Farming is one of the opportunities to generate a passive income in the Decentralized Finances (DeFi) ecosystem. This format of earnings is also called liquidity mining or yield farming.
The essentials of farming
According to many people, There are a lot of flows in the traditional financial system. As a result, more and more people are looking for alternatives. With the development of crypto technologies, it became possible to create a system that unites various decentralized financial services. Public blockchains are used as the basis for the operation of such applications and sites.
Decentralized services themselves can take different forms:
- Services for placing deposits and lending;
- Algorithmic stablecoins;
- Decentralized exchanges (DEX);
- Mutual insurance platforms;
Exchanges of tokenized assets, synthetic tokens, etc.
At present time, most of the decentralized finance services are based on the Ethereum blockchain. However, more and more projects are entering the market that are also capable of providing high-quality services.
Farming is focused on making money in the DeFi segment. To make a profit, cryptocurrency holders lend it to various platforms and services. And thus they provide much needed liquidity to the project pools. Essentially, it is a form of lending where users are rewarded for lending their assets. It is this process that is called farming or yield farming.
Smart contracts are used to govern the farming process. They lock digital assets provided by the user. Often, DeFi projects issue tokens that determine the user's share in the liquidity pool.
Liquidity mining strategies vary. Their level of difficulty may also differ. Yield farming is a segment of constant search for new, more complex and effective strategies. And the more complex the strategy, the more different tokens are used in the farming process.
The average return on investment in liquidity mining is 5-10% per annum of the amount of funds provided. But some users develop strategies that provide 50%, 100% or more ROI per year. These statistics make farming a popular way to generate passive income.
Differences between staking and lending
Farming is a universal profit-making scheme. But there are other lucrative ways to use your cryptocurrency holdings as well.
This term is used to refer to the storage of digital media that provides the overall health of the network. In this case, a reward is also paid for providing cryptocurrency.
When a user deposits their cryptocurrency to keep the project running, they receive a share in the stake. The partaking of such a share allows you to influence the development of the project and at the same time obliges you to become the validator to perform certain actions for the development of the system.
In the case with farming, the user does not receive such rights and obligations. He has no stake in the project and is not obliged to keep it running. All you do is earn a passive income. Sometimes it can be different, but as an exception.
Another notable difference is that a blockchain is always used in staking. And all transactions go through it. This is the system that needs to be maintained and developed.
In the case of farming, blockchain is not required. The liquidity pool can be off the blockchain, working only through smart contracts. With smart contract governance, assets are locked and reward is paid.
Also, staking differs from farming in the way that tokens are used:
- The vast majority of projects related to profitable farming use tokens created on Ethereum network. In the future, this Ethereum network dominance will be dealt with by using the blockchain bridges.
- Staking is already taking place in many other blockchains, without reference to Ethereum.
This is a lending process using digital money. The users are lending their coins and then receive them back with a set percentage. At its core, this format of earnings resembles a bank deposit.
Most of the services in this segment are related to lending margin trading, as well as investments in lending programs.
In farming, users do not lend their digital money. Cryptocurrency is used to increase liquidity.
If, in the case of a lending, the profit decreases due to the large commission of exchanges, then when choosing a profitable farming, there are no problems related to this matter.
Pros and Cons
The advantages of profitable farming include the following:
- Low entry level;
- A simple process of generating profits;
- Great potential for ROI;
- Favorable terms for reinvesting digital assets.
Especially, worth noting the possibility of obtaining internal project tokens. This farming feature provides additional income. And that could be substantial. For depositing certain amounts, users are rewarded with tokens that sometimes cannot yet be available for the public. These digital assets can be used to participate in other liquidity pools. Those, in turn, can also issue their tokens as a reward for activity.
As a result, users build long chains of such investments, receiving more and more digital assets. This feature of farming significantly increases the potential for annual ROI.
For a better understanding of farming let's use a specific example:
- The user has invested 500 USDT in the liquidity pool;
- These funds begin to bring passive income in the form of a commission;
- Plus the owner of the cryptocurrency receives more tokens of one or more projects;
- The received assets can be invested in another pool, which will also receive their tokens as a reward.
As a result, there is passive income from two pools + the participant has tokens of different projects.
The disadvantages of farming:
· Unstable commission. The amount of reward rarely changes once digital assets are deposited and locked. But the rate of the internal token of the selected project may drop in value significantly. As a result, the promised interest will be paid, but the actual value of the reward might be significantly lower than it was at the time of investment.
· Inconvenient internal rules and logistics. Some pools do not allow you to pick up all the provided assets at once. Sometimes it is allowed to withdraw only 50% of the crypto funds that were deposited. Reward percentage may also not be accrued from the first day.
· Possible errors in smart contracts. Sometimes the code contains an error since its inception. Plus, some projects do not have enough resources to have experienced auditors to conduct an audit. If there is a failure or theft, it will be extremely difficult to get your funds back.
· Like other segments of investment, decentralized projects can be unreliable. Even working pools need to be evaluated through a filter of their growth in popularity. The more demand for a project, the more its tokens are worth.
What is a liquidity pool
This is when smart contracts have the main task of ensuring the liquidity of decentralized applications. It is in the pools that digital assets are placed. And they use the funds received to carry out the necessary operations. For example, exchange.
In total, users' assets locked in smart contracts provide the exchange market. The more different digital assets will be retained in the pools, the better for the project. Internal tokens obtained in other projects are also invested in liquidity pools.
Users receive a reward for their investment. Those who allowed their assets to be blocked in smart contracts are assigned the status of liquidity providers.
The value of locked assets and the profitability of farming
In liquidity mining, a value such as TVL is used. This is the total value of crypto assets locked in the project.
TVL at its core resembles such a metric as the market capitalization of a company. In this case, the main task is to track the total value of digital funds blocked in the DeFi platform.
The higher the TVL, the more effective the project. This index compares the market shares of different DeFi protocols. You can find out the total value of locked funds of different projects using special analytical services.
One example is DeFi Pulse. This platform monitors the performance of DeFi protocols from a TVL perspective. The benchmark for calculating the profitability of individual pools is the annual percentage of profit that they provide.
You can get this value using one of 2 indicators:
· Annual Percentage Yield (APY). The effect of compound is taken into account. You can also track the accrual of a percentage of profits from reinvesting digital assets.
· Annual Percentage Rate (APR). The effect of the compound is not taken into account.
Each of these indicators is suitable for determining the annual profit. But even with such metrics, it is difficult to accurately determine the level of income from investments in a specific project, they only give an approximate forecast.
The DeFi application market is highly competitive. Any farming strategy that has shown a good level of efficiency is immediately actively used by other farmers. As a result, the likelihood of high earnings is rapidly diminishing.
Profitable farming platforms and protocols
To make money through farming, you need to find decentralized projects. Below are some examples to keep an eye on.
DEX exchange. You can exchange tokens on it. Liquidity providers are required to deposit the cryptocurrency that will be used in trading. The rewards are in the form of a commission from transactions carried out on the exchange.
This is the protocol used to issue synthetic assets. Any user can lock SNX - Synthetix Network Token or ETH. After providing liquidity. The synthetic assets are emitted.
DeFi exchange protocol that specializes in stablecoin swaps. The service provides exchange operations with a minimum possibility of slippage. It is popular in farming due to its increased level of stability.
It is a decentralized lending platform. The DAI is a stablecoin emitted for use on the platform. It is algorithmically linked to the value of the US dollar.
Several collateral assets can be locked here:
· And others.
DAI is generated as debt on locked digital assets. Gradually, users who provide liquidity receive interest. They are called the stability commission.
DeFi protocol built for lending and borrowing. Interest rates are adjusted periodically. Their significance depends on the current market situation. The reward accrual process starts immediately after the tokens are deposited.
In general, farming is the best choice for both beginners who want to safely increase the value of their assets, as well as for experienced investors who want to get the maximum passive income.