Understanding DeFi and the new rage, Yield Farming

The world of cryptocurrencies is interesting. And irrespective of whether you invest money in cryptos or not, if you are curious, then there is a deep rabbit hole to learn new things every day in this space. I have been spending some time trying to wrap my head around things here.

Yield Farming is one such concept.

But first, you need to know a bit about DeFi, which is a short form of Decentralized Finance.

DeFi is a sort of umbrella term used to address the peer-to-peer open-to-all permission-less financial system that eliminates the intermediaries and middlemen in financial transactions (like banks, card providers, even governments). The system is based on blockchain technology, mostly Ethereum.

DeFi allows one to use a range of financial services pseudonymously on public blockchains (without a third party) that usually require banks. Like what? Like earning interest, borrowing, lending, buying insurance, trading derivatives, and other assets, etc.

If it can be called that, then DeFi’s mission, in a way, is to create a more open, free, and fair financial market that is accessible to anyone with an internet connection and without any need for authority (banks, governments, etc.).

DeFi systems operate without any central authority exercising any control over the entire system. I know this sounds strange as we are brought up in a very different financial environment and ecosystem. But this authority-less approach has been the basic building block of the concept of cryptocurrencies, to begin with.

The rising popularity of DeFi and its applications might make it seem like an attractive investment. And many suffer from FOMO looking at these attractive returns figures. But it’s important to understand that DeFi is new and experimental. And so it comes with its own risk and hence, you need to be sure about what you’re getting into.

As mentioned earlier, Yield Farming and yield defi are getting a lot of interest these days.

There are many ways for investors to profit from the decentralized financial system without watching the market every hour. One of the popular ways to make money on the decentralized financial system today is Yield Farming.

What Is Yield Farming?

Decentralized financial systems can only survive if several users trust and stick with the platform. So, decentralized financial systems have added productivity farming to appeal to users even more. The process of users cultivating productivity will be rewarded with the system’s governance tokens, incentivizing users to support the blockchain project from the very beginning.

In Yield farming, crypto holders (or hodlers) stake or lend crypto assets in order to generate high returns or rewards in the form of additional cryptocurrency. This is a new and innovative but highly risky and volatile application of DeFi that is catching the fancy of many.

So in simple terms, the concept of yield farming is about cryptocurrency holders to lock up their crypto holdings to earn either fixed or variable interest by investing pooled crypto in a DeFi market.

In short, yield-farming protocols incentivize Liquidity Providers to lock up their crypto assets (known as staking) in a smart-contract-based liquidity pool. These incentives can be in form of interest among other options. These rates are expressed as an annual percentage yield (APY), which is the rate of return gained over the course of a year. And what is attracting most people is that in Yield Farming, the interest rates offered are much more attractive than what the traditional banks offer. And as you guessed it, it is ofcourse risky and that is why the higher returns.

Some key concepts you need to know about yield farming are:

  • Liquidity refers to the convenience of converting digital assets into real money without affecting the market price.
  • Liquidity pool is where the smart contract yield farming locks the cryptocurrency. Here users perform cryptocurrency transactions and decentralized lending.
  • Liquidity provider (also known as a market maker): This is an organization, company, or individual that quotes the buy and sell prices for a tradable electronic asset to earn money, take profit on the difference between the buying and selling prices.
  • Automated market maker: This model allows buyers and sellers to trade electronic assets without going through liquidity pools automatically. In this model, yield farming plays an essential role in helping users make big profits.

And a few terms to be aware of while calculating returns are:

  • TVL (Total Locked Value) – is a measure of the amount of cryptocurrency locked for lending on the decentralized financial system.
  • APR (Annual Percentage Rate) – is the amount of interest you pay annually. APR ignores the compounding impact.
  • APY (Annual Percentage Yield) – is the actual rate of return you earn on the amount invested. For APY, compounding interest plays an important role.

I know many youngsters get attracted to the high returns associated with yield farming, but it is incredibly risky. It carries significant financial risks for both sides of the borrowers as well as the lenders A lot can happen when your cryptocurrencies are locked up (staked). We all know how volatile cryptocurrencies can be and how sharp Bitcoin crashes are. Also, since it’s unregulated and no one owns the ecosystem, anyone can launch their own DeFi projects, contracts or tokens. So this place is full of scams and low-trust projects. So you really got to be careful and if something looks too good to be true, then maybe it’s better to skip it unless you know what it really is.

It is still early days for cryptocurrencies and the legal nature of Bitcoin and other cryptocurrencies in India is still being deliberated about by the government. But even though lot of small and young investors are getting into crypto investing, Yield Farming still continues to be a rather complicated area of cryptos. So one needs to be very careful about it and not get into it in a hurry looking at just the high yields on offer.

DeFi and DeFi Apps (called dApps) are surely expanding the use cases of cryptocurrencies. But it does come with its own share of risks. So this is something to keep a watch on for crypto enthusiasts.

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