Nothing screams ‘scam‘ like the promise of unrealistic returns.

However, in the world of cryptocurrency, you have to redefine the term ‘unrealistic’ because interest rates of up to 100 per cent are quite usual and even boring.

Welcome to the world of yield farming.

There are two main categories of yield farming – ‘staking’ and ‘liquidity mining’.

Staking

How it works: You deposit your tokens to an exchange and get paid interest represented by an APY or APR percentage.

APY includes compounding interest and APR is the base interest rate per annum.

Some exchanges have an ‘auto staking’ feature, which collects your interest and compounds it automatically on your behalf.

One example of this is the CAKE token of the Pancakeswap exchange which is offering 106.09 per cent APY at the time of writing. This takes into account interest being compounded 288 times a day automatically. Mind blown? Read on.

These returns sound like scams to the traditional investor until you understand how the interest is generated.

New methods to generate yield are constantly popping up but we will focus on the most popular two.

Inflationary farming

Not all cryptocurrencies are deflationary, with many yield farming tokens being printed out of thin air in order to pay interest.

When you create a token out of nothing it’s easy to pay high interest rates, but farmers must be aware that inflating a cryptocurrency can have the same effect on its value as inflating normal currency.

To combat inflation many of these tokens have a ‘buy back and burn’ system where fees generated by the exchange are used intermittently to buy tokens from the market and ‘burn’ them out of existence.
In theory, this offsets the effect of inflation.

Deflationary farming

This was pioneered by cVault.Finance and their CORE token.

The tokens paid to investors are generated from fees charged on all transactions. When buying or selling these tokens, the user usually pays a slightly higher fee and that fee is then used to buy the token from the market and pay it out to investors.

This method usually pays less, but the investor may be more inclined to stake because the token is not susceptible to the effects of inflation.

What’s more, the constant buying of the token from the market puts sustained upwards pressure on the price and in theory helps the value rise over time.

Liquidity mining

This is far more complicated and requires an understanding of how a decentralised exchange (DEX) works.

On a DEX you don’t need an account, nor do you need to leave your tokens in the exchange where they are vulnerable to being hacked.

You simply connect your wallet to the DEX, select the two tokens you wish to swap between, make the swap, and then disconnect.

The problem with this is that theoretically there must be someone on the other end of the swap who wants to swap the same amount of tokens.

This is unlikely to occur regularly enough to make the experience smooth and fast. The solution is something called an ‘automated market maker’.

Automated market maker (AMM)

In simple terms, there is always a pool of tokens kept on the exchange for users to swap in and out of.

Each pair has its own liquidity pool which is provided by the liquidity miners. The miner takes equal amounts of the tokens valued in US dollars and deposits them to the pool.

Then they’re rewarded with a share of the fees users pay when swapping with the pool.

The amount paid is equal to his or her share of the total pool. If you own 10 per cent of the pool you get 10 per cent of the fees.

The dangers of yield farming

Impermanent loss: This is when the tokens you are staking lose value faster than the value of the tokens being paid in interest.

Scams: Beware of very high returns and all new yield farming tokens. Any project can be a scam, but it becomes less likely the longer a project is established and consistently paying rewards.

The most common scam is the ‘rug pull’ where the project sells its tokens to the market, pays high interest to generate hype and increase the value of the tokens. They then dump all tokens onto the market for a huge profit and this crashes the price.

Yield farming is not straight-forward and you should do your research before investing. There’s further guidance in the Altcoin Ignition community.

www.altcoinignition.io