In our “DeFi Basics” blog series focusing on decentralized finance, we look at the basic products and services within DeFi. In this blog, we will explain yield farming and its role in DeFi.
Yield farming was one of the major drivers of DeFi’s explosive growth during 2020 and 2021. It is a type of tool that can potentially benefit both blockchain developers and DeFi users, as it creates an ecosystem where users are incentivized to participate in a particular DeFi platform.
Let’s look at yield farming more closely and describe how its properties have played a role as a powerful engine for DeFi growth and adoption.
First, let us deconstruct a little of the connection starting with the word “yield” and what it means in this context.
Yield refers to the revenue generated by a financial instrument over a particular period. For example, government bonds generate yield for the duration of the debt. It can be less than a year for treasury bills, or more than a year in the case of bonds. The value of the bond is then multiplied by the percentage it pays and the duration to get the yield of the asset.
Much of this is true also in the blockchain or DeFi world, with the difference being that yield can be generated through a variety of ways. For example, users can generate yield by interest from lending platforms, dividends from security tokens, fees from liquidity pools, or rewards from delegating and staking cryptocurrencies. Crucially, these methods are not mutually exclusive, in fact combining them is common.
Next, the term “farming” here refers to growing something.
It initially started as a joke among the DeFi community, who referred to the act of gaining yield from different sources as “growing their fields” as “farmers.” So, the term “yield farming” was coined as the phrase to encapsulate both ideas.
Let’s now get to the crux of the matter: What is yield farming?
It has two sides.
First, from the perspective of DeFi users, it is a strategy where users look for the best yields among different DeFi projects to lock their tokens and gain rewards. Since an individual user only has a set number of tokens, looking for the best yields is crucial.
From the perspective of a DeFi developer, yield farming is a mechanism to incentivize users to use a DeFi project by offering rewards in the form of yield.
The yield generated comes from two sources: one is the core activity of the platform, token pools, lending and borrowing, staking, etc.
The other portion of the yield comes in the form of rewards given in the platform’s token. For example, a person who lends his tokens to a lending pool first gets rewards from the interest paid by the counterparty. Second, the platform gives additional rewards in the form of the platform’s tokens for participating in the system. The DeFi user then has to calculate the value of the fees generated by the loans and the value of the token in the market to get the total reward amount.
The DeFi project’s token can be a major component of the reward.
A common way to start is with a simple example, which would be using a reputable decentralized exchange or DEX.
- Choose a DEX on a major decentralized network such as Cardano
- Provide liquidity to a pool
- Lock tokens to start farming
Yield farming can be a potentially powerful tool to grow a DeFi project and generate passive income for users. This dual property makes it one of the most innovative mechanisms created by the DeFi industry.
However, DeFi does carry many risks as it is decentralized and there is no legal mechanism to cover or safeguard user funds in case of hacks or security breaches. Users are expected to assume the risks of their actions.
Are you interested in learning more about DeFi?
Then, EMURGO’s DeFi workshop specifically geared for business professionals is right for you.
EMURGO and the Institute of Blockchain Singapore are scheduled to host a 2-day workshop on DeFi in early 2024 with speakers from EMURGO, EMURGO Academy, and other DeFi projects.
The workshop will provide you with a deeper understanding of DeFi, enabling you to prepare for DeFi’s evolution, participate in the DeFi ecosystem, and also contribute to the growth of DeFi.
For more workshop information including dates and registration info, please visit the official registration page here.
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