Decentralised finance has gained massive adoption within the blockchain and cryptocurrency community. The total funds locked in DeFi has scaled from just $1 billion in early June 2020 to almost $8.4 billion in less than four months. The hype is such that many compare it to the buzz around initial coin offerings in 2017.
However, unlike most ICOs that did not have a valuable product to back them up and went bust in a short time, the DeFi projects have added immense value to their users. Most DeFi projects are lending and borrowing protocols that allow instant loans and better interest rates compared to traditional financial institutions. But contrary to traditional banks, DeFi lending and borrowing protocols do not rely on an intermediary to sanction loans.
Users on these DeFi platforms perform yield farming to provide loan funds in a decentralized way to the borrowers on the platform. The yield farmers also move their funds from one pool to the other to get the best interest rates.
But how does yield farming work?
DeFi lending platforms allow cryptocurrency holders to allocate their funds to liquidity pools — common pools where people lock their digital assets. Users often have the option to lock their funds in a variety of pools, each having a different cryptocurrency and offering different interest rates.
People willing to take instant loans on the DeFi platform can opt to do so from any of the pools that provides the best interest rates and has the cryptocurrency they prefer. There is no limit on the amount a borrower can borrow as long as they can afford to stake the collateral required for it. And when they attain the loan, the lenders of the pool earn interest on the funds they allocated to the pool.
The whole process of adding or moving crypto funds to liquidity pools in return for the highest possible interest is called yield farming or liquidity mining. And the lenders who add liquidity to the pool through this process are called yield farmers.
It is similar to how banks use their customers’ funds to provide loans. They lend to borrowers at an interest rate that is higher than the interest they pay to their account holders. The difference with DeFi protocols is that they are decentralised and people can choose to withdraw from a pool at any time.
One of the major benefits of yield farming is that it is one of the best alternatives to storing funds in savings accounts. Yield farmers can earn considerably higher interest through yield farming than they would through traditional banks. Holders whose funds are sitting idle can also lock their funds in DeFi protocols to earn more cryptocurrencies, making it a great source of passive income.
The DeFi space is still heading through its experimental phase. There are many new projects deployed only for the sake of experiment. And the most critical risk with such projects is the software code itself. The slightest of errors in the software code can lead to hacks or manipulation of the protocol and lead to losses for everyone. The resilience of the code against such attacks depends solely on the person who wrote the code.
So, is yield farming here to stay?
Yield farming has brought tremendous benefits for lenders and borrowers alike. It has completely turned the tide of the traditional lending system. In place of having to wait for days to get loans from banks, people can now do so in minutes without even having to share any personal details.
The only challenge that lies ahead of yield farming and DeFi projects is to make the whole ecosystem more secure against attacks and manipulation. If we can surmount that and ensure better safety, DeFi has a huge potential to go mainstream.