Yield farming is a method of earning interest on your cryptocurrency in the same way that you would earn interest on money in a savings account.
Similar to depositing money in a bank, yield farming entails locking up your cryptocurrency for a period of time, known as “staking,” in exchange for interest or other rewards, such as more cryptocurrency.
What Is Yield Farming?
Yield farming is the practice of staking or lending cryptocurrency assets in order to generate high returns or rewards in the form of more cryptocurrency. While it might seem like simple terminology, there is more to it. It might be more sophisticated than you think.
This is similar to earning interest on a bank account in that you are technically lending money to the bank. Compared to putting money in a bank, only yield farming can be riskier, volatile, and complicated.
Yield farmers who want to increase their yield output can employ more complex tactics. For example, yield farmers can constantly shift their cryptos between multiple loan platforms to optimize their gains.
How Yield Farming Works
Yield farming enables investors to earn returns by depositing coins or tokens in a decentralized application (dApp). Crypto wallets, DEXs, decentralized social media, and other dApps are examples.
Decentralized exchanges (DEXs) are commonly used by yield farmers to lend, borrow, or stake coins in order to earn interest and speculate on price swings. Smart contracts, which automate financial agreements between two or more parties, facilitate yield farming across DeFi.
In some sense, yield farming can be paralleled with staking. However, there’s a lot of complexity going on in the background. In many cases, it works with users called liquidity providers (LP) that add funds to liquidity pools.
What is a liquidity pool?
It’s basically a smart contract that contains funds. In return for providing liquidity to the pool, LPs get a reward. That reward may come from fees generated by the underlying DeFi platform, or some other source.
Some liquidity pools pay their rewards in multiple tokens. Those reward tokens then may be deposited to other liquidity pools to earn rewards there, and so on. You can already see how incredibly complex strategies can emerge quite quickly. But the basic idea is that a liquidity provider deposits funds into a liquidity pool and earns rewards in return.
Yield farming is typically done using ERC-20 tokens on Ethereum, and the rewards are usually also a type of ERC-20 token. This, however, may change in the future. Why? For now, much of this activity is happening in the Ethereum ecosystem.
However, cross-chain bridges and other similar advancements may allow DeFi applications to become blockchain-agnostic in the future. This means that they could run on other blockchains that also support smart contract capabilities.
Yield farmers will typically move their funds around quite a lot between different protocols in search of high yields. As a result, DeFi platforms may also provide other economic incentives to attract more capital to their platform. Just like on centralized exchanges, liquidity tends to attract more liquidity.
Types of Yield Farming
There are different types of yield farming that you should take note of;
Liquidity provider
Users deposit two coins to a DEX to provide trading liquidity. Exchanges charge a small fee to swap the two tokens which are paid to liquidity providers. This fee can sometimes be paid in new liquidity pool (LP) tokens.
Lending
Coin or token holders can lend crypto to borrowers through a smart contract and earn yield from interest paid on the loan.
Borrowing
Farmers can use one token as collateral and receive a loan from another. Users can then farm yield with the borrowed coins. This way, the farmer keeps their initial holding, which may increase in value over time, while also earning yield on their borrowed coins.
Staking
There are two forms of staking in the world of DeFi. The main form is on proof-of-stake blockchains, where a user is paid interest to pledge their tokens to the network to provide security.
The second is to stake LP tokens earned from supplying a DEX with liquidity. This allows users to earn yield twice, as they are paid for supplying liquidity in LP tokens which they can then stake to earn more yield.
Top 5 Yield Farming Protocols
There is no standard method for yield farming. In fact, farming yield strategies can shift by the hour. Each platform and strategy will have its own set of rules and risks to contend with. If you want to start yield farming, you must first learn about decentralized liquidity protocols.
We already have a general idea. You deposit funds into a smart contract in exchange for rewards. However, implementations vary greatly. As a result, depositing your hard-earned money and hoping for high returns is generally not a good idea.
So, which platforms are most popular among yield farmers? This is not a comprehensive list; rather, it is a collection of protocols that are essential to yield farming strategies.
Curve Finance
Curve has nearly $19 billion in total value locked on its platform, making it the largest DeFi platform in terms of total value locked. The Curve Finance platform uses locked funds more than any other DeFi platform, thanks to its own market-making algorithm — a win-win strategy for both swappers and liquidity providers.
Curve offers a comprehensive list of stablecoin pools with attractive APRs that are linked to fiat currency. Curve maintains high APRs ranging from 1.9 percent (for liquid tokens) to 32 percent. Stablecoin pools are quite safe as long as the tokens do not lose their peg.
Impermanent loss can be completely avoided because their costs do not differ significantly from one another. Curve, like all DEXs, risks temporary loss and smart contract failure. Curve also has its own token, CRV, that is used for governance for the Curve DAO
Uniswap
Uniswap is a DEX system that allows for trustless token exchanges. To create a market, liquidity providers invest the equivalent of two tokens. The liquidity pool is then traded against by traders. Liquidity providers receive fees from trades that occur in their pool in exchange for providing liquidity.
Uniswap has become one of the most popular platforms for trustless token swaps due to its frictionless nature. This is beneficial in high-yielding agricultural systems. UNI, Uniswap’s DAO governance token, is also available.
Balancer
Balancer is a liquidity protocol that works in the same way as Uniswap and Curve. The key difference is that custom token allocations in a liquidity pool are possible.
This enables liquidity providers to create custom Balancer pools rather than the Uniswap-required 50/50 allocation. LPs, like Uniswap, are paid for trades that occur in their liquidity pool.
Balancer is an important innovation for yield farming strategies because of the flexibility it adds to the creation of liquidity pools.
PancakeSwap
PancakeSwap functions similarly to Uniswap; however, PancakeSwap operates on the Binance Smart Chain (BSC) network rather than the Ethereum network. It also has a few extra gamification-focused features.
PancakeSwap offers BSC token exchanges, interest-earning staking pools, non-fungible tokens (NFTs), and even a gambling game in which players predict the future price of Binance Coin (BNB).
PancakeSwap faces the same risks as Uniswap, such as temporary loss due to large price fluctuations and smart contract failure. Many of the tokens in PancakeSwap pools have minor market capitalizations, putting them at risk of temporary loss.
PancakeSwap has its own token called CAKE, which can be used on the platform and also used to vote on platform proposals.
Aave
Aave is a decentralized lending and borrowing protocol. Interest rates are algorithmically adjusted based on current market conditions.
Lenders receive “aTokens” in exchange for their funds. When you deposit these tokens, they immediately begin earning and compounding interest. Aave also supports more advanced features such as flash loans.
Aave is widely used by yield farmers as a decentralized lending and borrowing protocol.
Risks of Yield Farming
Yield farming is a complicated process that exposes both borrowers and lenders to financial risk. When markets are turbulent, users face an increased risk of temporary loss and price slippage. Some risks associated with yield farming are as follows:
Rug pulls
Rug Pulls are a type of exit scam in which a cryptocurrency developer collects investor funds for a project and then abandons it without repaying the investors’ funds. According to a CipherTrace research report, rug pulls and other exit scams, to which yield farmers are particularly vulnerable, accounted for approximately 99 percent of big fraud during the second half of 2020.
Regulatory risk
The regulation of cryptocurrencies remains hazy. The Securities and Exchange Commission has declared that certain digital assets are securities, bringing them under its jurisdiction and granting it the authority to regulate them. State regulators have already issued cease and desist orders against centralized cryptocurrency lending platforms such as BlockFi, Celsius, and others. If the SEC declares DeFi lending and borrowing ecosystems to be securities, the ecosystems could suffer.
While this is true, DeFi is built to be independent of any central authority, including government regulations.
Volatility
Volatility is the degree to which the price of an investment moves in either direction. A volatile investment is one that has a large price swing over a short period of time. While tokens are locked up, their value may drop or rise, and this is a huge risk to yield farmers especially when the crypto markets experience a bear run.
Smart contract hacks
Most of the hazards associated with yield farming are related to the smart contracts that underpin them. The security of these contracts is being improved via better code vetting and third-party audits, however, hacks in DeFi are still common.
DeFi users should conduct research and use due diligence prior to using any platform.
FAQs
Is Yield Farming Risky?
Risk farming carries a number of risks that investors should understand before starting. Scams, hacks, and losses due to volatility are not uncommon in the DeFi yield farming space. The first step for anyone wishing to use DeFi is to research the most trusted and tested platforms.
Is Yield Farming Profitable?
Yes. However, it depends on how much money and effort you’re willing to put into yield farming. Although certain high-risk strategies promise substantial returns, they generally require a thorough grasp of DeFi platforms, protocols, and complicated investment chains to be most effective.
If you’re searching for a way to make some passive income without investing a lot of money, try placing some of your cryptocurrencies into a time-tested and trustworthy platform or liquidity pool and seeing how much it earns. After you’ve formed this foundation and developed confidence, you may move on to other investments or even buy tokens directly.
What Is APY in Yield Farming?
Conclusion
“Yield farming” is the practice of staking, or locking up, your cryptocurrency in exchange for interest or more cryptocurrency. As cryptocurrency becomes more popular, yield farming will become more common. It’s a simple concept that has existed as long as banks have, and it’s simply a digital version of lending with interest for profit to investors.
