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How to take advantage of DeFi and the risks of yield farming

16 Dec 2021

Do you already know about DeFi, its ecosystem, protocols, and applications? Are you willing to start your journey in the crypto world and experience the features of peer-to-peer services? The timing for that couldn’t be better, as currently, decentralized finance is becoming more and more appealing to new market players. So let’s get down to business and find out the ways you can benefit from working with DeFi. 

Ways to generate passive income with DeFi

Decentralized finance consists of platforms providing different financial services that aim to replace traditional financial institutions (banks, money lending companies). At the moment DeFi is in the process of gaining the public’s trust and drawing more attention to the ecosystem by giving us a wide variety of ways to earn money. 

One of them is called yield farming — the process of earning more cryptocurrency by utilizing the one you already have. There are several options of doing that, so let’s delve into the features of the most popular and innovative ones:

  • Staking 

The process of staking is very similar to the deposit system in banks, specifically in interest-earning accounts. This relatively new way of generating income has grown in appeal since the emergence of Eth2, the first upgraded version of Ethereum blockchain, in 2020. The whole mechanism of the blockchain is based on its users and their participation: the more market players trust their funds to the platform, the more popular and reliable it becomes. Therefore, staking is profitable for all parties. So how can you earn rewards simply by having certain cryptocurrencies on the platform?

On Eth2, you can lock your tokens into a smart contract and earn more of the same token in return. To begin the process you need to have at least 32 ETH in your wallet and “locking” is the state when the tokens you possess are “frozen” and cannot be used for your transactions. On these terms, you become a validator, a member of the blockchain system that contributes to its work by holding the token and, meanwhile, earns interest.

There is another version of DeFi staking that operates on Binance and offers different conditions of service. The process remains the same, you have the minimum amount of money you need to stake and you have two options: flexible staking (you can redeem money whenever you want saving the earned interest) and locked staking (you are able to redeem the tokens only by the end of the locked duration, otherwise you won’t receive any interest generated during the staking period). Both types are worth your attention, but the second one allows you to make more money as long as you comply with the rules of the platform.

  • Liquidity provision

Earning interest from liquidity provisions is based on Decentralized Exchanges. Their purpose is to keep trade going and for that to be done successfully they need to initiate liquidity. Which means that if a person wants to exchange dollars for ETH, DEX has to provide the needed amount of ETH to grant the request. But as this system is decentralized and there are no banks to provide them with extra funds the platform may not have enough cryptocurrency for trading at that moment. Aiming to solve the issue, liquidity pools, smart contracts based on code, have been created to hold certain funds for trading. But whose funds are placed there? This is where a liquidity provider takes on the role of an investor in a liquidity pool.

Any user with cryptocurrency who is willing to earn interest can become a liquidity provider. Let’s take Uniswap as an example of a DEX and a liquidity pool. For instance, you decide to become a liquidity provider, for that you have to give a pool a certain number of two cryptocurrencies, so they are placed and locked there for other traders to carry out transactions. A pool works on an exact ratio of 50:50, if you choose to provide cryptocurrencies totally worth 100$, you will have to give 50$ of ETH and 50$ of Bitcoin (only you decide on what cryptocurrencies to use). As long as the pool exists (has been created), you and other investors of the pool start receiving income. The interest stands at 0,3% of the taxes charged from other users for each transaction in your pool and this sum of money is divided between all the investors. 

  • Lending and borrowing

Another way of deriving extra income is interacting with lending and borrowing platforms, such as Compound Finance and Aave. They provide rewards to those who lend crypto to their platforms. The process is quite similar to the ones mentioned earlier in the article: a user locks tokens into a smart contract which are then used by borrowers, who are obliged to pay interest for utilizing the tokens. Meanwhile, the user becomes a lender and gets a percentage of the interest earned. For instance, Compound currently offers an annual percentage yield (APY) of 2,74% for lending ETH. 

As surprising as it might sound, it is also feasible to make money from borrowing. Let’s say, you need money and have some ETH, but you don’t want to sell it, because there is a chance that its price will go up. In this case, you can borrow some DAI (stablecoins) and lock your ETH as collateral. All loans on such platforms are overcollateralized (so you lock even more money than you actually take as a loan) for security reasons — to make sure you won’t just run away with the borrowed crypto. So, you can lock 150$ of ETH and get 100$ of DAI in return for your personal usage. Of course, you have to pay some interest during the loan period, and if you have no debt left at the end, you can redeem your ETH back and, hopefully, it will increase in value by that time. Thus, you still have a more profitable cryptocurrency such as ETH on your hands to utilize and derive income using the methods mentioned above.

The risks of yield farming

It’s crucial to remember that none of these ways of earning income is risk-free. And because we talk about investment here, you should always consider each step carefully. Here are some of the pitfalls:

  • Impermanent Loss

This is a risk that liquidity providers can run into when placing their cryptocurrencies in liquidity pools. As mentioned earlier, a liquidity provider locks two different assets that are worth the same amount of money in a liquidity pool. But as crypto is volatile, it is feasible that one of the asset’s prices could go up or down, while the others would stay the same. This is when an impermanent loss takes place. Basically, it is the loss you get when you end up with less money by investing in a liquidity pool than the value you would have had by simply keeping them in your wallet and carrying out other transactions. The loss is called impermanent because the situation may still change if assets come back to equal liquidity before the moment you decide to withdraw them. We strongly recommend you to be selective when picking a liquidity pool to invest in as well as check what other users’ outcomes are.

  • Smart contracts risks

This is one of the main issues in the DeFi system. Liquidity pools and other transactions work on smart contracts and are dependent on them. Therefore, if some kind of malfunction or bugs occur, it may impede the work or even be used by hackers to take control over investors’ funds. Involving a third party that can audit a contract would significantly enhance the security level of your assets.

  • Rug pulls

A scam that involves dishonest developers is called a rug pull. As developers are able to create projects like liquidity pools, it is feasible that after they raise a decent amount of money from investors, they will just run away without paying back. 

Sometimes developers design a cryptocurrency and build buzz around it to make investors exchange their valuable tokens (ETH or Bitcoin) in exchange for the new one. Yet the cryptocurrency is actually a get-rich-quick scam, where the founders take all the valuable currency and disappear with it.

In conclusion

As we have learned, DeFi offers various innovative ways of yield farming for those who are ready to accept all the risks and difficulties they may encounter. Generating money using the methods described is not easy. This process requires you to be analytical, careful, and wise when choosing a liquidity pool or a platform to work with. But now that you are aware of the pitfalls, you are welcome to take the role of an investor and decide on the most favorable way to earn some tokens on your own.

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