What is liquidity farming?

Liquidity farming is a concept in Decentralized Finance (DeFi) that involves depositing cryptocurrency holdings in a liquidity pool to make more cryptos. A smart contract operates the liquidity pool, and the users who deposit or stake cryptocurrencies are called Liquidity Providers(LP).

Liquidity farming operates like the average investment where you put in money on a platform to get more money after some time. However, you will be using digital assets or currencies rather than traditional currencies in this case. As a result, the yield you will be getting from your staked cryptocurrencies is higher than you would typically get on a savings account.

So, if you are conversant with investment operations, this should hint you to the high risks involved in liquidity farming. Aside from the risks, liquidity farming is not as straightforward as it may seem. The operations can get quite complex. Hence, the need to increase your knowledge of the nitty-gritty of liquidity farming.

We have provided the details of liquidity farming that you will need to know in this article. Ride along with us!

What do you mean by liquidity farming?

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Liquidity farming is also referred to as yield farming or liquidity mining. An investment master plan in Decentralized Finance(DeFi) involves producing rewards on interest or transaction fees from cryptocurrency coins or tokens.

Although it can resemble staking since it involves locking cryptocurrencies to earn rewards, it is more complex and requires more technical knowledge. In liquidity farming, the users, called Liquidity Providers(LPs), stake their cryptos in a liquidity pool and receive rewards for providing funds to the pool. These rewards may come from fees generated by the primary DeFi platform and can be in the form of multiple tokens.

Liquidity farming requires unique, innovative strategies for LPs to earn more rewards because the more users know about a strategy, the less yield it brings. An example of a system used in liquidity farming is that as a user, you can choose to deposit the tokens received from a liquidity pool in other liquidity pools to earn rewards from there. In short, to gain more yield, liquidity farmers will need to move their cryptos through different marketplaces. So, to attract more capital, blockchain platforms often introduce various economic incentives.

What made liquidity farming become in demand?

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The launch of the COMP token, which is the government token of the Compound Finance ecosystem, can be pointed to as the reason liquidity farming began to reverberate. The governance tokens grant holders the right to partake in the administration of DeFi protocols.

They initiate a decentralized blockchain by algorithmically distributing the governance tokens with liquidity incentives. This way, potential yield farmers can be attracted to provide liquidity to the pool.

This COMP token made the model of distributing tokens more popular and encouraged other DeFi projects to come up with diverse schemes to draw liquidity to their platforms.

How do you know the overall health of liquidity farming?

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Before going into yield farming, you should know its liquidity state when you want to engage in it. You can know this by finding out the total value locked in a liquidity pool.

You can then use that to determine the well-being of the DeFi and the liquidity farming market. If more money is locked, more yield farming is going on.

How does liquidity farming work?

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A DeFi platform is created, and for it to function, Liquidity Providers put in funds(coins or tokens) to a liquidity pool. Then, the funds are locked or staked in the liquidity pool- a decentralized application (dApp) based on smart contracts. For each value of funds locked, the Liquidity Providers receive a fee, otherwise known as a reward.

This reward is obtained from the operations of the primary DeFi platform of the liquidity pool, such as the fee(interest) paid by users who borrow, lend, or exchange tokens from the liquidity pool.

It is an opportunity to generate income by lending your tokens to a liquidity pool controlled not by middlemen or intermediaries.

The funds mainly deposited are stable coins that are dollar-pegged such as USDT, DAI, USDC, and others. The liquidity pools operate based on different rules that have the possibility of getting complex.

The Ethereum platform is used chiefly for liquidity farming with ERC-20 tokens. This is why the rewards are a type of ERC-20 tokens most times.

How do you calculate liquidity farming returns?

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An annual percentage yield (APY) or annual rate (APR) is typically used to calculate estimated liquidity farming returns. The calculations give you an estimate of the returns you could get over a year.

Although APR and APY can be used interchangeably, what makes them different is that APY considers the effect of reinvesting profits to generate more returns.

However, you must understand that whatever results from your calculations are simply estimates and projections. The accurate value cannot be given because of the unpredictable and highly competitive nature.

What risks are present in liquidity farming?

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As simple as liquidity farming may seem, it can get complex in practice, and users can lose their capital funds and more funds. Complex strategies are most profitable but are only advisable for advanced users because of the huge risks involved. The risk is not only for lenders, but there are also risks involved for borrowers.

One risk for borrowers in liquidity farming is the liquidation of the collateral. When you are borrowing assets, you will need to set up collateral that will act as insurance for your loan. Different liquidity pools require a certain threshold that the value of your collateral must not fall below. Once your collateral falls below the threshold required by the liquidity pool you are borrowing from, you may have your collateral liquidated on the open market.

Another risk in liquidity farming is the smart contracts liquidity pools are built on. Smart contracts are built mainly by small teams with limited budgets. As a result, bugs and vulnerabilities are often found in smart contracts, leading to the loss of user funds.

The permissionless and seamless integration of DeFi protocols can threaten liquidity farming. The building blocks are dependent on one another, so as much as they could be of great advantage. It can disrupt the entire ecosystem when one block stops working. The whole system would crash, and all funds would be lost.

What platforms use Liquidity farming?

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We have already established the fundamental operations of liquidity farming. However, if you want to get the best returns on your investments, you should know how to manage your investment.

Some platforms and protocols will yield higher if you implement them. Some of these projects are:

• Aave
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• This decentralized protocol is popular among yield farmers because it allows users to lend and borrow. Based on current market conditions, the interest rates are updated algorithmically.
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• In return for the funds lenders put in, they receive 'aTokens' that start earning and compounding interest immediately after it is deposited.
• Curve FinanceThe abundance of stablecoins in liquidity farming gives curve pools a crucial place. With Curve Finance, users are allowed to make stablecoins of high value with relatively low slippage compared with other similar decentralized exchange protocols.
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• MakerDAO
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• This is a credit platform that is decentralized and supports creating DAI. You can lock collateral assets in a Maker Vault and generate DAI as a debt against this locked collateral. Interest is accrued to the debt over time with a rate set by MKR Token holders.
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• Compound Finance
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• It is one of the essential protocols of the liquidity farming ecosystem. In this algorithm money market, users can borrow and lend assets. The rewards you get from supplying assets to Compound's liquidity pool will compound immediately when they are earned. The demand and supply determine the algorithm by which the rates will be adjusted. It is, however, only open to people who have Ethereum wallets.
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• Yearn. finance
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• Liquidity farmers searching for a platform that automatically chooses the best strategies often embrace Yearn.finance. It enhances token lending by algorithmically finding the most profitable lending services. The funds LPs deposit is converted to yTokens that maximize profit through periodical rebalancing.

Gate.io

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Gate.io provides a liquidity mining platform where users can earn income from fees by providing dual-asset liquidity to the market.

Gate.io has, as of this writing, an accumulated bonus pool of 840,568.28 USDT and total liquidity of 53,360,111.18 USDT. Visit gate.io to get started.

Rounding Up

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We have looked in-depth at the essentials of liquidity farming. It is a dangerously exciting concept in DeFi. We anticipate what the next decentralized finance revolution has to offer in making the financial system more accessible to anyone connected to the Internet.



Author: Gate.io Observer M. Olatunji
Disclaimer:
* This article represents only the views of the observers and does not constitute any investment suggestions.
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