4 Types of Yield Farming and is Yield Farming Halal?
Yield farming is a concept that has gained great popularity in recent years in the DeFi world. It’s an investment strategy with which token holders seek to obtain excellent returns for their money, investing and participating in different DeFi platforms, always with the intention of finding any financial advantage that allows them to maximize profits.
Without a doubt, this is a form of investing that can generate excellent returns if done correctly and has quickly gained a lot of momentum for its application on many platforms within the crypto ecosystem.
But what are the 4 types of yield farming and is yield farming halal?
Generally speaking, the 4 types of yield farming are as follows: 1) Liquidity Pools, 2) Lending and Borrowing, 3) Staking (proof of stake), and 4) Holding for a Redistribution Fee. As for if yield farming is halal, not all types of yield farming would be considered halal. It depends on the type of yield farming you participate in.
Let’s take a closer look at each of the 4 types of yield farming and let’s see which type of yield farming would be considered halal and if any of the 4 types of yield farming would be considered haram.
What is yield farming?
Yield farming is a formula by which investors try to obtain profits from the storage of cryptocurrencies. With this investment method we have two key factors to consider:
- Liquidity provider (LP) – A user who brings cryptocurrencies to the market
- Liquidity reserve (LR) – A smart contract that validates and manages the funds provided by the LP
Basically, in yield farming, LPs obtain rewards in exchange for providing liquidity through their funds, something similar to the interest paid by banks to those who keep money in them for a certain period of time. But one main difference is that in Islam, it is haram to collect bank interest since it is derived from usury, but with yield farming, some types of yield farming are halal. We’ll touch on this more later in this blog post.
How does yield farming work?
In a yield farming system, investors transfer or deposit assets into a smart contract providing liquidity. In exchange for this, the system will offer them a benefit for the immobilization of these assets.
This can be done through specialized platforms that facilitate the whole process, usually on Ethereum ERC-20 tokens, but since there is no single model or a single system to apply this formula, each platform usually applies its own rules, which can be modified from time to time.
What are the 4 types of yield farming?
Here is a list of the main methods of yield farming that you can find in the market. Of course, it is also possible to find some variations of these methods, but in general, they’re as follows:
1. Liquidity pools
A liquidity pool is perhaps the most common form of yield farming. As I already explained, this works with a smart contract that blocks tokens to ensure liquidity on a decentralized exchange platform. The users who provide these tokens are called liquidity providers.
The liquidity pool will hold two tokens in a smart contract to form a trading pair. Suppose there are tokens “A” and tokens “B”. Suppose also that the price of A can be equal to 100 B.
LPs must contribute the same value of A and B to the pool so that someone who deposits an A token will also have to add 100 B to the same contract. So when someone wants to exchange A for B, they can do it based on the funds deposited in the contract, instead of waiting for another user to appear who wants to do the opposite operation – as happens in crypto exchanges.
LPs are then incentivized for their contribution with different types of rewards, which usually are native tokens of the platform that provides the service.
What are the risks of liquidity pools?
Although this activity can be very profitable, it’s important to be aware of the risk of impermanent loss (IL). This means temporary losses of funds due to the high volatility of the trading pair; the higher the volatility, the higher the IL risk.
In this case, the losses are for less money at the time of withdrawal, which means that a liquidity provider can end up with a greater amount of the B token and slightly less of the A token or vice versa. However, IL can be compensated by trade commissions and other additional rewards earned by LPs.
2. Lending and borrowing
The idea behind a lending and borrowing mechanism is very simple: lenders provide funds to borrowers in exchange for a regular interest rate.
In the crypto world, lending and borrowing are carried out through different types of platforms that can be centralized or decentralized.
If we take this to the world of DeFi, both providers and borrowers interact in fully decentralized platforms in which they have total control over their money, thanks to the use of smart contracts that operate mainly on the Ethereum network.
The way this works is very simple: user X sends a certain amount of funds to a lending platform using a smart contract, which will then provide them with earnings in the form of interest, usually in the platform’s native token.
Such a smart contract then becomes a kind of intermediary available to other users of the platform who want to apply for a loan – the money contained in the smart contract. Subsequently, lenders can withdraw their earnings from the platform from time to time in the form of interest in native tokens.
As a general rule, for a user to be able to request a loan in native tokens, he must previously deposit in the form of a guarantee, an amount in another cryptocurrency, equal to or greater than the amount of the loan that he’s going to request.
What are the risks of lending and borrowing?
Although this financial activity is usually quite safe in the DeFi context, there are also a couple of aspects that need to be considered.
First, there is always the possibility that the smart contract used for the operation receives some type of manipulation. This is more likely in the cases of smart contracts provided by third parties.
On the other hand, borrowing APYs on some cryptocurrencies could suddenly go up for some reason, which could lead to the most careless users ending up paying more than expected.
3. Staking (proof of stake)
Staking within the universe of cryptocurrencies involves keeping a certain amount of funds in a wallet in order to obtain yield for keeping this crypto locked up or “staked” on a blockchain.
This action of holding funds in a crypto wallet, also known as staking, serves to support the security and operations of a blockchain network by validating transactions on the network. In return, they are able to generate yield, or rather, earn cryptocurrency, for providing such a service to the network.
This consensus system is known as Proof of Stake (PoS) and is based on the fact that to obtain consensus, users must demonstrate possession of the indicated funds.
The idea is that users block cryptos and from time to time, the network randomly assigns the right to one of them to validate the next block, the probability of being chosen is directly proportional to the amount of frozen funds held on the network.
In this system and unlike what happens in other consensus mechanisms – such as PoW in Bitcoin – the users who act as validators, don’t compete with each other using the computing power of their equipment, but instead, put up a share of assets to certify that they’ll validate transactions in an honest way.
What are the risks of staking?
In the case of staking, you have to consider the risk of keeping a high amount of funds locked on a blockchain for a long period of time. Remember that there can always be attacks on these platforms that end in the partial or total loss of the funds held, something that has already happened on many occasions.
In addition, in some cases, these funds are placed in the hands of third parties, which implies a risk if there is an internal theft attempt on the platform.
4. Holding for a redistribution fee
Some decentralized exchanges facilitate the buying and selling of different crypto assets between users, but they do so through a model called automated market making (AMM).
Users can add their inactive tokens to the liquidity pools available on the platform and earn passive income according to their contribution and at the same time, other members can exchange tokens from these liquidity pools – the profits go to the community of users.
In the case of SushiSwap for example, anyone can provide liquidity through its internal app. When they do, they’ll receive SLP tokens (SushiSwap Liquidity Provider tokens). For example, for a $SUSHI and $ETH pair, the user would receive SUSHI-ETH SLP tokens.
Any user can create a new liquidity pool simply by providing a new pair, and it’ll be the proportion of tokens that the user adds, which will set the price of this new liquidity pool.
Afterward, other users can trade any ERC-20 token and when transacting on SushiSwap Exchange, a fee of 0.3% will be charged and 0.25% of this trade will go back to the users that make up the LP group.
In exchange for maintaining liquidity in these groups, LPs are rewarded with these fees, in addition to a portion of the SUSHI minted daily on the platform. The best part is that users can claim their funds at any time.
What are the risks of holding?
As with any liquidity pool, there is a risk of suffering losses due to IL, but also that the borrowing APY goes up in price or that the platform suffers from theft of funds.
BONUS
5. Hodling
The term “hodling”, also known as “hold on for dear life” in the crypto world, is used to define those who simply hold onto their cryptocurrency as a long-term investment strategy without worrying about the rise and fall in the price of tokens.
This is not a form of yield farming in its most pure essence, but you can also see it that way for your convenience – especially if you don’t have experience with crypto finances.
Hodling is a strategy used by people who don’t have the skills or the time to perform other types of operations, so these people invest in well-established projects for long-term investment.
The objective of hodlers is that, over time, the value of the selected cryptocurrency will increase, so the most common strategy is to invest in the purchase of relatively new cryptocurrencies with very low prices so that, as the value of these assets increases, they can, insha’Allah, make a good profit on such an investment.
This form of “yield farming” has proven to be one of the strategies that has worked best for Bitcoin users.
For example, if you had invested $1,000 to acquire 1,000 BTC when the price was at $1 during 2011, at the time of publishing this blog post, you would have approximately $60 million in a period of only 10 years!
What are the risks of hodling?
HODLing won’t increase the number of cryptocurrencies you have in your hands. This means that you will only make a profit if the cryptocurrency increases in price in the long term. But remember that the opposite could also happen, with which you would lose money instead of increasing.
Is Yield Farming halal?
Is yield farming halal? When it comes to yield farming, staking, as in Proof of Stake, is generally considered halal, while the other 3 types of yield farming, liquidity pools, lending and borrowing, and yield from redistribution fees would be considered questionable or even haram.
Proof of Stake is generally considered halal as you are earning yield for providing security to the network. This is obviously assuming that the network itself is not dedicated or established for some haram type of activity.
Earning yield from liquidity pools could be halal so long as the pool itself is not being used for haram operations such as loaning money to others to earn interest on the loan. Muslims should strive to not purposely put themselves in situations where they are directly contributing to what is known to be haram.
When it comes to earning yield from lending and borrowing, many scholars would say that this is haram as the objective of most DeFi projects is to establish lending and borrowing contracts that will allow the lender to earn money from interest. However, this may change if lending and borrowing contracts are established under Islamic finance investment tools such as “Murabaha” or other sharia compliant guidelines.
And as for earning yield from redistribution fees, this could also be seen as halal since you are providing a service to the platform so long as the purpose of the platform or DEX is not a lending pool where the goal is to earn interest off of loaning money by way of crypto.
All of this is said by making the assumption that the cryptocurrency you are using for yield farming is already seen as halal by scholars.
Final words
We have now explored the most common types of yield farming strategies, acknowledging that there are many variations in them. If your intention is to enter the world of yield farming, you should first familiarize yourself with the operation of the different platforms that offer this form of investment making sure that they are in harmony with Islamic principles.
Take into account that if you don’t understand what you are doing, you’ll probably lose money. Remember that the most profitable yield farming strategies are also the most complex ones and are recommended for advanced users.
It is not just about buying crypto when Elon Musk makes a comment that boosts its price, but there is a whole range of possibilities to earn much more money out there in a halal way. You just have to be well prepared and do your research.
May Allah guide you to success, Ameen.
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