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If you own some cryptocurrency sitting in your crypto wallets and want to earn some more without dumping them, you are in the right place. First, there are some notions you need to get a grasp on. Let’s start!
In general terms, yield farming refers to making cryptocurrency assets generate returns while maximizing gains. Traditional saving accounts generally benefit from around 0.1% APY rates, while yield farming can generate up to 100% or even more returns. Yield farmers benefit from compound interest by depositing their crypto assets into pools and farms that offer the best APY rates. In order to lower their risks, yield farmers move their assets to the more beneficial pools and farms from time to time since the APY rates don’t stay the same for a long time. Liquidity mining like this is the most common way to farm.
If a strategy doesn’t grant optimal returns anymore, yield farmers can move between protocols. Yield farmers often resort to other farming strategies, such as using borrowed money to increase their potential earnings from an investment, thus gaining even more than the amount they have borrowed. Sometimes, they even participate in pools with very high risks and annual percentage rates (APR), taking advantage of the system's shortcomings.
APY is the abbreviation of annual percentage yield. It is the gains you will get from your investment through compound interest. The gains are mainly funded by the fees that people pay when they swap or exchange a token on the platform. APR is calculated regularly and can swing either way. If you are thinking of putting your cryptocurrencies in a pool or a farm, you should be watching both the daily APR and the total APR in order to maximize your APY earnings.
Liquidity pools are separate pots that are dedicated to cryptocurrencies. Basically, you and other people can provide an equal value of two tokens to a pool in order to receive LP tokens. These tokens are minted for you when you add your funds to the pool and are burned when you remove them. LP tokens are always equal to your share of the pool; they represent your stake. Farming happens when you take your LP tokens and stake them on a farm. The farm locks your LP tokens via a smart contract in order to generate gains. By staking your LP tokens on a farm, you are basically trusting the farm with your cryptocurrency. If you would like to try out these steps firsthand, you can check out Spintop's staking pools and farms. Since you need to create LP tokens in order to participate in farms, Spindex will redirect you to PancakeSwap where you can combine the token of your choice and your SPIN tokens.
For everyone involved, yield farming can pose a considerable amount of financial risk due to the difficulty and complexity of the process. You need to be constantly watching and paying attention to the cryptocurrencies and LP tokens you possess, and check out the rates of pools and farms all the time. Since you will be moving around your tokens a lot, you are often vulnerable to losing a lot of money on gas fees, especially on the Ethereum network.
Most importantly, yield farming has potential flaws that are unavoidable in making farms vulnerable to fraud and hackers. Because of the nature of blockchain, losses are irreversible and permanent. Since you are trusting projects and smart contracts with your money, there is always a chance for a project to withdraw all the liquidity and perform a rug pull, or a risk for hackers to invade and suck all the liquidity out of the pool. There is also a thing called "impermanent loss" that happens after you have already deposited your cryptocurrency in a liquidity pool, which may result in, well, a loss.
An impermanent loss is the amount you lose when you have already deposited your assets into a pool but the value of the assets has changed. The more significant the change, the greater the risk becomes for this temporary loss. If you withdraw your tokens after the shift in price, you will have less than you had at the time of your deposit. Generally, stablecoins are much less exposed to impermanent loss since they maintain their value within a certain range.
Let’s say you are depositing $10.000 of Ethereum and $10.000 of a stable coin into a liquidity pool. If Ethereum's price goes up after you have deposited your tokens, other people can buy Ethereum from your share and from the price you have deposited, and sell it to other decentralized exchanges for profits since its price has gone up. Your Ethereum would be worth more if you hadn’t deposited your Ethereum and held it in the first place.
So basically, if one of the tokens that the liquidity provider deposited goes up in price, they will lose money because they didn’t hold on to those tokens. The provider will lose their money rapidly if one of the tokens' prices goes up and the other’s price goes down. The liquidity provider could profit from depositing their tokens if only the price of both tokens went up. The tokens’ values must stay equal in order to not experience impermanent loss.