Firstly Looking through history, the dynamics of money have benefited the top echelon of society. Yet, with decentralization, there are efforts to re-establish the sovereignty and power of the individual. Decentralized finance is a global, open alternative to the traditional financial system. It offers products and services built on open-source technology that anyone can use.
In contrast to the bureaucracies that rely on established social hierarchies to regulate and enforce the law, autocratic governance is when rules and regulations are written in code. At its core, decentralized finance centers around smart contracts that function as intermediaries between sellers, buyers, and lenders.
Even though decentralized finance is in the early stages, the total value locked has risen to over $200 billion. Over 60% of this figure is within the Ethereum ecosystem.
Yield farming is an avenue to earn interest in cryptocurrency. Like depositing money in a bank, you stake or lock up your stablecoins for a period in exchange for rewards. When you take a loan from the bank, you pay back the principal with interest. This is the same concept with yield farming.
How Yield Farming Works
Yield farming works by permitting investors to stake their coins. Then other users can borrow the coins through the application and use them for speculation. The borrowers aim to profit from sharp swings they envisage in the market price. To an extent, yield farming is a rewards program that favors early adopters. As more people discover the opportunity, the gains begin to reduce.
Liquidity providers are users who provide their cryptocurrencies for the running of the DeFi platform. These liquidity providers supply tokens to a liquidity pool. Having contributed to the pool, the owners are awarded rewards generated from the platform to which they supplied liquidity. The lending happens without a middleman. It is all coordinated by smart contracts. The liquidity pool serves as a reserve for a marketplace where people can lend or borrow tokens. Thus, the fees from the users of the marketplace are used to pay liquidity providers for staking their tokens in the pool.
Components of DeFi
As proposed by the Federal Reserve Bank of St. Louis, here is a list of the layers that make up the standard DeFi stack:
Settlement Layer: The settlement layer is the foundation for the components. It is considered the most essential DeFi component.
Protocol layer: Network protocols help to regulate actions. Many DeFi protocols help to spell out the rules that users follow. This provides the cohesion that allows different entities to collaborate and improve services for end-users. In a typical DeFi environment, the protocol layer helps to achieve enough and scalable liquidity.
Application layer: This is the layer where user-facing programs belong. This layer provides essential services through decentralized applications. These reflect the structures of the underlying protocols.
Aggregation layer: The aggregation layer integrates applications and resources from the lower layers. It helps to further strengthen the utility for end-users and streamline transactions between financeial instruments.
How the Yield Farming Boom Started
Meanwhile, Decentralized finance has opened up many channels of income for investors. Among the channels that DeFi has enabled is yield farming. It involves staking crypto tokens for rewards. This is like earning interest from the bank. At present, yield farming is the most significant factor that is driving growth in the decentralized fianance sector.
The boom in yield farming started after the launch of Compound finance. COMP token is the governance token for Compound finance. With this token, holders can partake in the governance of the protocol. The governance tokens are distributed with liquidity incentives. This potential profit gives lenders the necessary incentive to supply liquidity to the pool.
Risks Involved in Yield Farming
Meanwhile, After yield farming started in 2020, the returns which yield farmers have earned in APY is in triple digits. Yet, this potential return comes at a risk. With the promise of juicy returns, the protocols and tokens are subject to volatility and the developers can leave a project when it becomes obvious that it is not sustainable.
Cyber theft and fraud
Cyber theft and fraud are major challenges that bedevil the yield farming ecosystem. Transactions involve digital assets that use software as a storage. As a result of these, coupled with the fact that there is often a lot of money in the liquidity pools. This gives hackers the incentive to dig deep for vulnerabilities in the underlying software.
Rug pulls and volatility
Yield farmers can ignorantly put their coins into rogue projects. The owners of the project can make away with all the coins. Fraud accounts for a large percentage of crypto crimes. Besides the risk of hackers, there is also the risk of volatility. According to history, crypto prices are known to be very volatile. Besides, there can be a short burst of fluctuations in price. This could mean a lot of unrealized gains or losses.
Finally, We can compare yield farming to the early days of ride-sharing. Ride-sharing applications like Uber and Lyft needed to grow quickly, as a result, they provided incentives for early users on the platform. While yield farming is risky, it can also be very profitable. It is important to understand how yield farming works and the risks involved before you take part.