In the year 2021, many of us experienced the rise in value of the Decentralized Finance (Defi) sector in the crypto space. The Defi sector utilizes blockchain technology to perform financial activities without the involvement of any intermediary between clients on the platform. The various Defi protocols offer users the opportunity to gain passive income by participating in some activities on the platform.
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I have categorized the services with which users earn through Defi into three: yield farming, liquidity pools, and stake.All these services are offered in various Defi Protocols and some of the more popular ones among them include Uniswap, Compound, Sushiswap, Aave, Curve Finance. In this presentation, I will be discussing yield farming, and the other two will be discussed in my subsequent posts.
What is Yield Farming?
In the conventional financial system, people keep their funds in banks or other financial management organizations. These sectors are all centralized as they have authroities who control the affairs of the organization. All information about the users are accessible to the central authorities who have access to their users funds. Yield farming offers these services to users with the use of blockchain technology in a decentralized manner.
Users gain passive income with yield farming by moving their crypto assets from one marketplace to another based on the annual percentage yield of the marketplace, and users tend to benefit a lot when there's rapid appreciation in the price of the asset in hand and vice versa when there is depreciation. It is one of the most widely used strategies in the Defi sectors, and many have benefited a lot from their participation in yield farming in some of the Defi ecosystems. There are risks involved in participating in yield farming, and users who fail to adhere could lose massively as the crypto market is highly volatile.
How Yield Farming Works:
Users benefit from the services of yield farming by providing liquidity in liquidity pools, which I will explain in my next post. The liquidity pools, which are built with smart contracts, act as vaults for the platform's assets.
Users who lock their funds in these pools are regarded as liquidity providers, and they earn from the transaction and other fees on the platform in accordance with the amount they have locked in. The rewards that the liquidity providers earn could be the platform's own tokens, and on some occasions, they are rewarded in stable assets like USDT.
This means that they have lent their funds to the platform and they are rewarded as incentives for locking their funds on the platform, which is very important for the platform as they need liquidity to operate. The lenders can then claim the rewards in the form of tokens and use them as they wish.
Most of them use their rewards to speculate in other liquidity pools or marketplaces. They use arbitrage strategies to cash in their funds in appropriate marketplaces or liquidity pools, taking into account the annual percentage yield (APY) and the token's development in the pool.
They do this repeatedly across different market places, and they tend to benefit more when the price of the token appreciates significantly or lose when the token's price depreciates. Investors who participate in yield farming gain their returns in the form of an annual percentage yield (APY). This determines how much users will earn in a year and is calculated with compound interest.
The Risks of Yield Farming
The two main risks involved in yield farming include cyber fraud and the volatility of price actions. As we all know, there will be transactions by users on the platforms, and all of these transactions are done digitally with software. If the platform is not secure enough, user funds can be stolen. That is why it is necessary to do enough research about the platform before investing in it. Users can also lose their funds if the keys that control their wallets are exposed. To avoid this, the keys should be kept privately where no one can access them.
Price volatility is also a potential risk in yield farming. People invest their funds in the pools, and when the price increases, they gain immensely. In addition to the APYs, there are instances where the price will go the other way around, and this may cause losses to users.
Both the risks I mentioned above are controllable if the users practice better risk management. The number one risk management strategy will involve doing enough background research about the project, which will involve the team behind it, the benefits the project has to offer, and how secured your funds will be if you invest in such a project. Then
The Defi sector has grown significantly in the year 2021, and the growth and adoption is still increasing as people gain knowledge of the crypto space.
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