Summary

Profit farming is a way to earn cryptocurrency using what you already have. It is assumed that you lend your funds to other users through special computer programs - smart contracts. For providing services you receive a commission in cryptocurrency. Seems simple? Not really.

Farmers need to use very sophisticated strategies. To maximize profits, they constantly move cryptocurrency between different lending platforms. It is worth understanding that farmers keep the most profitable strategies secret. Why? The more people know about a strategy, the less effectively it will work. Yield farming is the Wild West of decentralized finance (DeFi), where farmers compete for the best harvest.

Interested? Read the details below.

Introduction

Decentralized finance (DeFi) has always been at the forefront of innovation in the blockchain industry. What makes DeFi applications unique? Minimum requirements. This means that anyone (or anything, such as a smart contract) with internet access and a supported wallet can interact with them. In addition, they usually do not require trust in intermediaries. In other words, they are unreliable. So what new use cases do these properties open up?

One of the new concepts was profitable farming. This is a new way to make money with cryptocurrencies using liquidity protocols. It allows anyone to earn passive income using a decentralized “money lego” ecosystem built on Ethereum. Thus, through yield farming, investors may change their approach to HODL strategies in the future. Why just store assets when you can use them to make money?

So how does a farmer get his crop? What result can he expect? And how to become a profitable farmer? We will talk about all this in this article.


What is yield farming?

Yield farming, also called liquidity mining, is a way to make money from the cryptocurrency you have. Simply put, in order to receive rewards you need to lock your cryptocurrency.

In some ways, yield farming can be compared to staking. However, upon closer examination, differences can be seen. Yield farming works with users called liquidity providers (LPs) who deposit funds into liquidity pools.

What is a liquidity pool? Essentially, it is a smart contract that holds the funds. In exchange for providing liquidity to the pool, liquidity providers receive a fee. Rewards may be paid through fees generated by the underlying DeFi platform or some other source.

Some liquidity pools pay out rewards in multiple tokens. These tokens can be contributed to other liquidity pools to receive rewards already in them. As you can see, many complex strategies have emerged in a very short time. But the basic idea is that a liquidity provider places funds in a liquidity pool and receives a reward for doing so.

Yield farming is usually done through ERC-20 tokens on the Ethereum blockchain, and rewards are most often also ERC-20 tokens. However, this may change in the future. Why? At the moment, most of the activity related to DeFi is happening in the Ethereum ecosystem.

However, cross-chain bridges and similar technologies may allow DeFi applications to become independent of blockchains in the future. This means that they will be able to run on other blockchains that support smart contracts.

Farmers often move funds between different protocols in order to generate the most income. As a result, DeFi platforms provide other economic incentives to attract more capital to their platforms. As with centralized exchanges, liquidity attracts more liquidity.


How did the income farming boom begin?

The sudden and strong interest in yield farming may be due to the launch of the COMP token, a governance token for the Compound Finance ecosystem. Governance tokens give token holders the right to manage the ecosystem. But how to distribute these tokens if you want to make the network as decentralized as possible?

A common way to run a decentralized blockchain is to distribute governance tokens algorithmically, encouraging liquidity. This attracts liquidity providers, who become “farmers” in the ecosystem of the new token, thereby providing liquidity for the protocol.

Although the Compound team did not invent yield farming, the launch of COMP increased the popularity of this token distribution model. From this moment on, other DeFi projects began to develop their own innovative schemes to attract liquidity into the ecosystem.


What is Total Value Locked (TVL)?

What is the best way to measure the overall health of the DeFi yield farming industry? The Total Value Locked (TVL) serves this purpose. This indicator measures how much cryptocurrency is locked in DeFi landing pages and other types of marketplaces.

In a sense, TVL is the aggregate liquidity of the liquidity pools. This is a useful index for measuring the health of DeFi and the yield farming market as a whole. It is also an effective metric for comparing the “market shares” of different DeFi protocols.

A good resource for tracking Total Value Locked (TVL) is Defi Pulse. Here you can check which platforms have the most ETH or other crypto assets locked in DeFi. This will give you a general idea of ​​the current state of profitable farming.

Naturally, the greater the total value of blocked assets, the greater the profitability of farming. It is worth noting that TVL can be measured in ETH, USD or even BTC. Each currency can present a different perspective on the state of the DeFi market.


How does yield farming work?

Yield farming is closely related to the automated market maker (AMM) model. It typically includes liquidity providers (LPs) and liquidity pools. Let's figure out how it works.

Liquidity providers place funds into a liquidity pool. This pool supports a marketplace where users can land, borrow, or trade tokens. There is a fee for using these platforms, which is paid to liquidity providers according to their share of assets in the liquidity pool. This is the essence of AMM's work.

However, implementations may vary greatly, not to mention it is a new technology. Undoubtedly, we will soon see new, better implementations of existing solutions.

Besides fees, another incentive to add funds to the liquidity pool could be the distribution of new tokens. For example, when there is no possibility of purchasing tokens on the open market and they are available only in small quantities. In this case, tokens can be obtained by providing liquidity to a specific pool.

The rules for token distribution will depend on the unique protocol implementation. The bottom line is that liquidity providers earn income based on the amount of liquidity they provide to the pool.

It is common to deposit various stablecoins pegged to the US dollar, although this is not a requirement. The most common stablecoins in DeFi are DAI, USDT, USDC, BUSD and others. Some protocols issue their own tokens that are equivalent to the coins you deposit. For example, if you deposit the DAI stablecoin into Compound, you will receive cDAI (Compound DAI). If you deposit ETH, you will receive cETH.

As you understand, in such a system a large number of strategies are layered on top of each other. You can transfer the cDAI you receive to another protocol, which will create a third token that replaces the cDAI, which in turn replaces the DAI. And so on. These chains can be so complex that they are difficult to trace.


How is farming profitability calculated?

Typically, the expected profitability of farming is calculated on an annualized basis. This is an estimate of the profit you can make in a year.

Metrics commonly used are annual percentage rate (APR) and annual percentage yield (APY). The difference between them is that the APR calculation does not take into account the effect of addition, while the APY does. Compounding in this case means directly reinvesting profits to generate even greater profits. Please note: APR and APY can be used interchangeably.

It is also worth remembering that these are only rough estimates and forecasts. Even in the short term, the size of the reward is quite difficult to accurately estimate. Why is that? Yield farming is a highly competitive and fast-paced market where rewards fluctuate frequently. If a certain income farming strategy works for some time, then many farmers begin to use it, thereby reducing the possibility of obtaining high earnings.

Since APR and APY are inherited from traditional markets, the DeFi industry may need its own metrics to calculate profits. Due to the fact that all events in the DeFi industry happen very quickly, it is better to use weekly or even daily expected profitability metrics.


What is collateral in DeFi?

Typically, when borrowing assets, you must provide collateral to cover the loan. It acts as loan insurance. How relevant is this? A lot depends on what protocol you're depositing into, but you'll still need to keep a close eye on the collateralization ratio.

If the value of the collateral falls below the threshold required by the protocol, the collateral will be liquidated on the open market. How can liquidation be avoided? You can add additional collateral.

Let us repeat, each platform has its own rules in this regard; for example, the required collateral ratio may differ. Additionally, platforms typically use the concept of overcollateralization. This means that borrowers must put down more than what they want to borrow. For what? To reduce the risk that a large market crash will eliminate a large amount of collateral from the system.

Let's assume that the landing protocol used requires a collateral ratio of 200%. This means that for every $100 you invest, you will only be able to borrow $50. However, it is usually safer to add more collateral than is required to reduce the risk of liquidation. With that said, to protect the entire platform from the risk of liquidation, many systems use very high collateral ratios (e.g. 750%).


Risks of profitable farming

Profitable farming is not that simple. The most profitable yield farming strategies are complex and only suitable for advanced users. It is worth noting that income farming, as a rule, is more suitable for those who already have large savings (the so-called whales).

Farming is not as simple as it seems. If you don't understand what you're doing, you'll most likely lose money. We just discussed how easily collateral can be liquidated. But what other risks should you be aware of?

One obvious risk in yield farming is smart contracts. Due to the nature of DeFi, many protocols are created and developed by small teams with limited budgets. This increases the risk of bugs in a smart contract.

Even in larger protocols where smart contracts are audited by reputable companies, vulnerabilities and bugs are constantly being discovered. Due to the impossibility of making changes to the blockchain, such errors can lead to the loss of user funds. This must be taken into account when blocking funds on a smart contract.

One of the biggest benefits of DeFi is also one of the biggest risks of the entire system. We're talking about the idea of ​​modularity. Let's look at how modularity affects profitable farming.

As discussed earlier, DeFi protocols are inclusive and can easily integrate with each other. This means that the entire DeFi ecosystem is significantly dependent on each of its components. This is what we mean when we talk about application modularity: protocols can easily work together.

What is this risk associated with? If just one component of a system does not function properly, the entire ecosystem may suffer. This is one of the biggest risks for farmers and liquidity pools. You need to trust not only the protocol on which funds are transferred, but also the components on which it depends.


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Platforms and Protocols for Yield Farming

How to make money through profitable farming? There is no specific way to make money. In fact, strategies for profitable farming can change by the hour. Each platform and strategy has its own rules and risks. If you want to earn income through farming, you should familiarize yourself with how decentralized liquidity protocols work.

We already know the basic idea. You deposit funds into a smart contract and receive a reward for it. But for each implementation, the required actions may differ. Do not blindly invest your hard-earned funds in the hope of high returns. The basic rule of risk management is that users must have control over their investments.

What are the most popular platforms used by farmers? Let us list the key protocols in developing strategies for profitable farming.


Compound Finance

Compound is an algorithmic money market that allows users to land and borrow assets. Any user with an Ethereum wallet can contribute assets to Compound's liquidity pool and receive rewards that begin accruing immediately. Rates are adjusted algorithmically depending on supply and demand.

Compound is one of the core protocols in the yield farming ecosystem.


MakerDAO

Maker is a decentralized lending platform that initiated the creation of the stablecoin DAI, which is algorithmically pegged to the value of the US dollar. Anyone can open a Maker Vault and lock collateral assets such as ETH, BAT, USDC or WBTC into it. As a debt against locked collateral, users can generate DAI. Over time, based on the size of the debt, interest is accrued, called a stability fee, the rate of which is set by MKR token holders.

Farmers can use Maker to issue DAI and use the resulting stablecoins in their strategies.


Synthetix

Synthetix is ​​a protocol for issuing synthetic assets. It allows any user to lock (stake) Synthetix Network Token (SNX) or ETH as collateral and issue synthetic assets. What can be a synthetic asset? Almost anything that has reliable information about the current price. This allows you to add almost any financial asset to the Synthetix platform.

In the future, Synthetix may allow all types of assets to be used for yield farming. Do you want to use gold for profitable farming? Synthetic assets may be a viable option.


Ghost

Aave is a decentralized protocol for lending and borrowing. Interest rates are adjusted algorithmically based on current market conditions. Lenders receive “tokens” in exchange for their funds. Immediately after the tokens are deposited into the lenders' accounts, interest begins to accrue. When using Aave, various advanced features are available, such as instant loans.

Aave is widely used by farmers as a decentralized lending and borrowing protocol.


Uniswap

Uniswap is a decentralized exchange (DEX) that allows for trustless token exchange. To create a market, liquidity providers contribute the equivalent value of two tokens, after which traders can trade against this liquidity pool. In exchange for liquidity, providers receive a commission on trades that occur in their pool.

Uniswap has become one of the most popular platforms for trustless token exchange due to its ease of use. Ease of use is also important in profitable farming strategies.


Curve Finance

Curve Finance is a decentralized exchange specifically designed for efficient stablecoin swaps. Unlike other similar protocols such as Uniswap, Curve gives users the ability to conduct large stablecoin swaps with low slippage.

As you can imagine, due to the sheer volume of stablecoins in the yield farming space, Curve pools are a key piece of infrastructure.


Balancer

Balancer is a liquidity protocol similar to Uniswap and Curve. The key difference of the platform is that it allows you to configure the allocation of tokens in the liquidity pool. This allows liquidity providers to create their own Balancer pools instead of the standard 50/50 allocation required on Uniswap. As with Uniswap, liquidity providers receive fees on trades that occur in their liquidity pool.

With the flexibility to create a liquidity pool, Balancer is an important innovation in yield farming strategies.


Yearn.finance

Yearn.finance is a decentralized ecosystem of aggregators for landing services such as Aave, Compound and others. It is aimed at optimizing token landing by algorithmically searching for the most profitable landing services. Deposited funds are converted into yTokens, which are periodically rebalanced to maximize profits.

Yearn.finance is useful for those farmers who want to use a protocol that automatically selects the best strategies.


Summary

We looked at a new hobby of the cryptocurrency community - profitable farming.

What else could the decentralized financial revolution bring? It is impossible to even imagine what other applications may appear in the future based on existing components. However, liquidity protocols and other DeFi products are certainly at the forefront of cryptoeconomics and computer science.

There is no doubt that DeFi money markets will help create a more open and accessible financial system for everyone with an internet connection.


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