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Yield & Liquidity Farming For Passive Income - Solana Defi Guide

Yield Farming

Yield farming is one of the trending ideas in the decentralized finance (DeFi) realm. Since last year, it has overtaken the crypto ecosystem, mainly because it compensates investors for securing their cryptocurrency assets in the DeFi market.

What Is Yield Farming?

Yield farming is a process that involves lending or staking crypto assets to generate rewards or high returns as passive incomes in the form of additional cryptocurrency. In simpler terms, yield farming is a DeFi activity that allows you to make more cryptocurrencies with your digital assets. In doing so, you’re providing liquidity to a platform and collecting income as a result.

The yield farming process is comparable to putting fiat currency in a savings account in a conventional bank. The bank uses the funds in a savings account in its liquidity pool to lend and provide money to its consumers. Yield farming follows the same concept, except you contribute to a lending platform instead of a bank.

Thanks to new developments like liquidity mining, this creative but risky and unpredictable application of decentralized finance (DeFi) has exploded in popularity lately. Yield farming is presently the most crucial development engine in the still-developing DeFi industry, enabling it to expand from $500 million in market capitalization to $10 billion by 2020.

How Does Yield Farming Work?

To grasp the working principle of yield farming, one needs a basic understanding of smart contracts since they play an essential role. Smart contracts, which are essentially tiny computer programs, function as a link between your funds and those of other users.

Yield farming closely links to an automated market maker (AMM) model like Raydium. The model typically involves liquidity pools and liquidity providers.

Adding money to a liquidity pool, essentially smart contracts, is the first stage in yield farming. These pools provide the foundation for a marketplace for users to trade, borrow, and lend tokens. Any type of lending, including crypto lending, aims at making money. You've formally become a liquidity provider once you contribute your money to a pool.

A lender receives rewards or fees in the form of coins in proportion to their contribution to the pool, making yield farming one of the most common ways to profit from cryptocurrency ownership.

Now that we understand yield farming, it's time to know how to start it on Solana.

How to Start Yield Farming on Solana

The first step in Solana farm yielding is to install a wallet to interact with Solana decentralized apps (DApps). The wallet will serve as storage for your funds. Unlike other blockchains that users can access through a standard Metamask or a hardware wallet Trezor or ledger, Solana has several wallets you can pick from to store your funds. These wallets include Sollet, MathWallet, and Solong.

All these wallet options are non-custodial, allowing you to take complete control over your money. You can use them to transfer or receive SOL (Solana's cryptocurrency) and all other Solana Program Library tokens. But in this piece, we’ll recommend you use the Sollet wallet since it supports most projects that currently run on Solana.

Once you're through with setting up your Solana wallet on Sollet web wallet, the next step is to load funds on it. You can either fund the wallet using your FTX account or via the Sollet wallet itself. You’re ready to start yield farming when you successfully set up your wallet and fund it.

Risks Associated with Yield Farming

Despite all the benefits and glitz, yield farming has some significant drawbacks and risks to consider.

  • Liquidity Risk: This risk arises when the value of your collateral falls below the loan charge, resulting in a penalty on your security. Liquidation happens when the value of your loan rises or the value of your collateral drops.
  • Scam risk: Because developers have access to your money, there's a risk that they'll run away with it. The dangers are much greater if you don't know the developers. Thus, participants need to ensure that they get a trusted team to thoroughly investigate their chosen pool, although this does not entirely remove the risk.
  • Gas fees risks: During the height of the decentralized financing season, gas fees increased by almost 100 times. If they continue to rise, yield farming may become unaffordable for most traders. Fortunately, Solana’s transaction fees are pretty low, and other blockchains like Ethereum are launching new scalable platforms to address the problem of excessive gas fees.
  • Price risk: If the price of a coin that a yield farmer invests in falls below a certain threshold in the market due to their chosen strategy, the platform may remove the borrower before they have an opportunity to repay their loan.