What is Yield Farming and Cash Extraction?
Welcome to the fourth in PYMNTS ‘eight-part Decentralized Finance (DeFi) series.
Over the next few days, we’ll take a look at every part of DeFi – the most important, hottest, most rewarding, and riskiest part of the blockchain revolution.
By the end, you will know what DeFi is, how it works, and the risks and rewards of investing in it.
See part 1: What is DeFi?
See part 2: What are the best DeFi platforms?
See part 3: What is a smart contract?
So what is yield farming? Start with that. It earns passive interest on your crypto holdings, usually at rates much higher than you might get with a savings account.
Then move on to this. It’s risky. Like any other investment, the higher the reward, the higher the risk. Bank savings accounts now earn a small fraction of 1% APY (Annual Percentage Return) or APR (Annual Percentage Rate), the difference being that the APY feeds the income back into the investment for compound interest. The rewards of yield farming start at a few percent and can grow into the hundreds of percent.
By lending your crypto holdings to a Decentralized Finance Project, or DeFi, you can earn a lot more. However, even with ridiculous interest rates, in yield farming you need money to make money and you need to be able to let it sit for long periods of time.
One of the biggest DeFi lending projects is Aave, with $ 24.4 billion stranded. On December 13, it was offering 2.87% APY on USD Coin and 5.44% on Binance USD – the two stablecoins – but only 0.01% APY on Ethereum. But the Curve DAO token was offering 12.15%.
For the biggest reward, you loan funds to more obscure DeFi projects, with the highest returns from the most obscure projects. Which means that the potential for hacking, fraud, and real “carpet draws” – a project creator running away with all the funds – is considerably higher than with established DeFi lending protocols like Curve, Yearn or Aave.
What are you doing?
Let’s take a step back and take a look at how DeFi projects work. Lending protocols are one of the greatest forms of DeFi projects. They work like this: Person A locks the crypto – usually dollar-linked stablecoins – in a cash pool on a DApp, which is borrowed by Person B, who pays interest. (Yield farming is also called cash farming.)
The funds are locked or staked in smart contracts that control the pools of liquidity upon which DeFi lending protocols are based. They are simply mutual funds from which borrowers draw funds. Pool members earn a share of the interest received based on the amount they have blocked. Swimming pool rules can get complex, so make sure you know what you’re getting yourself into.
Among the many drawbacks, some projects offer rewards in their own tokens as rewards. This has a number of potential advantages and disadvantages. On the one hand, you are basically investing in this token, hoping that it will increase. It also gives access to tokens that are difficult to buy as they are from a new project and have limited availability. And are therefore very volatile.
In June, billionaire investor and crypto fan Mark Cuban tweeted that he had lost a good chunk of the money when an obscure DeFi token he owned called Titan crashed from around $ 60 to almost zero.
Another wrinkle in the combination of yield farming and crypto volatility is what is known as ‘impermanent loss’. Staked cryptocurrencies can rise and fall in value when locked in a pool of cash, creating temporary – sometimes frightening – gains or losses on paper. However, if you withdraw your crypto from a pool at the wrong time, these losses become permanent.
Where Yield Farming gets really complex – and it’s best left to experienced, knowledgeable investors how DeFi works – is when you reinvest those reward tokens into other cash pools, earning different tokens. . Complex investment chains can be built.
Next step: what is staking?
Another great area of DeFi is staking, and this is in some ways the most important. Most new blockchains operate on proof of stake rather than Bitcoin’s power-hungry proof of work – even Ethereum is toppling over. Staking is how new tokens are created (rather than the “mined” Bitcoin) and how new information is added to these blockchains. But unlike bitcoin mining, anyone can participate and earn rewards by staking.