Yield farming, also known as liquidity mining, is a popular method in the world of cryptocurrencies that allows users to earn rewards and profits by depositing their assets. In this process, individuals allocate their digital assets to liquidity pools and, in return, receive additional tokens or profits.

Yield farming generally involves two main activities: lending and staking. In lending, individuals lend their assets to others and receive interest in return. In staking, users lock their assets in a smart contract and receive new tokens or additional profits as a reward.

This method is particularly popular in decentralized finance (DeFi) protocols operating on the Ethereum network. Most yield farming platforms use ERC-20 tokens. Users can deposit their tokens on these platforms, act as liquidity providers, and receive rewards in return.

Definition of Yield Farming

Yield farming is an innovative way to earn profits through cryptocurrencies. Instead of holding or trading cryptocurrencies, you can lend your assets to specialized platforms and receive rewards in return.

These platforms, known as "liquidity pools," are places where liquidity is gathered for transactions. By depositing your assets into these pools, you act as a "liquidity provider" (LP) and enable market participants to trade cryptocurrencies easily.

In return for this service, you receive various rewards, usually including the platform's tokens and transaction fees generated in the pool.

Additionally, yield farming helps increase liquidity in the cryptocurrency market, which in turn benefits traders and participants in this field.

The Rise of Yield Farming in 2020:

In 2020, the concept of yield farming peaked with the launch of the COMP token on the Compound platform. This token was awarded to users as a reward for depositing their assets on the platform. The release of COMP led to a sudden increase in the volume of assets deposited in Compound, making it the largest DeFi project.

Although yield farming was not a new concept, governance tokens like COMP attracted widespread attention to this method of earning profits in the decentralized finance (DeFi) sector. These tokens not only provided users with profits but also gave them voting rights on the platform’s governance.

The success of COMP prompted other DeFi platforms to also reward users with their own tokens, leading to a significant growth in yield farming in 2020.

How Yield Farming Works:

DApps (decentralized applications) attract individuals' cryptocurrency assets by offering rewards for deposits. When someone decides to deposit, they send their cryptocurrency assets to a smart contract. This smart contract holds the assets and tracks the rewards earned. As a receipt, the smart contract issues a token to the depositor. This token allows the depositor to claim any outstanding rewards and withdraw their cryptocurrency assets from the smart contract.

Steps of Yield Farming:

Creating a Liquidity Pool: Yield farming starts with the creation of a liquidity pool. This pool is tied to a smart contract that facilitates all the investments and borrowings for that particular yield farm.

Depositing Assets by Investors: Investors can connect their digital wallets to deposit cryptocurrencies into the liquidity pool. This process, sometimes called "staking," is similar to depositing in a bank or investing in mutual funds or ETFs.

Lending Enabled by the Smart Contract: The smart contract can facilitate several processes, including adding liquidity to cryptocurrency exchange markets or lending to others.  

Reward Payments: The rewards, which may include interest, bonuses, and other benefits, vary depending on the type of yield farming. These rewards may be paid out at regular intervals or at a specific future date.

Positive and Negative Features of Yield Farming

Yield farming is recognized as one of the key strategies in the world of DeFi (Decentralized Finance). In this method, users lend their cryptocurrency assets to liquidity pools and, in return, receive rewards in the form of additional tokens. This method has various positive and negative features, which are detailed below:

Positive Features:

High Income Potential: Yield farming can offer higher returns compared to other investment methods. Users can earn significant income by depositing their assets into liquidity pools and receiving additional tokens.

Transparency and Independence from Intermediaries: In the yield farming system, all transactions and contracts are executed on the blockchain, ensuring high transparency and security. No intermediaries are involved in this process, and all operations are conducted directly between users.

Increased Liquidity in the Market: Yield farming helps increase liquidity in DeFi markets, which can lead to improved overall market performance.

Encouragement of Innovation: By offering attractive rewards, yield farming encourages innovation and the development of new projects in the DeFi space.

Negative Features:

Security Risks: Yield farming faces security risks such as hacking and vulnerabilities in smart contracts. These risks can lead to the loss of assets.

Market Volatility: The value of the tokens received as rewards can be highly volatile, and sudden market changes can reduce the value of assets.

Complexity and Need for Specialized Knowledge: Yield farming requires a high level of knowledge and experience. Without sufficient information, users may face unexpected risks.

Possibility of Fraud: Given the novelty of this field, some projects can be fraudulent and trap users.

Types of Yield Farming:

Lending Protocol:

Lending cryptocurrency assets to borrowers through smart contract applications is possible. Lenders receive interest rates as rewards for this action.

Borrowed Assets:

Investors can choose to use a type of token as collateral for borrowing. This allows investors to retain their initial collateral and increase its value while also benefiting from the yield on the borrowed tokens.

Liquidity Providers:

Users place their assets in liquidity pools and earn yields from transaction fees. On DeFi platforms, users can also expect to receive transaction fees and yield farming rewards.

Staking:

Primarily done on Proof of Stake (POS) blockchains, where users are incentivized to place their cryptocurrency on the blockchain to secure the network, earning rewards in return.

Conclusion

Yield farming has quickly gained popularity in the DeFi space, attracting considerable attention from users. This attractive concept is expected to draw more people to Ethereum and BSC networks in the coming years. However, to profit from the high yields of yield farming, it is essential to have sufficient knowledge and experience in working with DeFi platforms.