How to Calculate Rewards in Yield Farming?
The investors enter the yield farming space with an aim to generate high yields and then farm those yields to earn further profits. While each yield farming platform highlights the various benefits they offer to the liquidity provider, almost none of them clearly state the number of returns that the investor can obtain by farming yields. So, here we are explaining about how the investors can calculate rewards in yield farming. Also, we have explained some common reward terms that you may encounter while reading about the yield farming platforms.
How Does Yield Farming Work?
The entire setup of yield farming consists of three main components, that is, the liquidity provider, the liquidity pool, and the automated market maker. Each of them has its definitive role in facilitating the process of yield farming. Here’s the breakdown of the yield farming process in four parts.
Deposition of Money in Liquidity Pools
The liquidity providers deposit their money in the liquidity pools. The liquidity pools are basically smart contracts that lock the money. After the deposition of money in the smart contracts, the funds become available to the participants in the liquidity pool.
Decision to Buy, Sell, or Trade Tokens
As the funds become available in the liquidity pool, the users decide whether to buy, sell, or trade the tokens in the pool. Depending upon the operation that they choose to perform, the participants have to pay a certain fee to the protocol. The liquidity providers earn this fee as reward according to the amount of share that they put into the protocol.
Obtaining the Rewards
The third step in the yield farming process is where the users obtain the farming rewards for their willingness to lend money to the protocol. The protocol rewards the participants depending upon the amount of money that they provided to the liquidity pool.
Farming Rewards Again
Then the reward gainers lock their rewards in the liquidity pool again. They keep on doing so until they earn maximum profits on their investment assets. The farmers earn rewards in the form of native tokens. So, they can farm their rewards on different platforms and diversify their crypto assets.
How Do Investors Earn Farming Rewards?
The investors of the liquidity pool can earn farming rewards in three categories. These are token prizes, translation fee revenue, and an increase in capital. Let’s understand each of these rewards in a bit more detail.
The investors obtain token prizes in the form of governance tokens. This is done to propose liquidity in the pool. The investors can trade these tokens on crypto exchanges or farm them again in the liquidity pool.
Transaction Fee Revenue
The protocol charges some fees from the users to participate in the liquidity pool. The investors earn this fee as farming rewards at the end of the farming period.
Increase in the Capital
The investors earn a raise in their capital depending upon the price rise of the tokens in the decentralized exchanges. However, there is an equal chance of reduction or loss of capital. So, the investors have to be very strategic in terms of when to pull their share out.
How to Calculate Rewards in Yield Farming?
The returns are calculated in the form of APR and APY. APR stands for Annual Percentage Rate whereas APY stands for Annual Percentage Yield. The investors earn APR as interests because of their willingness to lend their assets to the protocol for providing loans to the borrowers.
Here’s how you can calculate the APR for your assets.
- Firstly, you must add the fee and the interest rates that the borrowers will need to pay for the loan.
- Secondly, divide this sum by the principal amount of the loan.
- Now take the division of the result obtained by the total time period of the loan.
- Lastly, multiply the outcome with 100. This will give you the value of APR that you will earn.
Then APY is the rate of return that you get for your investments in the liquidity pool. The main difference between APY and APR is that APY considers the compounding effect, whereas APR ignores it. In addition to APY and APR, the investors must be aware of another term called Total Value Locked (TVL). It is the total value of assets locked in the liquidity pool. The value of TVL helps the investors in finding the level of prospects for yield farming in that particular pool. When assessing TVL, the investors must take the metrics as USD, BTC, or ETH. This is because these are more stable coins and hence, are likely to give more accurate estimates.
Is Yield Farming Profitable?
Yes, yield farming can be very profitable to the liquidity providers, otherwise, no one would have bothered trying their hands on it. Even some liquidity pools have a record APY in double digits and some in thousand percentages of farming rewards. However, the investors must not be blinded by the high-profit margins that yield farming offers. It is because, in addition to the high potential of gains, yield farming may involve several risks like gas fee risks, impermanent losses, strategy risks, and so on. Therefore, yield farming may subject investors to an added effort and concern about losing their money and choosing the right yield farming platform.
It should be noted here that the way to calculate rewards in yield farming is purely subjective. It is because the calculation methods do not take the market volatility into consideration. As we all know that crypto markets are highly volatile and keep changing every now and then, the investors are advised not to rely on their estimations completely. They should monitor the value of their locked assets and make decisions accordingly. Furthermore, the investors must keep with the crypto news, the latest flashes from the exchanges, and other research material to protect their assets from losing value.