If you’ve ventured into cryptocurrencies recently, you may have heard about a promising as well as problematic category of crypto tokens known as DeFi (Decentralized Finance). DeFi removes any intermediaries from financial activities and enables peer-to-peer lending. DeFi lending is a rapidly-growing segment and application of DeFi. When you buy crypto tokens, you can hold them without any utility. Using DeFi lending protocols, you can obtain a loan against your crypto holdings.
Liquidity Farming or Yield Farming is yet another application of DeFi.
Curious how this all works? Let’s find out.
What is Liquidity Farming?
Liquidity farming allows you to earn passive interest on your crypto holdings at rates far higher than you get in a traditional savings bank account. You lock up your cryptocurrencies and get rewards using permissionless liquidity protocols. The word ‘farming’ is a justified analogy to growing your own crypto crop.
Consequently, liquidity farming may change how investors HODL in the future. Crypto HODLing is a term used by cryptocurrency investors who refuse to sell their crypto regardless of high market volatility and poor performance.
When investors can put their crypto to work for them, why would they keep them idle?
How Does Liquidity Farming Work?
Liquidity farming works with users called Liquidity Providers (LPs) that contribute funds to liquidity pools which are smart contracts that hold funds. The liquidity pool invests in a marketplace where users borrow, lend and exchange tokens. Each transaction incurs a fee, which is then paid to investors as per their contribution to the pool.
Some liquidity pools pay rewards in terms of multiple tokens, which can then be deposited to other liquidity pools to earn rewards and so on. Much liquidity mining currently happens in the Ethereum ecosystem with ERC-20 tokens that lead to ERC-20 token rewards.
In the future, liquidity farmers may be able to move funds a lot between different blockchains in search of yields.
What Are the Different Yield Farming Platforms and Protocols?
Each liquidity farming platform has its own rules and risks. Here are the most popular ones:
Maker is a decentralised platform that supports the creation of DAI. DAI is a stablecoin cryptocurrency that aims to keep its value as close to the USD as algorithmically possible through automated smart contracts on the Ethereum blockchain.
Anyone can open a Maker Vault to lock collaterals, such as USDC, ETH, BAT or WBTC and generate DAI as debt against them. The debt incurs interest called the stability fee which MKR token holders set. Liquidity farmers can use Maker to mint DAI and use it in further farming strategies.
Aave is an established DeFi protocol for borrowing and lending with over $23 billion (or 2,300 crores INR) locked in. The protocol adjusts interest rates algorithmically according to market conditions. Lenders receive “aTokens” against their funds, which immediately start earning and compounding interest. Aave also enables advanced functions such as flash loans.
As a more established protocol, Aave is highly used and trusted by liquidity farmers.
Uniswap is a cryptocurrency exchange that uses a decentralised network protocol, facilitating automated transactions between crypto tokens on the Ethereum blockchain through smart contracts. Liquidity providers create a market by depositing the equivalent of two tokens. Traders then trade against the liquidity pool. In return for supplying liquidity, providers earn fees from trustless token swaps and trades that happen in the pool.
Uniswap’s frictionless nature makes it lucrative for liquidity farming strategies.
How Does Liquidity Farming Differ from Crypto Staking?
Liquidity farming or yield farming or liquidity mining may be paralleled with crypto staking at times. However, crypto staking involves supporting a blockchain by participating in validating transactions by committing crypto assets to the network. Blockchain networks that employ the Proof of Stake (PoS) method for consensus use crypto staking. Investors earn interest while they wait for block rewards to release.
Between yield farming and crypto staking, the latter is the simpler strategy to earn passive income. Investors can decide on the staking pool and lock in their assets. On the contrary, yield farming requires investors to choose tokens and platforms to lend on, with added complexity of switching platforms and tokens.
Yield farming is also the riskier strategy with chances of rug pulls (the creator running off with the pool assets), bugs in smart contracts and impermanent losses (staked crypto can rise and fall substantially on paper). But, it can result in an annual percentage yield of 1% to 1,000%. Staking rewards stay in the range of 5% to 14%.
In this article, we have covered what liquidity farming is, how it works, its different platforms and protocols, and its differences with crypto staking.
At ZebPay, we encourage only proficient experts in DeFi lending and borrowing to explore Liquidity Farming. If you’re dipping your toes more recently, earn fixed returns on your crypto holdings through ZebPay crypto lending platform.