Understanding Yield Farming in Cryptocurrency
In the past couple of years, the most significant evolution in the world of cryptocurrencies has been the emergence and focus on decentralized finance, also known as DeFi. Let's explore this concept more comprehensively:
DeFi pertains to a network of decentralized applications built atop blockchain networks (predominantly Ethereum) and operating autonomously without any central governing authority.
These DeFi projects utilize open-source software to offer users a comprehensive array of financial services and products that mirror traditional offerings.
In essence, DeFi encompasses financial services that are powered by smart contracts operating on programmable blockchains.
A prevalent practice within this realm is yield farming. Yield farming is an investment tactic where users, also known as liquidity providers, temporarily supply liquidity to DeFi projects in return for tokens. Despite being a potentially lucrative strategy, it carries a fair degree of risk, which we will discuss shortly.
But how does yield farming function? Yield farming involves earning tokens as rewards for supplying liquidity to a project by depositing a specific pair of tokens into a pool. Nowadays, more intricate pools composed of multiple pairs exist.
Liquidity pools act as repositories for tokens that facilitate the trading of specific currency pairs by acquiring liquidity from users. In return, these users receive compensation from the project proportionate to their stake.
In the cryptocurrency world, a decentralized exchange (DEX) is a platform that places buy or sell orders for cryptocurrencies, while liquidity pools function as smart contracts within these exchanges. A smart contract allocates a pre-defined quantity of tokens to farmers based on their investment stake. Having deciphered how this works with crypto markets, it's now simpler to draw a parallel with Non-Fungible Tokens (NFTs).