DeFi promises to eliminate the need for banks almost entirely. Known as yield farmers, holders of a cryptocurrency can earn yields by serving the same role that banks traditionally did. Here’s how it works.

Yield Farming Basics

Anyone can yield farm, and it can be a productive means to generate income.

Instead of just waiting for prices to increase, yield farmers earn yields by putting coins or tokens to work in DeFi apps (dApps). Farmers typically utilize decentralized exchanges (DEXs) to lend, borrow, or stake coins to earn interest.

Types of Yield Farming

Liquidity providers deposit their coins into a liquidity pool through a DEX. The liquidity pools are used to swap and exchange cryptocurrencies. For example, there could be an Ethereum/Chainlink pool. The DEX charges a fee for other users wanting to swap these two. Liquidity providers are compensated when others swap their coins. Liquidity providers do not lose their original deposit and earn passive income through the fees.

Lending is typically reserved for banks in traditional finance, but in DeFi anyone can become a lender. Holders can also lend their coins or tokens to borrowers and earn interest. Smart contracts are used between the lender and borrower to establish the duration of the loan, the interest to be paid, and the collateral required.

Surprisingly, borrowing can also generate income. Yield farmers can place one coin or token as collateral on the loan and then use the borrowed money for other purposes like providing liquidity, lending to someone else, or staking. This type of yield farming is most successful when the collateral increases in price and the borrowed cryptocurrency generates income as well. This can be risky and it is not advised for beginners.

Staking is one of the most effective forms of yield farming. It is low risk and offers consistent returns. Holders of cryptocurrencies that use a proof of stake consensus mechanism can offer up their coins or tokens to be locked for a certain amount of time. When they are selected as the validator of the next block in the blockchain, they earn a reward. Joining a staking pool is a simple way to start getting in on the action.

Yield Farming Platforms

Curve is the primary DEX for trading stablecoins. As one of the largest DeFi platforms, it has nearly $16 billion dollars in its ecosystem. In order to trade stablecoins, Curve runs on liquidity pools. Because stablecoins are meant to keep their same price, stablecoin yield farming is generally a little less risky. This makes Curve one of the favorites for liquidity providers looking to minimize speculation.

Aave is similar to a traditional bank. it is the main platform for all lending and borrowing in DeFi. Lenders can earn interest and borrowers can not only use their borrowed money but can also leverage their collateral to earn more money. Again, this is very risky.

Uniswap is the most widely used token exchange. It is a DEX built on Ethereum’s blockchain. A large proportion of tokens are built on top of Ethereum’s network because of the smart contracts it uses. As a result, Uniswap has become favored by yield farmers looking to earn profits by providing liquidity for all kinds of tokens. Every time a swap occurs, a yield farmer can make some income.

RELATED: What Is a DEX? Decentralized Exchanges Explained

A Final Word of Caution

There are some risks with yield farming. Volatility is one of the downfalls of cryptocurrencies. If the price of a coin or token plummets while engaged in yield farming, then losses can be catastrophic. Yield farming with stablecoins can help mitigate some of this risk. If engaging in yield farming, do your research. Try to start small.

DeFi aims to eliminate the need for banks. The goal is for smart contracts to ensure that both borrowers and lenders hold up their end of the bargain. If done right, yield farming can be profitable. There are ways to minimize risks like yield farming with stablecoins. Before taking any action, research thoroughly to help avoid major losses.