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What Is Yield Farming and How You can Earn Passive Income with Cryptocurrencies?

December 22, 2021

What Is Yield Farming and How You can Earn Passive Income with Cryptocurrencies?

Is there a way to earn passive income with cryptocurrencies? If you’d like to know the answer to this question, you’ve come to the right place. The main principle behind earning passive income with cryptocurrencies dates as far back as the inception of banking and finance, and it is none other than utilizing your current funds to earn an even greater amount. It is simply a case of putting your money to work for you instead of allowing it to sit idly in a bank or wallet. Decentralized Finance (DeFi) makes it possible to put your cryptocurrencies to work and generate a return. 

Decentralized Finance replaces financial intermediaries like banks with blockchain technology and smart contract-based applications. DeFi is a younger and, in many cases, more efficient system than traditional finance. One of the most lucrative ways of earning passive income by utilizing cryptocurrencies is yield farming.

What is Yield Farming and How Does it Work?

Yield farming (also known as liquidity mining) represents lending cryptocurrencies to others through DeFi platforms that use smart contract technology, all in order to receive a passive return. 

To participate in yield farming, users add their crypto holdings to a smart contract that provides liquidity to a certain pool. By doing that, they become liquidity providers and earn rewards. 

The majority of yield farming is done on DeFi applications built on the Ethereum blockchain. However, this is expected to change soon as the increased interest in yield farming is slowly making way for cross-chain advancements with other protocols. 

Why is Yield Farming Important? 

Yield farming helps lenders earn returns (much higher than they normally would if they had left their money in the bank) by utilizing their cryptocurrencies via DeFi platforms. 

Since the returns are denominated in the token that liquidity providers are investing in, yield farming also helps increase token holdings rather than just leaving tokens in wallets and waiting for them to increase their dollar value. 

Yield farming benefits new projects by securing them with the necessary liquidity to attract even more trading. 

These use cases allowed for its astronomical growth in 2020. At the moment, yield farming is the biggest contributor to the developing DeFi sector. 

Yield Farming Risks

Even though yield farming has many advantages and upsides, it is susceptible to a few risks, which every investor should be aware of.

Smart Contract Risk

Smart contracts are a cheaper, safer, and better substitute for intermediaries, but they also come with a set of flaws. Mistakes in writing the smart contract code can be exploited, meaning that they are as good as their underlying code.While this is not very common, and most high-profile protocols invest heavily in security, it is worth knowing as a risk. 

Large Gas Fees

All the inefficiencies that plague the underlying blockchain also plague protocols built on it. As most yield farming takes place on the Ethereum network, the problem regarding high gas fees is a big one. While this may not be as big of a problem for large liquidity providers, small investors’ returns can be decreased by large fees.

However, each market moves to achieve full efficiency, and so is the case with yield farming. The number of yield farming protocols built on other blockchains, or layer 2 solutions, is rapidly increasing.

Risk of Impermanent Loss

Impermanent loss, in simple words, happens when volatility occurs to an extent where the returns you earn by putting a token in a liquidity pool are worth less than they would be if you didn't as a result of a divergence between the price of the asset in the pool and the price outside of it.  

This loss is called “impermanent” because you don't suffer any losses until you remove your money from the liquidity pool. The best way to avoid Impermanent losses is to choose pools that have assets with low volatility. 

Liquidation Risks

Liquidation risk is one of the most feared risks associated with yield farming, and it is very common amongst volatile assets. If the value of your collateral drops way below the price of the loan, or if the loan value increases, the liquidity provider bears the loss. 

Let's take an example. Eddy takes a loan in Ripple (XRP) and uses Ether (ETH) as collateral. A massive hike in Ripple’s price would make the value of Ethereum used as collateral quite worthless. Eddy would benefit from this, but the liquidity provider wouldn't. This is the summary of liquidation risk. To avoid this, liquidity providers should consider stablecoins (or low volatility cryptocurrencies) for both the loans and the collateral. 

Conclusion

Yield farming is a great way to earn passive returns from cryptocurrencies. All investments bare risks, and it’s important to analyze and understand the benefits and risks involved.  

Yield farming is undoubtedly one of the most lucrative avenues for earning additional returns with using cryptocurrency without too much risk. With all the information you now have, would you like to start participating in yield farming?

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