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Yield farming is a way of maximizing the return on capital by switching between several DeFi or Decentralized Finance Protocols. The most profitable yield farming strategy involves the movement of funds between the most popular DeFi protocols like Balancer, Uniswap, Curve, and Compound. The reason for these movements across protocols is simply to make the most profit for providing liquidity or market making in each of these protocols. Market making is how centralized exchanges arrive and the buying and selling price without having too much effect on the price of the asset in question. In AMMs the constant product market function, X*Y=K is used to establish the new price of the asset in the market automatically. Most DeFi protocols pay users for adding liquidity which established the price of one currency against another and facilitates trading and exchange of several cryptocurrencies. Uniswap, for example, pays 0.30% of all fees to liquidity providers to cover for impermanent loss while curve rewards LP providers with their native LP tokens. Lending platforms like Aaave and Compound pay users for staking their idle cryptocurrency which is borrowed to other market participants like traders who need funds to profit from short-term market fluctuations. Some DeFi projects also pay additional tokens known as LP tokens or governance tokens to encourage users to stake their assets for rewards on their platform.
The exact correlation of these instances with earning interest from staking cryptocurrencies may not be obvious, but a simple X*Y=K or an interest paid on crypto loans can only work if such project is working properly internally and has no issues with authorities that would discourage investors from staking their cryptocurrencies in such projects. Liquidity mining, for example, will involve the creation of governance tokens like COMP or BAL and determining how these tokens will allow holders to participate in future decision-making on the issuing platform. There may also be a need to consider how to avoid a situation in which a whale gains inordinate control and through an unfair share in future decision-making.
To give you a better insight into yield farming and yield farming development we will explain liquidity and liquidity pools.
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Liquidity can be any cryptocurrency you own, although most liquidity pools request specific cryptocurrencies to be deposited for rewards. Idle assets in traditional banking systems usually earn users about nothing with some fixed deposit accounts earning about less than 1 percent annually. These assets locked in the traditional financial system are liquidity because they represent positions that can be easily converted to cash in economic terms. Liquidity pools are used in automated market-making systems common in most decentralized exchanges. These pools are used to determine the price of assets traded on these exchanges since there is no order book like in centralized exchanges. In liquidity pools, a constant product market maker is used to calculate the new price of access after each transaction. The constant products market-maker functions to ensure that a certain ratio of both assets in the pool must be present thus ensuring that the value of the pool remains constant. For each transaction, the buyer is actually taking one asset and adding the same value of another asset to the liquidity pool. So someone who buys ETH from an ETH/DAI pool must pay a certain amount of DAI to get the required quantity of ETH. Mathematically, after such a transaction, the new price of ETH in an ETH/DAI pool of 500 DAI worth a stable coin pegged to the dollar, and 5 ETH worth $100 each becomes (5-1)*(500+X) = 2,500 or $125 after removing $500 from $625. The new price arrived after buying one ETH from the pool with the DAI stable coin. The foregoing can be a bit confusing if you don’t particularly like numbers but you should have an idea that liquidity pools are necessary to enable decentralized exchanges to perform their function of exchanging one coin for another.
Since DeFi is highly competitive, DeFi protocols have been on their heels in search of the best way to attract more investors and steal the day. Compound was the first protocol to offer rewards in form of governance tokens. COMP tokens allow investors or crypto yield farmers on the COMP protocol to participate in future network decision-making aside from earning a fixed amount of interest. Balancer followed suit with the BAL tokens which serve nearly the same purpose as COMP does for investors. They are now a significant number of DeFi projects that offer liquidity mining rewards and the number will only go higher owing to the success recorded in some of the previous projects mentioned here. Again, crypto yield farmers are motivated by the possibility of earning these high returns and millions of crypto yield farming investments have been made simply because of the prospects of these rewards.
Liquidity providers are the investors of DeFi yield farming. They are motivated by the unfairness of traditional finance, coupled with the innovations in DeFi. Being a liquidity provider means that you have locked up to your funds and you function as a market maker which was described earlier. Your funds will be used by the protocol for lending and market-making while a fixed relative interest will be paid to your wallet in form of LP rewards which can include the interest earned and the native governance reward tokens.
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Unlike centralized traditional financial platforms that offer no reward for users who provide the funds they use for their transactions and money-making activities, DeFi yield farming offers lots of rewards to users. Another important factor is the reliance on traditional finance on a central authority. These authorities have acted in their own interest most of the time and there have been cases of breaches of individual information available on this system. This personally identifiable information (PII) is not necessary to participate in DeFi yield farming. Aside from having no barrier to entry, people can understand what to expect from each protocol and no individuals behind closed doors can come up with a sudden decision that will affect everyone even before they are fully aware of such developments. The following are more concrete reasons why DeFi yield farming of cryptocurrencies has more advantages than traditional finance.
Smart contracts cannot be altered after they are deployed, and these smart contracts are the rules that guide most DeFi yield farming projects. Information stored on the blockchain is therefore error-proof and free from human manipulation which is possible in centralized finance.
Smart contracts are written lined of codes that execute as long as certain conditions are fulfilled. A simple smart contract may simply say pay reward A for every instance of a deposit, B. The self-executing nature of these contracts saves users a lot of stress and complicated processes present in traditional finance.
An NPM package that gives application binary interface, ABI, along with solidity interfaces makes DeFi projects easy for developers to deploy, interact with and work with existing data to build even better projects. Money legos have become a buzzword to mark how developers can stack DeFi projects by building on as well as integrating features of existing protocols.
Everyone sees everyone else’s transactions on the blockchain. Codes are also accessible to everyone so even skilled developers can study a project to understand how it works before investing. There is also no such thing as an arbitrary project or invisible set of rules for future actions. The transparent nature of DeFi projects ensures trust and recently communities across DeFi have worked together to identify malicious attackers and take certain actions to stop further attacks or force the attacker to act otherwise.
The only tool required to participate in DeFi projects is an ERC20 cryptocurrency wallet that allows you to store your funds while interacting safely with the platform. DeFi is literally accessible to everyone and they can reap the rewards present in DeFi. Crypto yield farming is also devoid of such long KYC practices which are common in centralized finance.
To start earning from DeFi, the only thing needed is your wallet. No one would require you to send your funds to an address to participate in a DeFi project. You basically retain ownership of your funds while earning the unlimited rewards of DeFi.
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Most DeFi projects have a unique way of allocating value which is often defined clearly, and visible to everyone. While some projects allow staking or locking of funds that are used for lending and other interest-yielding operations, others focus on AMMs and liquidity pools. Curve protocol uses the same AMM function with a low slippage curve that allows users to earn a lot more for their stable coins. Curve basically ensures low slippage between the different flavors of the same crypto assets or different assets that are meant to have the same value. Users providing liquidity in several stable coins can earn as much as 50% APY of staking their assets on Curve. Users can also earn veCRV, the governance token for curve, by locking a specific amount of Curve tokens for a set period of time. Although users can always earn protocol fees for staking their tokens. Uniswap offers similar rewards for staking all kinds of cryptocurrency tokens in the available pools on the Uniswap protocol.
While the AMM function is used by most decentralized exchanges DeFi lending protocols create a money market for liquidity providers to supply tokens and earned the supplied tokens plus a percentage of interest. The interest is distributed to the liquidity providers according to their current supply APY. These protocols send the supplied funds to a smart contract that makes these funds available for others to borrow. The supply tokens plus interest are returned to LP providers for these lending pools in the form of new tokens known as ctokens and atokens in the Curve and Aaave protocols and can be redeemed for the underlying tokens when the users so desire. Borrowers of cryptocurrency funds usually borrow because they do not want to sell their underlying assets but they sometimes want to avoid paying capital gain taxes on those tokens or simply need to settle some urgent expenses. Some traders, however, borrow funds to increased leveraged positions. The amount that can be borrowed in DeFi lending protocols depends on a collateral factor which is determined by the supply of specific tokens in the pool. Ideally, the value of borrowed amount must be less than the value of the collateral multiplied by the collateral factor. Collaterals in DeFi lending are always higher than the borrowed amount and if the value of the collateral amount falls below the required level, the user collateral will be liquidated. The borrow APY in DeFi lending is higher than the supply APY since the interest paid by borrowers is used to pay lenders. Interest in DeFi lending is calculated per Ethereum block which is how Compound arrives at a variable APY. Although lending protocols like Aaave offer stable APYs and flash loans where users can borrow funds without collateral for a short time in the same transaction.
The simple way DeFi works is that liquidity providers add funds to liquidity pools because they are interested in earning the rewards for those pools in swap-based protocols. The same happens in lending protocols where liquidity providers supply tokens in anticipation of the interests the protocol offers in return. Borrowers from DeFi lending protocols pay interest for borrowing supplied funds, which is used to pay supply providers while traders in swap-based protocols pay trading fees which are then used by the protocol to pay liquidity providers. Additionally, some protocols reward supply token providers and liquidity providers with extra tokens through liquidity mining. The supply and allocation of these tokens can either be determined by the community or fixed fairly in the smart contracts. Newer developments in Uniswap V3 allow users to provide concentrated liquidity and earn several times more efficient LP rewards for lower risks and staked capital. The diagram below shows the workings of DeFi yield farming protocols.
Although uncommon in DeFi, centralized financial institutions often cash in on the wrong interpretation of the differences between APY and APR. In DeFi, however, it is important to consider the overall value locked or TVL to ascertain the rewards distributed as LP tokens and actual interests or rewards earned on the amount provided. Like in centralized financial institutions, you will find APY/APR listed on most DeFi platforms which should inform users about the possible returns on their investment.
APR does not include the compound interest which is the amount earned on the principal capital added to the capital as an investment for subsequent months. The formula for calculating APR is simply the total profit multiplied by the number of periods the rewards were received. The actual mathematical value is given by periodic rates x number of periods in a year.
APY on the other hand is the total rewards for each period compounded by adding that reward to the subsequent capital to increase the reward value throughout the span of the investment. The formula for APY is (1+periodic rate )number of periods-1 this calculation gives the exact amount including a compounded interest on the original investment.
It is also important to note that yield farming is a profit-oriented endeavor so yield farmers can earn way more than anyone can imagine depending on the sophistication of their yield farming strategies. They do this by investing in the most profitable pools daily.
Yield farmers earn their returns in three ways: from trading fees paid by traders who swap tokens in decentralized exchanges, from liquidity mining as rewards from the native staking protocol, and from a compounding of their initial investment. We have explained liquidity mining in other parts of this article, so we shall talk a bit about trading fees and compounding.
Uniswap and other DeFi protocols charge trading fees which they in turn use to reward liquidity providers. Uniswap provides trading fees for all transactions is 0.30%. Curve charges a 0.04% fee, while PancakeSwap, a fork of Uniswap charges 0.20 in fees. Compounding in crypto yield farming comes from the APY mentioned earlier. Traders can also get compounded rewards by doing it manually. Take the example of a trader who invests in several DeFi protocols and adds the return on the previous investment to every new investment.
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Uniswap was the first decentralized DeFi protocol that allows users to exchange tokens on Ethereum without giving anyone access to their funds. Uniswap popularized the automated market-making function, X*Y=K, allowing liquidity providers to earn trading fees as liquidity rewards. Liquidity providers on Uniswap are the enablers of trading pairs on the Uniswap protocol. Current improvements of Uniswap such as the Uniswap V3 will allow concentrated liquidity and adjustable rewards based on investor risk tolerance.
Balancer is an automated market maker running on the Ethereum network. It uses an n-dimensional automated market maker, which allows anyone to create and add liquidity to customizable pools and earn trading fees for providing such liquidity. An n-dimensional pool allows users to build a pool consisting of several combinations of different assets. The balancer algorithm works to maintain a stable ratio of funds in the pool.
Yearn Finance became popular in crypto lately as a decentralized yield farming aggregator. Yearn finance uses a yVault that stores funds and constantly put these funds into the most profitable liquidity pool based on an algorithmic calculation. That way, there are limitless rewards for users, and yield farming can be automated since the farmer has a better advantage than looking out for profitable pools manually.
Curve is the decentralized DeFi protocol for stable assets with prices that are not supposed to be largely different. Using the platform’s AMM, Curve Finance allows users to exchange these stable assets even if the other part of the trade is unavailable. Users of this DeFi platform can earn trading fees, and some curve pools allow users to earn from other platforms that have pools in the curve ecosystem. Curve Finance has a remarkable slippage of 0.06% and has some of the best stable coin pools available.
Is the first cryptocurrency to allow users to earn loans which are protected by the value of deposited assets on the platform. Maker DAO issues a stable coin called DAI which is bowwowed to users who deposit ETH to the Maker platform. The platforms required overcollaterization of the deposited assets to prevent loss of funds dure to volatility of the collateral assets. The collateral ration of the Maker platform is about 150%. Maker uses the opening, closing, and liquidation of collateralized debt positions as a mechanism to keep the DAI stablecoin stable at $1.
Synthetic protocol users can issue synthetic assets backed by real assets on the Ethereum blockchain. These assets can be valuebles like precious metals or other cryptocurrencies, and fiat currencies.
Aaave is one of the most popular lending protocol in DeFi and was launched in 2018. Aaave users can become depositors for borrowers on the platform who can receive the sum of money they need for immediate use. Borrowers in turn pay interest on the amount they borrow which is then paid to users. Depositors provide liquidity to the Aaave protocol which offers stable borrow rates and depositors receive a tokens which represent the value of their deposited amount. Borrowers can also stake the borrowed tokens for rewards. Aaave also allows the flash loans, loans borrowed and repaid in the same transaction.
Compound finance allows you to take loans on collateralized assets. It also allows depositors to deposit their funds and receive ctokens which are the governance tokens of the Compound platform. The project runds on the Ethereum blockchain, and distributes rewards to users for using their platform.
The complexities of a new areas in technology like blockchain and DeFi are better managed by experts who are good at whatever programming languages such a project wold require. At Rejolut we have a track record of success in deploying the blockchain and DeFi yield farming projects of the future. Our clients includes established and existing protocols for which we have deployed over 100,000 lines of code. Our services are trusted by the best in the industry, and we have a reputation to maintain. We save time by planning projects properly and work hard and smarter to implement lasting solutions and innovations in DeFi yield farming.
Liquidity pools, however, offer the possibility of loss being impermanent in extreme price swings. … Despite the risks, it’s important to keep in mind that liquidity is usually profitable even with temporary losses that is compensated by the reward pool received, based on the volume of trading.
Decentralized money, or DeFi, is closely related to Bitcoin (CRYPTO: BTC) and other cryptocurrencies, but not exactly the same.
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