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Understanding DeFi Yield Farming

The Ethereum blockchain has enabled developers to replicate most financial instruments in a decentralized format. In other words, we can now bank without a bank involved. This emerging sector of the digital assets space has come to be known as Decentralized Finance or DeFi. 

Here’s how investors seeking passive income are using DeFi tools to farm for yield.

What is yield farming?

Put simply, yield farming is like private credit to startups. Traditionally, investors offer startups and consumers private credit in exchange for an above-average interest rate. Yield farming is the same, but the investors are offering digital assets to crypto startups who pay interest in digital tokens. 

One of the first platforms to pioneer this was Compound. The crypto startup offers developers “open financial applications.” To fuel these financial applications, the platform needed liquidity. The team solved this by offering users COMP tokens for locking their crypto assets on the platform. 

Since then, several other crypto platforms and decentralized exchanges have launched similar programs. A niche marketplace for generating market-beating passive income has emerged. The industry is now worth an estimated $92 billion and is rapidly expanding. 

Understanding DeFi Yield Farming
Source: Glassnode

This growth in popularity implies that at least some investors are achieving their primary objective: better-than-average passive income. 

How high are the yields?

The effective yield an investor can achieve depends on a number of factors, including the digital asset being lent, the platform used, and the market cycle. 

However, Bitcoin serves as a useful benchmark. The world’s most popular cryptocurrency can currently be loaned out at an annual rate of 4% on BlockFi. The yield can go as high as 6.2% on Celcius, according to data published by DeFiRate

By comparison, Ethereum is a lot more liquid. It’s also far more compatible with multiple DeFi platforms since it is the base layer technology for most of these platforms anyway. That’s why ETH can attract yields as low as 0% on some of the most popular platforms like AAVE

However, stablecoins are probably the most interesting assets to lend on these platforms. That’s because stablecoins are effectively pegged to the value of fiat currencies. In most cases, the most popular stablecoins are pegged to the value of the U.S. dollar. 

Yet, these assets can attract yields much higher than a U.S. dollar savings account. USDC, for instance, can attract annual yields as high as 9% on platforms like Lend. The ultra-low volatility of stablecoins coupled with such high yields is one of the primary reasons DeFi tools have become so popular. 

Bottom line

Ethereum’s ability to decentralize finance comes at a time when traditional fixed return opportunities are rare. As yields remain elevated, DeFi tools could continue to attract investor capital. This sector has plenty of room to grow. 

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