In this article, we will explain what Yield Farming is, how it works, and the risks involved. We will also briefly cover some of the most important yield farming platforms and protocols.
What Is Yield Farming?
With the DeFi movement at the forefront of innovation in the blockchain space, more and more concepts have emerged. Yield Farming is among them, but what does it actually mean?
Simply put, Yield Farming is a way to generate rewards with cryptocurrency holdings. Often referred to as liquidity mining, yield farming is a process that allows cryptocurrency holders to lock up their funds and earn variable or fixed interests.
Think of loans that are made via banks using fiat money. The amount that is lent out is paid back with interest. When it comes to yield farming, the cryptocurrency that would otherwise sit in an exchange or wallet is lent out through DeFi protocols to get a return.
Yield Farming is typically carried out using ERC-20 tokens on Ethereum, and the rewards are usually a form of ERC-20 token since most current yield farming transactions happen in the Ethereum ecosystem.
How Does Yield Farming Work?
Yield farming is closely related to AMMs, and in most cases, it involves liquidity pools and liquidity providers. The first step in yield farming is adding funds to a liquidity pool. Such a pool powers a marketplace where users can borrow, lend, or exchange tokens.
Since using a platform of this type incurs fees, liquidity providers are rewarded with the generated fees in return for locking up their funds in the pool. The rewards are paid out based on the liquidity provider’s share of the liquidity pool and the protocol’s rules.
The funds deposited into a liquidity pool are typically stablecoins pegged to the USD, such as USDC, USDT, and DAI. Some protocols even mint tokens that represent the deposited coins. For example, if you deposit ETH to Compound, you will get Compound ETH or cETH.
On top of fees, liquidity providers are further incentivized to add funds to a pool by earning rewards in a token that is not on the open market.
Annual Percentage Rate (APR) and Annual Percentage Yield (APY) are some of the commonly used metrics to estimate the yield farming returns. The difference between the two metrics is that APY takes into account the so-called effect of compounding, which means directly reinvesting profits to generate more returns, while APR doesn’t.
Yield Farming Strategies
Yield farmers use different strategies to generate a high yield on capital. These strategies can be combined to further increase the yield. Yield farmers can also swap coins for other coins that generate more yield or move their funds around protocols, which is known as crop rotation.
Yield farmers take one or more of the following steps to generate higher returns:
- Lend and borrow – for example, a yield farmer can supply a stablecoin like USDC on a lending platform and get a return. Some popular DeFi platforms, such as Compound, reward investors with tokens for both supplying and capital borrowing. Yield farmers can thus make a deposit and then borrow against it to earn tokens.
- Supply capital to liquidity pools and reinvest the rewards for higher returns.
- Stake LP tokens – several DeFi protocols, including, Synthetix, Ren, and Curve, incentivize yield farmers by allowing them to stake their LP tokens.
Yield Farming Risks
Yield farming is not free of risks and the strategies that generate higher returns are complex and only recommended for advanced users. Some of the risks involved are the following:
- Liquidation risks – when borrowing assets, you’re required to put up collateral in order to cover your loan. If the collateral’s value drops below the threshold set by the protocol, the collateral may be liquidated.
- Impermanent loss – when a farmer supplies liquidity to an LP and the price of the invested assets changes after the deposit time, an impermanent loss occurs.
- Smart contract risks, such as smart contract bugs, admin keys, systemic risks, and platform changes.
- DeFi specific risks, such as attacks on liquidity pools.
Yield Farming Protocols and Platforms
Yield farmers typically use various DeFi platforms to optimize the returns on their staked funds. Some of the most popular yield farming platforms include:
Compound is an algorithmic money market protocol for lending and borrowing assets. Anyone with an Ethereum wallet can supply assets to its liquidity pools and earn rewards. The characteristic that sets Compound apart is that these rewards begin compounding immediately.
MakerDao is a decentralized credit platform that supports the creation of DAI (a stablecoin that is algorithmically pegged to the value of USD). It lets users lock their crypto as collateral assets to borrow this stablecoin. The so-called “stability fee” is the form in which this interest is paid.
Uniswap is a decentralized exchange and an automated market maker where users can swap almost any type of any ERC20 token pair and do so without intermediaries. A liquidity provider must deposit an equivalent value of two tokens in order to create a market. The LP then earns fees from the transactions that take place in that pool.
This is a decentralized lending and borrowing protocol that makes it possible for users to borrow assets and earn compound interest for lending in AAVE.
Synthetix is a synthetic asset protocol that lets anyone create synthetic crypto assets via oracles. This can be done for almost all traditional finance assets that have a reliable price feed.
This is a liquidity pool that offers flexible staking, which means that lenders aren’t required to add liquidity equally to both pools. Instead, they can use varying token ratios and create customized liquidity pools.