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Today on PancakeTheorem we’re going to discuss a topic within the crypto-verse that isn’t known by the majority of smaller investors, which has the potential for serious profits (and, just like any form of investing, losses). 

By now I’ll assume if you’re reading this post, you already have an understanding of the DeFi (Decentralized Finance) movement, especially with it being at the forefront of innovation within the blockchain space. If not, then one of the things that makes DeFi applications completely unique is that they are permissionless, what this means is that anyone or anything with an internet connection and supported crypto wallet can interact with them.

With the rise of this, comes a new concept that has been emerging over recent years known as yield farming. Yield farming is a new way to earn rewards with current holdings in cryptocurrency using permissionless liquidity protocols. This type of investing allows anyone to earn a passive income using the “money legos” decentralized ecosystem which is built on Ethereum. It’s no wonder that it’s taking off, why keep your assets lying idle when you can put them to work for you? 

In this article, we’ll be covering just the basics of yield farming and where you should start out if you’re thinking of becoming a yield farmer.

What is yield farming?

Yield farming is often referred to as liquidity mining and is a way to use cryptocurrency holdings in order to generate rewards. Simply put, you lock up your crypto and in doing so get rewarded.

A lot of people get confused and think yield farming is staking, however there’s a lot more complexities happening in the background and it works with the users (who are referred to as liquidity providers) to add funds to liquidity pools. 

Hang on, what’s a liquidity pool (LP)? Well, it’s a fancy piece of terminology for a smart contract which contains funds. LPs are compensated for the liquidity that they contribute to the pool, and the award may come from the fees collected through the DeFi platform, or from some other source, depending on the circumstances.

Multiple tokens are used by certain liquidity pools to distribute payouts to the providers. These reward tokens may then be placed into additional liquidity pools to receive prizes there and so on. Isn’t it obvious how rapidly complicated methods may emerge? A liquidity provider, on the other hand, gets interest on the cash they deposit in a liquidity pool, which is the core premise.

Yield farming is generally done using ERC-20 tokens on Ethereum, and the payouts are often ERC-20 tokens as well. It’s possible that this may change in the future, however. Why? For the time being, the Ethereum ecosystem is where much of this work is taking place.

In the future, cross-chain bridges and other developments might enable DeFi apps to run on any blockchain. Smart contracts can operate on any blockchain that has smart contract capabilities.

In order to maximise yields, yield farmers often shift their resources between various farming methods. As a result, DeFi platforms may offer additional financial incentives in an effort to draw in additional funding. Liquidity tends to draw in additional liquidity, just as it does on controlled exchanges.

How did yield farming become so popular?

The Compound Finance ecosystem’s governance token, the COMP token, was possibly the main catalyst that has sparked a surge of interest in the prospect of yield farming.

These currencies may be distributed algorithmically with liquidity incentives in order to establish a decentralised blockchain. By supplying the system with liquidity, liquidity providers may “farm” the new coin.

The COMP launch boosted the popularity of this sort of token distribution strategy, although it did not originate yield farming. As a result, numerous DeFi ventures have devised creative means of attracting capital to their own ecosystems since that time.

How does yield farming work?

The automated market maker concept and yield farming concept have a lot in common. With both, LPs and liquidity pools are involved. This is how it works: Money is deposited into a liquidity pool by sources of liquidity. Users may lend, borrow, or swap tokens in this marketplace powered by this pool. Using these platforms incurs costs, which are subsequently distributed to liquidity providers in proportion to their part in the pool. An AMM is built on this basis.

Because this is a novel technology, implementations might be drastically varied. There’s no denying that new ways will emerge that improve on existing solutions.

In addition to fees, the issuance of a new cryptocurrency might provide an additional incentive to contribute money to a liquidity pool. For example, there may not be a means to acquire a token on the open market, only in tiny quantities. However, it may be built up by increasing the liquidity of a particular pool.

The distribution rules will be based on the protocol’s specific implementation. Overall, liquidity providers are paid depending on the quantity of liquidity they supply to the pool.

The monies deposited are generally stablecoins tied to the USD – however this isn’t a standard necessity. DAI, USDT, USDC, BUSD, and other stablecoins are often used in DeFi. Tokens that reflect your deposited funds are minted by certain systems. You can obtain Compound DAI (cDAI) if you deposit DAI into Compound. You will get cETH if you put ETH into Compound.

As you can expect, there are a plethora of variables at play here. You could use another protocol to store your cDAI, which would create a third token to represent your DAI. And so on, and so on. These chains may get incredibly complicated and hard to follow.

How are yield farming returns calculated?

An annualised value is often used to determine the projected yields of agricultural endeavours. This is an estimate of how much money you may anticipate to make in a year.

Annual Percentage Yield (APY) and Annual Percentage Rate (APR) are two often used measures. Compounding is not taken into account by APR; however, it is taken into account with APY. In this context, the term “compounding” refers to the act of reinvesting gains in order to increase their value. However, keep in mind that APR and APY may be used interchangeably in the financial industry.

Keeping in mind that these are only estimates and forecasts are also an important thing to keep in mind too. Even in the near run, it is difficult to predict the benefits. Why? Fast-paced competition and fluctuating rewards make yield farming a very volatile industry. There are many farmers that will rush at the chance to profit from yield farming, which might lead to a decrease in returns.

DeFi may need to develop its own measures for computing returns, because APR and APY are derived from the established markets. DeFi’s rapid speed necessitates weekly or perhaps daily return estimates.

Where you can yield farm with you crypto?

PancakeSwap is one of the most popular areas where people may farm these days, but it’s not the only one. One of the first decentralised exchanges, PancakeSwap (DEX). Binance Smart Chain (BSC) instead of Ethereum and a few other features geared at gamification make it a better option than other exchanges, such Uniswap. It has a total worth of roughly $7 billion, making it the most valuable BSC DeFi project to date. It’s possible to trade BSC tokens, make interest via staking pools, wager on the future value of BNB, and even purchase non-fungible token art on PancakeSwap.

Uniswap’s risks apply to PancakeSwap as well, including the possibility of irreversible loss as a consequence of big price swings and the failure of smart contracts. Many of the tokens in PancakeSwap pools have low market capitalizations, which means they are more susceptible to short-term losses. However, Ethereum-based tokens of increasing size are accessible to stake on Uniswap, therefore the dangers remain the same for Uniswap users.

The difference in value between retaining your two assets and staking them for interest is known as an impermanent loss. Due to the fact that your assets are rebalanced to keep a 50/50 share in each, you will sell part of the more valued asset to acquire the less valuable asset if one of them appreciates.