should be eradicated in the crypto world, where cryptocurrency developers abandon a project and run away with investors’ money. Rug pulls often happen in decentralized finance (DeFi) ecosystems, where bad individuals create a token and list it on a DEX, then pair it with an ETH-based cryptocurrency, BNB, UNI, … or any stable coin.
Note that decentralized exchanges have algorithms to determine the price of tokens in a liquidity pool depending on the available balance. Therefore, to make sure you don’t fall victim to a carpet pull, check the liquidity in a pool. However, this is only the first step. You should also check if that liquidity pool is locked. Most large, reputable projects lock up accumulated liquidity for a certain period of time.
8. Permanent loss
Before you want to join the liquidity pool, it is important to emphasize the impact of impermanent losses.
As mentioned in the previous article on liquidity pools, permanent loss describes the temporary loss of funds that liquidity providers sometimes experience due to volatility in a trading pair. This also illustrates how much more money investors would have if they just kept their assets instead of providing liquidity.
Let’s say you have 50$ UNI and 50$ ETH, a total of 100$. If you deposit your tokens in the 50/50 liquidity pool, you will have a token ratio of 5 UNI ($10) and 0.025 ETH ($2000). After depositing your tokens into the pool, the rate and price of the tokens change – due to market and trading volatility. This leads to the fact that at any given time, there can be more UNI than ETH in pools (or more ETH than UNI).
If you decide to withdraw your tokens from the pool, you can get more UNI than ETH (or vice versa). For example, you got 4 UNI and 0.030 ETH – And the price of UNI/USDT went up – Your impermanent loss has become permanent.
An example of where liquidity is compared with HODLing. Let’s say you start with the same token ratio as mentioned before and UNI has increased by $2 so you have $12:
In a liquidity pool where UNI to ETH ratio changed to: (4 UNI * $12 = $48) + (0.03 ETH * 2000$ = 60$) = 108$
If you HODLED: (5 UNI * 12$ = 60$) + (0.025 ETH * 2000$ = 50$) = 110$
According to the calculation, you will earn 2$ more if HODLing.
When you get into farming, you have to minimize your risk as much as possible. Here are a few things to do:
Always use the blockchain network’s foundation currency (UNI, BNB, ETH, …) or stablecoin (USDT, USDC, …) when starting to farm new tokens. You should not buy new tokens at the time of the sale because the small liquidity pool at that time can cause you to buy at a very high price.
After you get tokens from profits, you can reinvest farming in a single pool (farm only 1 token) to maximize profits.
Calculate the risk if you want to farm a matching pool such as (token A – UNI) or (token A – stable coin). In some cases, it can lead you to permanent loss or Rug pulling.
You should withdraw all the principal fund and leave interest to regenerate more profits. That will minimize your risk and protect your funds from unforeseen bad situations.
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