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Yield farming is the staking or lending of crypto assets in order to generate returns or rewards in the form of more cryptocurrency.
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The DeFi world is rapidly expanding, and as the global financial system continues its transformation towards digitalization, DeFi has very large growth potential, attracting the attention of over 3 million investors worldwide. Hence, it is essential to understand the assets, markets, investment approaches, etc.
We have covered the basics of DeFi in the previous article. In this one we will dive into:
Referring to investment types in cryptocurrencies, they can be divided into fiat and token-based.
Token-based (or Yield Farming)
We will further our discussion in Yield Farming by introducing the 3 Major DeFi investment categories, which are: AMM DEX, Lending, and Yield Aggregator.
Uniswap is built on Ethereum as the decentralized exchange and supports all cryptocurrencies on this network. Unlike traditional orderbook exchanges, it uses an AMM (Automated Market Maker) algorithm to allow users to exchange various ERC-20 tokens with higher efficiency.
In Uniswap’s AMM model, a liquidity provider (abbreviated as LP) is required to create a pool of liquidity for traders to swap the required tokens.
There are 2 scenarios included.
Suppose 1 ETH is equal to 2220 DAI, and trader Alex wants to swap his DAI for ETH. He needs to pay 2220 DAI plus a trading fee (for easy understanding, all scenarios in this article ignore gas fee) to get 1 ETH.
Endy as LP needs to provide a pair of two tokens (e.g. DAI+ETH) to the liquidity pool with equal value. In return, he will receive a partition of the trading fees from the trading activities. Also, he will receive an LP token, which is the credential for providing liquidity and represents his share of the overall liquidity pool.
How does it realize the automatic pricing? This brings us to the “constant product market maker” model behind Uniswap’s AMM mechanism. The formula for this model is: x*y=k, where x and y represent the liquidity of each, k is a constant.
It is worth noting that the model does not vary linearly. In fact, the larger the relative amount of the order, the larger the magnitude of the imbalance between x and y. That is, the price of a large order increases exponentially compared to a small order, leading to an increasing sliding spread.
In the process of providing liquidity, LPs need to be aware of impermanent losses.
Assuming Endy holds 2000 DAI and 1 ETH (1 ETH= 2000 DAI), he has 2 options.
Option 1: as liquidity provider (LP)
Option 2: just hold them
Under the same conditions, “Option 1 provides liquidity” is 343 DAI less than “Option 2 just holds”, or a 5.72% drawdown. This loss is called Impermanent Loss. When ETH recovers 2000 DAI, this impermanent loss will disappear.
In DeFi’s lending platform, an investor provides a crypto asset in the pool to earn interest; if this deposit is collateralized, the investor is able to borrow another crypto asset. Currently, DeFi’s lending platform typically uses “over-collateralization”, where the borrower provides assets worth more than the actual loan in case of default.
Nowadays, DeFi projects are popping up all over the place. Investors might face the following problems:
DeFi’s Yield Aggregators can somehow solve the above troubles, where the value of a specific asset provides a complex investment strategy that combines lending, pledging, and trading to maximize profits.
Take the ETH Vault as an example.
The diversity of investment opportunities and the continuing growth make DeFi an attractive and lucrative investment. However, as with any investment, there are risks associated with a DeFi investment.
Investors must do their own research (DYOR) before investing, start with the following 6 aspects:
1. Basic questions to ask：
2. Fundraising history with famous inventors
3. Project introduction: Official website + public articles + GitHub
4. Attention to the price trend
5. Attention to extremely high APY
6. Activities of the community
DeFi offers a more convenient place for investors to choose as an alternative to traditional investments. With more and more investors, institutions, capital, and developers coming in, a more open, transparent, and safer financial system is expected.
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