While some prefer to let their crypto sit pretty on a wallet, many others in the crypto space are looking to maximize earnings using potentially lucrative, though risky, investment strategies. In the world of DeFi, Yield farming is one of the most profitable strategies you can use to boost your ROI. It is also one of the major growth drivers for DeFi platforms.
In this guide, we’ll take a closer look at yield farming and how it works. Here’s what we’ll cover:
- What is yield farming?
- How does it work?
- How are returns calculated?
- What are the benefits of yield farming?
- What are the risks of yield farming?
- Yield farming protocols
What is Yield Farming?
Put simply, yield farming is moving your assets around in a way that allows you to make as much profit as possible. More specifically, yield farming is an investment strategy that involves participating in crypto staking, lending, and liquidity mining in order to earn rewards and obtain the highest possible returns. This entire process is facilitated by DeFi protocols.
Rewards obtained by yield farming come from different sources, including interest and a share of a liquidity or staking pool’s fees. In some cases, farmers are also rewarded with additional tokens. For example, Compound users are rewarded with COMP, the protocol’s governance token.
However, it is important to keep in mind that yield farming is a high risk, high reward venture. If you want to participate in yield farming, you must be willing to take on some risks, which we will explore in greater detail later in this guide.
How Does Yield Farming Work?
Yield farming takes place on Decentralized Finance applications, and more specifically on Automated Market Makers (AMMs). AMMs are smart-contract protocols that use liquidity pools and a set of algorithms to process trading transactions without the need of any intermediary intervention. These liquidity pools provide the necessary funding to facilitate decentralized trading or, in some cases, the lending and borrowing of assets.
The protocols provide incentives for liquidity providers contributing to liquidity, staking and lending pools. Once assets are deposited to a pool, contributors can earn a share of the fees collected by the DeFi platform, collect interest and receive rewards in the form of additional tokens.
Let’s break down the three elements of yield farming:
- Staking: You can stake crypto by locking up your assets in a validator’s staking pool, enabling you to participate in the blockchain’s validation process. Those that participate earn rewards for their contribution.
- Lending: To lend crypto, you’ll need to deposit your asset’s to a DeFi lending pool from which other users can borrow coins/tokens. Borrowers pay back their loan plus interest. Lenders receive a share of said interest in proportion to their contribution.
- Liquidity mining: This involves providing liquidity to a DeFi protocol for trading by placing your assets in their liquidity pools. In return you can earn interest and additional tokens.
Yield farmers look for the best possible yield (or the maximum amount of earnings they can obtain) by using a combination of the three elements above. When well-executed, taking advantage of these investment methods and strategically moving around assets among different pools enables them to generate a profit.
How Are Returns Calculated?
Yield farming returns are described as an annual percentage yield (APY), which is expressed as a percentage. It shows the rate of return for the amount you contribute to a liquidity pool. In some cases, yield farmers can obtain an APY that is well into the three-digits, driving interest in this strategy.
What Are The Benefits of Participating In Yield Farming?
Crypto enthusiasts are drawn to yield farming due to its high profitability. Many liquidity, staking, and lending pools offer high returns, with APYs in the double or even triple digits. Yield farming enables you to maximize your earnings and gives you the possibility of generating a passive income by putting the assets you currently hold to work.
Another benefit of yield farming is that it can allow you to gain more rights within a DeFi protocol. This is best illustrated by staking. The larger the stake of a digital currency, the more the validator will be able to contribute to the blockchain. This is also seen when liquidity providers are rewarded with protocols’ governance tokens. Their contributions allow them to become more involved in decision making, by giving them the right to vote and submit proposals. By holding a large enough amount of these tokens, stakeholders can acquire the power to move the protocol in a given direction.
What Are The Risks Of Yield Farming?
Getting involved in any type of cryptocurrency investing implies risk, due to the high volatility of the market. Asset prices can vary greatly in short periods of time. If prices drop significantly while your crypto is locked up in a liquidity, staking or lending pool, this can result in unwanted losses, which could have been mitigated if your coins were available for trading.
Yield farmers should also be wary of “rug pulls”, a type of scam that can occur in the DeFi space. This happens when a cryptocurrency developer obtains funding from crypto investors only to abandon the project, without returning any of the funds. This is why it is important that yield farmers do thorough research on the projects they get involved in.
Smart Contract Risks
Furthermore, since yield farming is facilitated by DeFi platforms, the integrity of their protocols has a direct impact on the investor’s safety. If a protocol’s smart contracts are affected by bugs, this can cause the protocol to fail, affecting all of its transactions. However, DeFi platforms are implementing measures such as bug bounty programs and external auditing to reduce this risk.
Yield Farming Protocols
These are some of the most popular platforms for yield farming:
Aave is a popular decentralized finance lending protocol. By providing liquidity to Aave’s lending pools, lenders can earn interest and rewards in the form of AAVE tokens. Interest varies across cryptocurrencies based on the borrowing demand. Deposits can also act as collateral, allowing users to borrow crypto from other lending pools on the protocol.
Compound is another DeFi protocol that allows users to lend and borrow crypto. Operating on the Ethereum network, Compound supports Ethereum-based tokens and currently offers lending pools for 17 different assets. Users that contribute to Compound’s liquidity pools, either as lenders or borrowers, are rewarded with the protocol’s governance token, COMP.
Uniswap is an open-source DeFi protocol that facilitates trading for ERC20 tokens. Liquidity pools on Uniswap contain two assets and liquidity providers must deposit both assets in a 50/50 ratio in order to contribute. In return, they receive a share of transaction fees and additional UNI tokens.
Due to its high earning potential, there’s a lot of buzz about yield farming in the DeFi space. Considered an advanced strategy, it is true that yield farming can help you make the most out of the crypto you own and obtain impressive returns. However, you should also consider the risks involved, especially when participating in small, less established, and unaudited projects.