Though Yield farming includes a broad range of opportunities to generate a return actively, it shouldn’t be confused with staking, which generates a return from helping blockchains process transactions.
There is a range of ways blockchains validate transactions, known as Consensus Mechanisms. Bitcoin and Ethereum use Proof of Work, while many blockchains that emerged since have focused on an approach called Proof of Stake – PoS for short.
Proof of Stake requires that participants in the consensus process hold a financial stake in the system to ensure that they will act in its best interests.
A Proof of Stake blockchain will allow anyone to act as a Validators by running specific software, downloading the entire blockchain and staking a required amount of the native cryptocurrency.
In return for validating new transactions and adding them to blocks, they will earn the associated fees paid by the end-users. Acting as a Validator requires a technical and financial commitment beyond an average crypto user. However, you can still participate and earn a consistent return by staking a more modest amount to a Pool.
More generally, staking is considered a long term approach to generating returns given requirements to lock in funds for a minimum period and a protracted withdrawal process known as unbonding.
Yield Farming is far more flexible, with returns calculated every block and the opportunity to move funds around as often as you like, with the understanding that every transaction has an associated Smart Contract transaction fee paid in GAS.
What are the types of yield farming?
Yield Farming can be broken down into the following categories, which mirror services available from traditional financial services. These key terms will help understand what each offers:
Key terms:
- Decentralised Exchange – An application that allows you to swap and trade crypto without holding your funds, or requiring you to create an account. A DEX operates entirely through Smart Contracts.
- Liquidity – The amount of an asset that is immediately available for exchange
- Liquidity Provider – Someone who supplies liquidity for a fee
- Synthetic Token – A representation of a token that has equivalent value and can itself be farmed
- Governance Tokens – Tokens that enable the holders to have a say in how a protocol is run – its governance
- Liquidity Pools – A pool containing two crypto assets that can be swapped
- Protocol – The collection of Smart Contracts that create tokens and automate tasks enabling DEFI services to work. In simple terms, the backend of DEFI.
- Smart Contract – An automated agreement executed by a blockchain without any intermediary.
- dApp – A digital application; the interface with the end-user.
- APR – Annual percentage return; interest earned/paid based on a rate and fixed period.
- APY – Annual percentage yield; compounding interest rate, calculated on the initial deposit and interest received.
- Slippage – The difference between a quoted price and the actual transaction price because of the impact on the liquidity pool of the transaction
- Impermanent Loss – The unrealised loss in value of funds added to a liquidity pool due to the impact of price change on your share of the pool
Lend & Borrow crypto assets – Deposit crypto into a pool and immediately earn interest and tokens specific to the protocol as a reward for using the service. Alternatively, you can deposit crypto assets as collateral and then borrow a different token (such as a Stablecoin), paying interest on the loan. The rates are algorithmically adjusted based on supply and demand.
Examples – Compound & Aave
Collaterised Debt Positions – A more complex approach to borrowing against existing crypto, where funds are locked into a vault, minting a Stablecoin which can then be used for trading or yield farming elsewhere. To unlock the collateral, the loan must be repaid along with fees. Often abbreviated to just CDP.
Example – MakerDAO
Liquidity Provision – Deposit an equivalent value of two tokens with a decentralised exchange creating a liquidity pool for other users to trade against. Liquidity providers earn fees from the trades executed from their share of the pool.
Examples – Uniswap & Sushiswap
Stablecoin Liquidity Provision – Providing liquidity for a decentralised exchange that focuses on providing pools of like priced assets, such as Stablecoins.
Example – Curve
Custom allocation liquidity provision – Deposit tokens to create liquidity pools on decentralised exchanges, but instead of a 50/50 allocation, customising the ratio of the funds deposited. By providing liquidity, you earn fees from the trades executed in your pool.
Example – Balancer
Yield Aggregators – Decentralized ecosystems aggregate the various DEFI services and use algorithms to find the most profitable strategies. Deposits are converted into synthetic Tokens that periodically rebalance to maximise profit.
Example – Yearn.finance
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