Yield farming is one of the most discussed subjects in decentralized finance, and there’s a good chance you’ve heard something about insane returns that DeFi yield farming produces.
But what exactly is DeFi yield farming? What does it mean for your personal finances? And how can you utilize yield farming to earn more interest and get a better return on your savings?
We’ll answer all of these questions in this post so that you have a thorough understanding of the fundamentals of DeFi yield farming.
What DeFi yield farming means
DeFi yield farming, in a nutshell, is the practice of earning interest on your cryptocurrency similar to how you earn interest on money in your savings account.
And similar to traditional savings accounts like term deposits, yield farming involves locking up your crypto assets for a set amount of time in exchange for returns such as interest or more cryptocurrency.
The key difference is that the interest rates and returns are much greater than with a traditional savings account with a bank.
While that might sound too good to be true, it makes sense when you dive a bit deeper into what DeFi yield farming is. But to do that, you first need to understand what DeFi means.
What does DeFi mean?
DeFi, short for decentralized finance, can be best understood by comparing it to its counterpart: centralized finance.
Centralized finance is something that we all use today. It’s the entire financial network from your personal bank account or ATM on the street all the way to Wall St and central banks.
The term ‘centralized’ refers to how there is an institution, organization or some other kind of central governing body controlling all of these transactions within the financial network.
This includes your bank and credit card provider all the way up to the government printing new money.
The problem with centralized finance
Because the traditional financial system always involves some centralized body behind every transaction, you’re always going to be at their mercy.
Let’s say you want to take out a loan at a bank. If the people at the bank don’t like your credit, or if they don’t like anything about you, whether that’s where you work, where you live, or the color of your skin, they can deny your loan application.
Even if you’re approved and you’re happy with their terms and conditions, they also have the power to make changes to these with minimal or no notice.
And let’s say you want to deposit money into a bank account. At the end of the day, it’s the bank that controls access to your money. In extreme cases, governments can even freeze people’s access to their own bank accounts.
How decentralized finance addresses these issues
This is in complete contrast to decentralized finance, or DeFi.
Instead of having to rely on one central body that controls everything, DeFi removes the need for any middlemen or third parties that can control your money.
With DeFi, all the elements of the financial system including lending, investing and borrowing are run on self-executing programs that exist on the blockchain.
These programs, known as Dapps (short for decentralized applications) do not run on any centralized servers controlled by any company like Google or Amazon.
Instead, they’re hosted on a network of nodes distributed across the world so that nobody can control them or stop or start them. The only thing that needs human action is for someone to initiate a transaction.
To learn more about DeFi, check out our article on what DeFi is and why we need it here.
What this means for you
This means that when you go to get your loan, or perform any other financial transaction, the process is not based upon not anyone’s personal interpretation but whether or not you meet the rules that have set been set up by the Dapp.
If it says that you have to do x things and y things, and you do them, you’ll be able to complete the transaction regardless of who you are, where you live, etc.
How this relates to DeFi yield farming
When you purchase crypto, there are two main things you can do with it: you can keep it in your wallet until you spend it or exchange it for another cryptocurrency or fiat, or you can put it to work, usually in what’s known as liquidity pools.
Liquidity pools are simply a group of funds that have been ‘pooled’ together so that more serious investors can make sophisticated trades such as arbitrage and loans.
In return for providing this liquidity, you receive a percentage of the fees these investors pay to execute these transactions.
When your liquidity is loaned out, you also earn a percentage of the interest the borrower pays. Much in the same way as interest works in the traditional financial system except this time there isn’t a middleman (i.e., a greedy bank) taking most of the profit, which lets you earn a much higher interest rate.
Different liquidity pools will also offer bonus rewards to people depositing their crypto assets into them as a way to incentivize more people to contribute to their liquidity pool.
So DeFi yield farming is simply the process of using your money in these liquidity pools in order to earn a return on your crypto assets instead of leaving it to sit in a wallet and do nothing.
What about potential falls in the value of the crypto?
Hopefully, you should now be beginning to see how DeFi and yield farming can earn you a much greater return on your assets than with a traditional bank in the world of centralized finance.
At this stage, you might be thinking about what happens if the value of your crypto asset falls against the currency you use every day, such as the US dollar, for example.
After all, cryptocurrencies are prone to price volatility so it’s natural to be concerned that a fall in their value could wipe out all the gains you’ve made.
This is where stablecoins come in.
Stablecoins are a special type of cryptocurrency that is pegged to a stable asset such as gold or a fiat currency (usually the US dollar). This makes them extremely stable and not subject to volatility in the wider crypto market.
This is why stablecoins are an essential part of DeFi and DeFi yield farming as they safeguard your savings from fluctuations in, say, the price of Bitcoin.
As a result, you can earn interest on your crypto assets and have your portfolio reliably increase in value in relation to fiat currencies. You don’t have to worry about price fluctuations.
For more about stablecoins, check out our explainer on what stablecoins are and how they work here.
So now you know the fundamentals of DeFi yield farming and how it opens up opportunities that can bring a substantially better return on your savings than what you can find with banks.
You’ve also seen how DeFi fosters a more open and accessible financial system that is available to everyone with an internet connection.
So, if you’re sick of earning pitiful amounts of interest with your bank and losing ground due to rising inflation, it’s time to join the future of finance.
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