An Introductory Guide to Yield Farming
Yield farming is the act of lending cryptocurrencies, usually to decentralized exchanges, to fund liquidity needs. Exchanges need liquidity for various purposes, but generally it’s to have enough cryptocurrency on hand to meet buying and selling demands from users.
Buying and selling demand often comes from new cryptocurrencies, which are listed on exchanges. When people buy these new cryptocurrencies, the exchange grows its token supply; for instance, when people buy a new cryptocurrency using Ether or Bitcoin, the decentralized exchange takes in some fees in Ether or Bitcoin, and the rest goes to the seller. However, when people sell a new cryptocurrency, there may be a deficit, meaning the exchange may not have enough Ether or Bitcoin (or other cryptocurrency) to buy all of the new cryptocurrency back from users. To fill this need, the exchange allows sellers of new cryptocurrencies to borrow more popular cryptocurrencies, like Ether and Bitcoin, and pay interest, to create liquidity. Part of this interest is paid to lenders. When users lend cryptocurrencies for interest payments in this way, they’re yield farming.
Where does the money to pay interest come from?
When issuers of a new cryptocurrency borrow tokens, they must meet the borrowing requirements of the exchange. This might involve a commitment of collateral, usually consisting of other, more established cryptocurrencies; meaning a borrower might offer 1000 Bitcoin in order to borrow 700 Bitcoin from the exchange, so they can create liquidity for their new cryptocurrency. (We know this doesn’t make much sense on its face, but read on for more.)
Why would an issuer do this? Generally because they expect their new cryptocurrency to rise in value. This means the issuer can make money selling their new cryptocurrency and have enough funds to readily pay back their Bitcoin loan without having to sell any of their collateralized Bitcoin.
Do you need to create a new cryptocurrency to borrow cryptocurrency?
Sometimes users borrow cryptocurrencies on one platform so they can lend them on another, in an attempt to arbitrage differences in yield. This is also a type of yield farming. For instance, if Platform X is lending Bitcoin at 5%, and Platform Y is borrowing Bitcoin at 6%, a user may choose to borrow Bitcoin at Platform X and then immediately lend it to Platform Y to make the 1% difference.
(An important takeaway here is that the cryptocurrency market is inefficient and often creates opportunities like the example described above. Additionally, the market allows for significant creativity and innovation from users; it may be possible to yield farm in many ways not yet known.)
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