In Part I of the yield farming series, we comprehensively discussed what yield farming is and what started the yield farming boom. In Part II of this series, we will discuss how yield farming works and how to calculate returns.
How does Yield Farming Work?
Yield farming borrows from a concept known as an automated market maker (AMM), which primarily entails liquidity providers (LPs) and liquidity pools. Let us see how it precisely works.
Liquidity providers deposit digital assets into a liquidity pool. The pool supports a market where users lend, borrow, or exchange digital assets. According to their percentage stakes in the liquidity pools, users of these platforms are charged fees, which are then distributed to liquidity providers according to their percentage stakes. This is how an AMM works.
Nevertheless, the applications can differ a lot since this is a new technology with novel ideas. We are likely to experience new approaches that build upon the current AMM applications.
Apart from fees, adding funds to a liquidity pool is the distribution of a new token. For instance, investors may be limited to buy a specific token on the open market in small amounts. Besides, it can be accumulated by injecting liquidity into a particular pool.
The terms and conditions of distribution may rely on the unique execution of the protocol. The bottom line is that liquidity creators receive returns on the liquidity stakes in the pool.
The assets deposited are mostly stablecoins pegged to the USD- although this is not the rule of the thumb. Some of the most common stablecoins used in DeFi are DAI, USDT, USDC, and BUSD. Some DeFi protocols mint tokens that represent the staked coins. For instance, if you deposit DAI into Compound, you will earn cDAI, or Compound DAI. If you use ETH in Compound, you will earn cETH.
As you can see, there are several layers of density to the above approach. You could deposit your cDAI to another DeFi protocol that mints the third token to represent your cDAI that symbolizes your DAI. And so forth. These chains can become so complicated and challenging to follow.
How to Calculate Yield Farming Returns
Basically, the estimated yield farming revenues are calculated yearly. This approximates the returns that you could receive throughout a year.
The standard yield calculation methods are Annual Percentage Rate (APR) and Annual Percentage Yield (APY). APR does not consider the impact of compounding, while APY does. Compounding, in this regard, refers to directly reinvesting returns to create more profits. But, sometimes APY and APR are used interchangeably.
It is also important to remember that these are just approximations and projections. Even short-term incentives are hard to estimate correctly. This is because yield farming is a highly competitive and fast-paced market, and the profits can fluctuate quickly. When a yield farming strategy works for a while, many farmers will buy into the idea, which may stop yielding high returns.
Since APR and APY are borrowed from traditional markets, DeFi needs to create its calculating earnings methods. Because of the fast pace of DeFi, weekly or even daily estimated profits may be more sensible.
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