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Yield farming is becoming increasingly popular among investors in Decentralised Finance (DeFi). When done right, yield farming can generate exceptional profits, but it can also be very risky. Let’s dive a little deeper and see what yield farming is all about.
Yield farming, in essence, is the investment in cryptocurrencies or tokens via decentralized apps (DApps) to maximize profits. A proficient yield farmer can not only gain profit from price appreciation in their holdings, but also from yield generated by these holdings.
By locking assets in liquidity pools such as the ones found on PancakeSwap, or by lending their assets to other users via Venus, investors can generate passive income.
Most of the yield farming on DeFi is done via liquidity pools. A liquidity pool is a smart contract that holds on to and locks the cryptocurrencies/tokens of investors. Liquidity providers contribute to the liquidity of a trading pair pool, such as CAKE-BNB, by depositing their crypto (in this case CAKE and BNB) in the pool, receiving LP (Liquidity Pool) tokens in return.
The assets in a liquidity pool create a market where the assets can be exchanged by traders. If there were no liquidity pool, it would not be possible for a trader to swap tokens, as there would be no “other side” of the trade. When an investor swaps tokens (e.g. CAKE for BNB), he needs to pay a trading fee.
This fee is paid to the liquidity providers in proportion to the amount of liquidity (CAKE and BNB) they have added to the pool. An investor who “owns” a big part of the liquidity pool will receive more trading fees compared to an investor that provided little liquidity to the pool. The fee at Pancakeswap is fixed at 0.17% per token swap trading.
The Annual Percentage Yield (APY) of a liquidity pool generally gives a good indication how much trading fees can be earned in a pool. However, note that these rates are not fixed, and change daily based on historical trading data from the pool.Other ways to
There are, other than trading fees, several other mechanisms that allow a yield farmer to generate yield:
Token rewards: Some DApps offer token rewards as an additional incentive. Sushiswap, for example, rewards its liquidity providers with the SUSHI token, on top of the collected trading fees. The SUSHI token of Sushiswap is a governance token. Governance tokens give their holders voting rights over future platform decisions and can potentially be staked or profitably traded.
Interest: Let’s take a look at Venus as an example. The Venus protocol allows investors to lend and borrow their assets to other investors via asset pools.
Like liquidity pools, the APY of an asset pool is the most interesting for a yield farmer. This percentage indicates how much interest a yield farmer recieves annually for depositing his token to a pool.
For lending and borrowing platforms like Venus, a part of the Annual Percentage Rate (APR) is paid to lenders by their borrowers, who need to pay interest when borrowing assets.
By making use of compound interest, yield farmers who lend their assets to borrowers receive interest on their initial deposit + previously earned interest. This means that when the first interest is paid out, the initial deposit of the yield farmer has grown, resulting in the next interest being paid out based on the new value of the deposit and so on.
Price appreciation: In addition to the previously mentioned ways of making profit, a yield farmer also benefits from price increases of the token that he is using to farm. This is a double-edged sword: value can be lost as the price of the token declines.Due to this, it’s important to research both the DApp and its liquidity pools. Luckily, this is where rugdoc.io can help you out.
Yield farming is not for the faint-hearted. The most profitable yield farming strategies are very complex and only advisable for advanced users. Also, there are a lot of risks involved in defi yield-farming:
Thanks to yield farming, investors can generate excellent returns on various smart contract compatible networks and their platforms. It’s worth comparing the risks and rewards before starting to yield farm to prevent any losses. Rugdoc.io can help you with picking the right DApps so you can start yield farming without unnecessary risk.
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