DeFi is guiding the digital asset markets into a realm in which many thought it could never find a home: institutional-style investing—without the institutions.

Yield farming is emerging as one of the most popular ways investors can earn investment income on their digital asset investments. But how does yield farming work, and can you really make money with it?

What Is Yield Farming?

Yield farming gives people the chance to earn interest—fixed or variable—by placing funds in a DeFi (decentralized finance) protocol. It’s different than buying or selling a digital asset. With yield farming, an investor lends out their digital asset using a platform, earning a return that, ultimately, stems from borrowers paying a premium for the asset.

For example, a yield farmer can lend ETH on Compound and earn a yield based on how much Compound charges borrowers for ETH loans.

To start digging in the fields of yield farming, you have to pay to play. If you’re only throwing in a few hundred dollars, the fees will likely eclipse any earnings you realize. With larger investments, however, the rate of return can more than cover the fees, positioning you to realize consistent profits.

How Yield Farming Works: Liquidity Pools

All lending schemes depend on the liquidity of the asset being lent. If a bank didn’t have money, it couldn’t provide loans. Similarly, a DeFi player like Compound Finance needs digital assets to lend to others. This is where yield farmers come in. They lend digital assets to the DeFi provider, which puts them into a liquidity pool. In Compound Finance’s system, this is done using smart contracts on the Ethereum blockchain. The smart contracts connect lenders and borrowers and calculate how much interest the borrower pays.

The Problems Yield Farming Solves

Despite all the advantages of digital assets, there are a few stubborn challenges. Two of these, digital assets losing value while in storage and a lack of borrowing options, can be remedied by yield farming.

Yield Farming Can Prevent Digital Assets from Losing Value

If you’re like many owners of digital assets, they sit in a wallet, stagnant and unproductive.

With yield farming, your digital assets can earn a rate of return while you’re not using them. In that sense, yield farming is much like putting money in a savings account. But instead of earning a paltry 0.1% interest, you have the opportunity to rake in 50 or 100 times as much.

Yield Farming Provides More Borrowing and Lending Options

Digital assets have the power to help fund cutting-edge, life-changing ideas, but often people don’t have access to the digital capital they need to turn ideas into reality. On the other side of the table, there are people holding loads of digital assets, not necessarily because they’re hodling, but because they don’t have access to convenient investment tools. Yield farming connects those who need digital assets with those who have them.

How Yield Farming Works on Compound Finance

Compound Finance is currently one of the leading protocols in the DeFi space. The decentralized lending application offers a straightforward process for yield farming newcomers.

Connect Your Wallet

If you have a wallet such as Ledger, Metamask, or Coinbase Wallet, you can link it with the Compound Finance app. During the connection process, you give Compound Finance access to the digital funds in your wallet.

Check Out the Rates of Return

Once inside the Compound Finance app, you can peruse the rates of return and the costs of borrowing. Of course, the cost to borrow is higher than the rate of return, which gives Compound a role similar to that of a market maker in the stock market. The rates change based on demand and other market conditions, so what you see one day may be significantly different later.

Lending

In order to use Compound Finance, you have to supply a token. The platform doesn’t allow people to join just to borrow funds. Once you supply a token, you are told how much collateral you have “earned.” Unlike with traditional banking, the collateral you get when you yield farm doesn’t have the same value as the asset you “put down.” The platform decides how much your collateral allows you to borrow.

For example, you may only be able to borrow up to 65% of the value of the tokens you’ve supplied. This would mean that if you supplied 1000 BAT, about $273 at the time of writing, you would only be able to borrow up to the equivalent of 650 BAT or about $177.45.

The Risks of Yield Farming

As with all investments, yield farming doesn’t come without risks. The primary risk you run is the liquidation of your position. On Compound Finance, for example, you can never borrow more than what the platform allows you to—in relation to the amount you provided. To use the example of 1000 BAT, if you’re allowed to borrow $177.45, and you take out $177, you’ll be fine as long as the value of BAT doesn’t drop significantly. But if BAT drops 2%, your borrowing limit would also fall to about $173.90. Because you borrowed $177 worth of BAT, your account could be liquidated to make up the difference.

If you have to get liquidated, another participant can pay back as much as 50% of your loan. As a reward, that participant can earn a portion of your collateral.

Also, if you borrow non-stablecoins using stablecoin collateral, you expose yourself to another kind of risk. If the price of your non-stablecoin asset rises, you risk getting liquidated because its value becomes, proportionately, too low. As with all investing, only get involved with yield farming after carefully considering the risks.

Yield farming, if you have enough digital assets, can be a useful way to let your coins work for you. Whether you want to borrow, lend, or both, DeFi platforms can help you get started farming a handsome crop of revenue.

Further Reading:

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Source: https://www.bitcoinmarketjournal.com/what-is-yield-farming/