Yield Farming the Rocket Fuel of DeFi Part I: What is it? 

by | Nov 1, 2020 | Industry | 0 comments

The Decentralized Finance (DeFi) train has left the station, and it is at the forefront of disruptions in the blockchain ecosystem.  DeFi apps are permissionless, implying that anyone with a smartphone, a stable internet connection, and a digital wallet can access them. Besides, DeFi apps do not rely on intermediaries or third parties to function. In other words, they are trustless. 

One of the latest trending ideas in the DeFi world is yield farming. It is a new way to generate rewards with crypto holdings using permissionless liquidity protocols. Yield farming allows DeFi users to earn passive income through the distributed ecosystem of “money legos” built on the Ethereum blockchain. Analysts strongly feel that it will affect how investors HODL in the future since investors can put their money to work instead of keeping them idle. 

This is the first article of the yield farming series. We shall define what yield farming is and what started the yield farming boom. 

What is Yield Farming?

Yield farming, also known as liquidity mining, is a method of creating rewards with crypto holdings. We can also view it as locking up digital assets and earning rewards. To some extent, yield farming resembles staking. Nevertheless, there is so much density transpiring in the background. 

It works mostly with users known as liquidity providers (LP) that introduce capital to liquidity pools, which are basically smart contracts loaded with funds. In exchange for introducing liquidity to the pool, LPs earn rewards. The rewards may come from fees produced by the underlying DeFi platform or some other sources.  

Some liquidity pools compensate their rewards in several tokens. These reward tokens may be invested in other liquidity pools to generate more rewards, and so on. You can already perceive how too dense these strategies are, as they can sprout so quickly. However, the central concept is that a liquidity provider invests funds in a liquidity pool and gets rewards in return. 

Yield farming is mainly done using ERC-20 tokens on the Ethereum network, and the rewards also the form of ERC-20 tokens. However, this may change in the future since yield farming is currently majorly carried out on the Ethereum blockchain. Cross-chain bridges and other related advancements may enable DeFi apps to become blockchain-agnostic in the future. This implies that they could run on different ecosystems that also support smart contracts. 

Yield farmers will most likely move their assets from one protocol to another in pursuit of high yields. Consequently, DeFi platforms may also offer extra-economic enticements to attract more users to their platforms. Just like on centralized marketplaces, liquidity tends to attract more liquidity.     

What Started the Yield Farming Boom?

The sudden unceasing interest in yield farming can be attributed to the launch of the COMP token- the native token of the Compound ecosystem. The COMP token gives governance rights to token holders. But how do you distribute these tokens if you plan to make the ecosystem more decentralized?

 The primary way to kickstart a decentralized network is by issuing these governance tokens algorithmically, with liquidity inducements. This entices liquidity providers to “farm” the new token by bringing liquidity to the protocol. 

Although it did not invent the yield farming concept, the COMP launch gave this type of token distribution model a lift in popularity. Since then, several DeFi projects have created ground-breaking schemes to attract liquidity to their ecosystems. 

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