TL;DR

  • Yield farming is a way to put your cryptocurrency to work, earning interest on crypto.

  • It entails lending your funds to other participants in the DeFi ecosystem and earning interest on these loans by utilizing smart contracts.

  • Yield farmers can strategically move their assets across multiple DeFi platforms to capitalize on their cryptocurrency holdings.

What Is Yield Farming in Crypto?

Yield farming, also known as liquidity mining, refers to the lending or staking of cryptocurrency in decentralized finance (DeFi) protocols to earn additional tokens as a reward. Yield farming has become popular because it offers the potential to earn higher returns compared to traditional saving methods.

Let’s say an investor owns coins like ether (ETH) or stablecoins like DAI. Instead of letting these assets sit idle in their crypto wallet, they can put their coins to work by lending or depositing them on various DeFi platforms. These DeFi platforms can be decentralized exchanges (DEX), lending and borrowing platforms, yield aggregators, liquidity protocols, or options and derivatives protocols.

In exchange for providing liquidity and becoming a liquidity provider (LP), investors may receive the platform's native tokens, governance tokens or even a portion of the platform's revenue in blue chip coins such as ether.

Yield farmers may use a liquidity pool to earn yield and then deposit earned yield to other liquidity pools to earn rewards there, and so on. It's easy to see how complex strategies can emerge quickly. But the basic idea is that a liquidity provider deposits funds into a liquidity pool and earns rewards in return.

The rewards you may receive depends on several factors, such as the type and amount of assets you lend, the duration of your participation, and the overall demand for the platform's services.

How Does Yield Farming Work?

Yield farming is closely related to a model called automated market maker (AMM). It typically involves liquidity providers (LPs) and liquidity pools.

Liquidity mining begins with liquidity providers depositing funds into a liquidity pool. This pool powers the DeFi protocol, where users can lend, borrow, or exchange tokens. The use of these platforms incurs fees, which are then paid out to liquidity providers according to their share of the liquidity pool. This is the foundation of how an AMM works, but the implementation can vary widely depending on the network.

In addition to fees, another incentive to add funds to a liquidity pool could be the distribution of a new token. For example, there may not be a way to buy a new DeFi protocol’s tokens on the open market. Instead, the protocols may offer to accumulate it for LPs who provide liquidity to a particular pool. And the LPs get a return based on the amount of liquidity they provide to the pool.

Some protocols mint tokens that represent your deposited coins in the system. For example, if you deposit DAI into Compound, you’ll get cDAI or Compound DAI. If you deposit ETH to Compound, you’ll get cETH.

These tokens could then be used further in a yield farming strategy. For example, an investor could deposit the cDAI to another protocol that mints a third token to represent their cDAI. Yield farming strategies can become complex, contain many steps, and require users to understand each protocol’s underlying mechanics.

To engage in yield farming, you’ll need to connect your digital wallet to the DeFi platform of your choice, deposit necessary assets, and follow the platform-specific instructions.

How Are Yield Farming Returns Calculated?

The estimated yield farming returns are usually calculated on an annualized basis. This is an estimate of the returns an investor can expect over a year.

Some commonly used metrics are Annual Percentage Rate (APR) and Annual Percentage Yield (APY). The difference between them is that APR doesn't take into account the effect of compounding, while APY does. Compounding, in this case, is the reinvestment of earnings back into the protocol to generate more returns. Note, however, that APR and APY are often used interchangeably.

It's also important to remember that these are just estimates and projections. Even short-term rewards are difficult to estimate accurately because yield farming is highly competitive and fast-paced, and rewards can fluctuate rapidly. If a yield farming strategy works for a while, many farmers will jump on the opportunity, and it may no longer yield high returns.

There is also the possibility of impermanent loss, which refers to the potential loss in value of cryptocurrency compared to simply holding the assets outside the pool. This affects LPs in certain yield farming strategies, particularly those involving liquidity pools. As a result, the returns earned from farming may not be enough to offset the loss in value caused by impermanent loss, making the strategy less profitable or potentially unprofitable.

Common Types of Yield Farming

1. Providing liquidity

Providing liquidity involves depositing equal amounts of two cryptocurrencies into a liquidity protocol. All LPs with the same asset mix are pooled together. When someone trades between the two cryptocurrencies, LPs earn a share of the trading fees generated by the platform.

2. Staking

Staking involves locking up a certain amount of coins in a blockchain to help support the security and operation of a blockchain network. By staking their tokens, users are often rewarded with additional coins as an incentive. The rewards may come from transaction fees, inflationary mechanisms, or other sources as determined by the protocol. An example of this is the Ethereum network, which runs on a Proof of Stake consensus mechanism by using staked funds to secure the network. 

3. Lending

DeFi also allows people and projects to borrow cryptocurrency from a pool of lenders. Users can offer loans to borrowers through the lending protocol and earn interest in return.

Risks of Crypto Yield Farming

1. Smart contract vulnerabilities

Yield farming relies on smart contracts, which are subject to potential vulnerabilities and exploits. Bugs or security vulnerabilities in smart contracts can result in financial loss, including the loss of deposited funds and earned rewards. It's essential to assess the security and audit the protocols you choose to participate in and exercise caution.

2. Protocol risks

Each yield farming protocol has its own set of risks. These risks may include flaws in the protocol design, smart contract upgrades, changes in the protocol's economic model, or even the potential for the protocol to be abandoned. 

3. Market volatility

Crypto markets are known for their volatility, which can impact the value of the tokens users hold or the rewards users earn through yield farming. Sudden price swings can result in a reduction in the value of a user’s deposited assets or rewards, potentially affecting the overall profitability of a user’s farming strategy.

This is also why impermanent loss occurs. If the prices of the deposited tokens diverge significantly during the farming period, liquidity providers may experience a loss when they withdraw their assets from the pool.

3. Liquidity risks

Yield farming typically involves locking up a user’s funds for a specific period of time. This lack of liquidity means that a user may not be unable to access or withdraw their funds immediately as and when they need to. Additionally, if a particular pool or platform becomes less popular or loses users, the reduced liquidity could lead to less rewards, difficulty exiting the yield farming position, or even failure of the project, causing its token price to plunge.

Now let's look at some of the core protocols used in the yield farming ecosystem.

1. Compound Finance

Compound is an algorithmic money market that allows users to lend and borrow assets. Anyone with an Ethereum wallet can contribute assets to Compound’s liquidity pool and earn rewards that begin compounding immediately. The rates are adjusted algorithmically based on supply and demand.

2. MakerDAO

Maker is a decentralized credit platform that supports the creation of DAI, a stablecoin algorithmically pegged to the value of USD. Anyone can open a Maker Vault where they lock collateral assets, such as ETH, BAT, USDC, or WBTC. They can generate DAI as a debt against the collateral they have locked. This debt accrues interest over time, called the stability fee, at the rate set by Maker’s MKR token holders. Yield farmers may use Maker to mint DAI for use in yield farming strategies.

3. Aave

Aave is a decentralized protocol for lending and borrowing. Interest rates are algorithmically adjusted based on current market conditions. Lenders receive “aTokens” in exchange for their funds. These tokens begin earning and compounding interest immediately upon deposit. Aave also allows for other advanced features, such as flash loans.

4. Uniswap

Uniswap is a decentralized exchange (DEX) protocol that enables trustless token swaps. LPs deposit the equivalent value of two tokens to create a market. Traders can then trade against that pool of liquidity. In exchange for providing liquidity, LPs earn fees from the trades that occur in their pool.

5. Curve Finance

Curve Finance is a decentralized exchange protocol designed specifically for efficient stablecoin swaps. Curve aims to allow users to make large stablecoin swaps with relatively low slippage.

6. Yearn.Finance

Yearn.finance is a decentralized ecosystem of aggregators for lending services, such as Aave and Compound. It aims to optimize token lending by algorithmically finding the most profitable lending services. Funds are converted to yTokens upon deposit and then rebalanced periodically to maximize profit. Yearn.finance is useful for farmers who want a protocol that automatically chooses the best strategies for them.

7. Synthetix

Synthetix is a protocol for synthetic assets. It allows anyone to lock up (stake) Synthetix Network Token (SNX) or ETH as collateral and mint synthetic assets against it. Synthetic assets can be thought of as tokenized derivatives that use blockchain technology to replicate the value of their underlying assets. As such, they provide an accessible way to hold and trade assets without actually owning them. Virtually any financial asset, such as stocks, altcoins, or options contracts, can be added to the Synthetix platform.

Closing Thoughts

Yield farming plays a role in the evolving DeFi ecosystem and contributes to the development of new financial services. By providing liquidity to decentralized platforms, individuals participating in yield farming contribute to the overall liquidity and efficiency of the DeFi market. It also allows individuals to earn rewards in the form of cryptocurrency for their participation.

Yield farming promotes financial inclusion by allowing anyone with an internet connection and cryptocurrency to participate in the DeFi revolution. It provides an alternative to traditional financial systems, giving individuals greater control over their funds and the ability to earn passive income.

Further Reading

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