Amidst risk and volatility, how do crypto holders and investors grow their wealth? Riding on the fluctuations of the DeFi market, yield farming is a novel strategy that creates passive income for investors. As an advanced investment tactic, a lot remains unknown and there are doubts about its overall safety and ethical standing as a financial tool. Let’s get to the basics and understand how yield farming works, the pros and cons, and whether it can be considered a halal DeFi investment opportunity.
What is Yield Farming?
Yield Farming is the practice of depositing crypto assets into specialized liquidity pools to earn passive income or token rewards. Liquidity providers are incentivized to stake or lock up their cryptocurrency to support the functioning of the decentralized applications (DApps). In return, they are offered crypto-based benefits expressed in terms of an Annual Percentage Yield (APY).
APY in Yield Farming Explained
Yield Farming is an advanced investment strategy that uses a combination of methods to maximize depositors’ returns. People contribute their digital assets into smart contract-based liquidity pools in hopes of earning high profits over time.
Yield farmers calculate their estimated profits over a year as annual percentage yield or APY. Simply put, APY is the rate of return on an investment gained over the course of one year, after factoring in the effects of compounding returns.
In effect, everything that a contributor gets back for providing liquidity to a DApp is counted as part of their APY. This can include a percentage of transaction fees, interest income, or a share of platform-specific tokens.
How Does Yield Farming Work?
To understand how yield farming works, we should look at how it serves the DeFi ecosystem. The main activity which takes place on most decentralized exchanges comprises digital transactions and trade. DEX platforms create peer-to-peer exchanges between two parties by eliminating intermediaries.
To facilitate smooth transactions, these platforms need a ready pool of liquidity at their disposal. This is where the funds deposited by liquidity providers come into play. These funds are collected into platform-specific liquidity pools which are governed by smart contracts. Yield farmers utilize such pools and their associated incentives to maximize returns on invested assets.
In order to increase profits, yield farmers use a range of tactics that leverage the functions of blockchain networks. These tactics include shifting funds between multiple platforms to optimize gains or contributing to diverse liquidity pools to obtain project-specific rewards.
Types of Yield Farming
With the rise of DeFi, yield farming has become the go-to strategy that cryptocurrency holders use for putting their assets to work. Let us understand the three main styles of yield farming:
1. Liquidity-providing
Decentralized exchanges use liquidity pools to complete transactions through the Automated Market Maker (AMM) protocol. Contributors who provide funds to a DEX are called liquidity providers (LPs). They are compensated for their deposits with a percentage of exchange fees as a reward.
Liquidity pools hold tokens in a smart contract where crypto assets must be stored as trading pairs. For example, if the value of token “A” equals 100 tokens “B”, then a depositor must provide a proportionate amount of the two tokens to their liquidity pool. Whenever there is a transaction between tokens A and B, the associated LPs will receive a share of the transaction fee as a reward. An example of such a trading pair would be the VERSE-WETH tokens.
Impermanent losses are a common risk associated with this form of yield farming. This occurs due to the high price volatility of tokens that make up trading pairs.
Platforms that offer liquidity mining as a feature include Uniswap, Sushi, and EmplifAI.
2. Staking
Staking involves locking up your cryptocurrency assets to serve the operations of a blockchain network. Blockchains that use the Proof-of-Stake (POS) consensus mechanism utilize this method for validating transactions. Users who deposit their funds to support the POS protocol of a blockchain are rewarded with returns on their investment.
So, whenever your token is assigned to validate a block of the transaction, you will accrue profit or yield within the network. Well-known blockchains such as Cardeno, Solana and Ethereum employ staking on their platforms. MRHB Network also has the world’s first halal staking platform, M.I.R.O.
Staking requires you to keep your funds locked on a blockchain for extended time periods. This is accompanied by a risk of loss in case of cyber attacks or network breaches.
3. Lending and Borrowing
DEX platforms allow users to lend their cryptocurrencies and earn a yield on their loans. You can lend crypto to liquidity pools and get an interest payment whenever a borrower uses this token. When it comes to borrowing, yield farmers can submit one cryptocurrency as collateral to receive a proportionate amount of another token.
Most blockchain projects let borrowers and liquidity providers interact in a fully decentralized setting, which is governed by smart contracts. This means that a self-executing contract helps lenders realize their profits whenever their tokens are issued to a borrower.
Some popular crypto lending platforms are Celsius, Compound, and CoinLoan.
The risk in these operations emerges from corrupt smart contracts or the possibility of unexpected platform insolvency. In the current DeFi space, lending and borrowing protocols usually impose interest payment, which is not Sharia-compliant.
Pros and Cons of Yield Farming
Yield Farming offers a new way of making profits from your digital assets. As it gains popularity in the crypto investment space, it is important to know how it might affect our wealth prospects. Let us discuss the most relevant benefits and risks of yield farming:
Benefits of Yield Farming
1. Lower platform fees and increased liquidity
Unlike traditional financial institutions, decentralized exchanges do not need physical offices or staff to function. This reduces their operating costs and enables lower platform fees. Additionally, digital assets are more liquid compared to standard investment instruments such as stocks or physical commodities.
2. Passive income
Once you lock up your assets into a yield farming scheme, you do not need to put any more effort to earn a return on them. Tokens that could be lying stagnant in your wallet can now serve the larger blockchain ecosystem. This is a win-win for both you and the DeFi network.
3. High projected returns
As DeFi becomes a booming market, returns from cryptocurrency are expected to be higher than traditional investment options. It is common for yield farming protocols to cross the 100% yearly mark on APYs.
Disadvantages of Yield Farming
1. Corrupt smart contracts
Smart contracts are created to ensure the smooth completion of platform protocols. However, just like any computer code, there can be faults or bugs in a smart contract. Small errors in coding can result in big losses when digital transactions are fully dependent on them. Apart from this, loopholes in protocol algorithms can be exploited by cybercriminals to steal money from a project.
2. Liquidation risk
Unlike traditional banks, DeFi platforms do not maintain a corpus of stable cash on their systems. Also, the value of their token keeps fluctuating along with price volatility in the crypto market. Any funds you lock into these platforms are subject to liquidation risk if the price of collateral drops below the price of the loan. In such a case, you cannot trade your platform tokens in the wider market without recording a loss.
3. Rug Pulls
Yield farmers are vulnerable to a form of exit scam called rug pulls. This happens when a developer collects funds for a project, promotes its tokens until a monetary threshold is met, then disappears with the investor’s money. There is no way to track down the digital funds or owners who abandon their projects without repaying investors.
Is Yield Farming Halal?
In basic terms, income from yield farming is earned as passive interest. In Islam, riba or interest on deposits is considered Haram. Does this fact render the entire arena of yield farming unethical?
The moral soundness of an investment depends on many factors such as the real usage of deposited funds, its social implications, and long-term effects on wealth creation. That is why, the aim of a DeFi Project must be analyzed first. Any project which supports unethical businesses or ambiguous financial tactics cannot be considered permissible. Therefore, yields earned from such projects are haram.
But what about the different methods of yield farming? When can they be considered halal? As long as your funds are being put to work for supporting essential functions on a crypto network, the rewards you earn on them are Halal. For example, returns from staking can be permissible because you are getting paid back for contributing to the security and stability of transactions on a blockchain. Even liquidity pools and redistribution protocols are halal if they are being operated to provide services on a platform.
However, yield farming is not halal when the lending of a crypto imposes an interest payment towards a borrower. This is considered riba and therefore the protocol is not Sharia-compliant.
Potential for Wealth Creation but Beware of Riba
Yield Farming is essentially a way for you to build crypto wealth. There are various methods such as liquidity-providing, staking, and lending and borrowing. If you’re an ethical and halal-conscious investor, you would need to understand the objectives of the protocol and ensure that it doesn’t require interest payment. As the saying goes, DYOR—do your own research.
With MRHB Network, you wouldn’t need to worry about the halal aspect as our Sharia Scholars are here to ensure that each DeFi product we release is Sharia-compliant. We have created the MRHB Ecosystem so that the faith-conscious community can participate in Islamic finance with ease.
Our halal DeFi products such as TijarX, M.I.R.O., and EmplifAI can help you on your journey of wealth creation. Download the Sahal Wallet app to access the halal DeFi ecosystem today.