What is Yield farming?: explained for beginners

The topic will be discussing yield farming, you may have heard of some investors gaining insane returns within defi. So this post will be explaining exactly what yield farming is, why it can be popular amongst some investors and the risks associated with it. This topic was requested by u/maolyx and u/joshlambonumberfive

Hopefully this post will help educate newer investors into some of the workings within defi.

If anyone is interested in previous past posts please see:

• Fundamental Research on projects: here
• What is a cryptocurrency wallet: here
• Staking: the concepts of PoS: here
• What is the blockchain: here
• Trading strategies: here
• Fundamental analysis: here
• Sentiment analysis: here
• Mobile device security education for crypto: here
• The smart money market cycle: here
• Lump sum vs Cost averaging: here
• Arbitrage Explained: here
• Dusting attacks explained: here
• Liquidity Pools Explained: here
• ETH London Hardfork Explained: here
• Defi hacks and exploits explained: here
• Smart contracts explained: here
• BTC Halving Explained: here
• Analysis on the $600 million theft: here
• Inflation vs deflation: here
• Cryptographic hashing for the blockchain. What is it?: here
• Longs vs Shorts, leverage, margin and liquidations explained for beginners: here
• Type of orders for beginners: here
• ETH gas explained for beginners: here
• BTC market cycle theories explained for beginners: here
• How are the mnemonic phrases & seeds created?: BIP39 explained for beginners: here
• Lending and borrowing in defi: Explained beginners: here

WHAT IS YIELD FARMING

Essentially yield farming is the process of trying to maximise the return of capital through leveraging various decentralised finance protocols. Individuals who partake in yield farming will attempt to seek out the highest yield (rates of return) rates which revolves around various protocol strategies by moving the funds around between these different protocols or swap tokens for higher generating yield.

If we imagine a traditional bank offering minimal interest rates on savings account, you can see why individuals are incentivised to look for better returns when yield farming can generate into the hundreds and even thousands of percentage. So how it possible for these sometimes insane yield rates?

HOW ARE HIGH YEILDS GENERATED

Essentially there are 3 main relatively strong factors that determine these yield rates.

1. Liquidity mining: This is essentially the process of distributing liquidity tokens. In this case some protocols will offer higher rewards for using their protocols. This is covered in my liquidity pool here post.

2. Leverage: this is essentially the process of accessing higher capital with minimal capital, this is covered in my Longs vs Shorts, leverage, margin and liquidations explained for beginners: here post. In the case of yield farming, individuals will deposit tokens as collateral and borrow other tokens or coins, these borrowed assets are then also collateralised to borrow more tokens and coins and this process is repeated to leverage their initial capital to generate more returns.

3. Risk: The risk associated to the previous points is the risk of collateralised liquidations. Additional risks can be dangerous smart contract vulnerabilities and bugs, liquidity pool attacks such as drainage of liquidity, system risks (collapse of the entire system) and dramatic price fluctuations.

HOW DOES YIELD FARMING WORK

Individuals will typically follow the following methods to yield farm:

• lending and borrowing: as mentioned in the above section, individuals can supply supply tokens on a lending platform and use the method described in the previous section to generate higher rewards

• Supplying liquidity: as described in my liquidity pool post, individuals can supply tokens into a liquidity pool and be rewarded from liquidity pool fees and can enhance returns through liquidity mining.

• Staking liquidity pool tokens: again as described in the liquidity pool post, when individuals provide capital into a liquidity pool, they are given LP tokens, some protocols can give individuals further incentives by staking those LP tokens.

Yield farmers can use a combination of these methods to create a lucrative stream of income but requires a highly monitored process by the individuals due to the associated risks involved.

WHAT ARE THE RISKS

As mentioned in the yield generation section, yield farming is a high risk and high reward strategy. Some of the risks involved include:

• Collateral liquidation: this will be discussed in more detail within my upcoming lending and borrowing educational post but essentially If the collateral falls below the value of the borrowed assets then the collateral will be liquidated
• Smart contract vulnerabilities: as we have seen in recent weeks, source code bugs are a regular occurrence in any technology and can be taken advantaged of by malicious entities
• Systemic risks: DEFI is still a new and testing space, lucrative opportunities are available but the risk of a system collapsing is also ever present.
• DEFI hacks: as discussed in my defi hacks here post, a risk of a liquidity pool drainage otherwise known as a rug pull can also be an associated risk.
• Dramatic price fluctuations: what once may be profitable one day can simply be unprofitable the next. Hence, the statement stating the requirement of continuous monitoring.

I’ll be doing one more educational post about NFTs and then I’ll be taking a break on the educational topic covering for a bit and will be creating some educational quizzes to test knowledge of the content that’s already been covered. If this sounds like a fun idea for you all, just let me know :)