Yield farming is a new way to make money in the DeFi sector. Users invest in the project and make a profit in its token. There are several strategies for getting your investment back, and almost all of them offer multiple returns. Farming in cryptocurrencies is like depositing in a bank. However, DeFi’s expected return is higher, like are the risks.
Earning mechanismThe mechanism of earnings in DeFi occurs in the following main ways:
- Earning interest through loan funds and fees. To do this, the farmer needs to register with a DeFi project that issues loans. The user's funds are transferred to another user who has issued an application for a loan on special conditions - with subsequent payment of interest.
The commission received is the income of the crypto farmer from participating in the project. Besides, project tokens can be distributed among users. By selling them, or saving them for the future (expecting a price increase), you can also get additional profit.
- Liquidity mining. Users are rewarded for working with a specific protocol. They act as liquidity providers by promoting the project. As a rule, the project distributes a certain amount of cryptocurrency between the participants daily.
The influx of customers increases the demand for the project and its products and, as a result, the project token becomes more expensive. It can then be sold on a decentralized exchange or other trading platforms.
- Swaps, meaning an exchange of tokens of one protocol for tokens of another. An important part of profitable farming is constant market research to find alternative strategies.
As soon as a community member finds a new, more profitable investment option, he reallocates funds. This is where the swap principle comes in handy! With its help, less profitable tokens can be converted into other - more economically attractive ones. Among crypto farmers, this procedure is commonly called “asset rotation”.
Therefore, DeFi farming returns are composed of three main things:
- Trading commissions that are given to liquidity providers;
- The repo market and its flows, which are also given to liquidity providers;
- Obtaining a protocol token that has a high capitalization, and in the initial stages is a significant factor for increasing profitability.
At the same time, it should be noted that, unlike banks, no one insures the funds of DeFi-protocol investors. In this case, they risk losing everything.
Return calculationThe estimated yield farming returns are calculated on an annualized basis. This is an estimate of the profit that the user can expect over a year.
The following metrics are used for calculations:
- Annual Percentage Rate (APR) - does not take into account the effect of compounding.
- Annual Percentage Yield (APY) - takes into account the effect of compounding.
Compounding in this case means direct reinvestment of profits to generate more returns. However, APR and APY can be used interchangeably. Both metrics are used for evaluation and forecasting, but the real outcome is difficult to quantify as yield farming is a highly competitive and fast-growing market and rewards can fluctuate rapidly. Due to the fast pace of DeFi, weekly or even daily estimated returns may make more sense.