What Is Yield Farming?
What You Need To Know
The world of DeFi is complex, but some users have learned tactics to make their cryptocurrency generate as much income as possible
Yield farming is the process of using decentralized finance (DeFi) to maximize returns. Users lend or borrow crypto on a DeFi platform and earn cryptocurrency in return for their services.
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.
Yield farming is the process of token holders maximizing rewards across various DeFi platforms. Yield farmers provide liquidity to various token pairs and earn rewards in cryptocurrencies. Top yield farming protocols include Aave, Curve Finance, Uniswap and many others. Yield farming can be a risky practice due to price volatility, rug pulls, smart contract hacks and more.
How does yield farming work?
Yield farming allows investors to earn yield by putting coins or tokens in a decentralized application, or dApp. Examples of dApps include crypto wallets, DEXs, decentralized social media and more.
Yield farmers generally use decentralized exchanges (DEXs) to lend, borrow or stake coins to earn interest and speculate on price swings. Yield farming across DeFi is facilitated by smart contracts — pieces of code that automate financial agreements between two or more parties.
Types of yield farming:
Liquidity providerUsers deposit two coins to a DEX to provide trading liquidity. Exchanges charge a small fee to swap the two tokens which is 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.
StakingThere 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.
BorrowingFarmers can use one token as collateral and receive a loan of 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.
Calculating yield farming returns
Expected yield returns are usually annualized. The prospective returns are calculated over the course of a year.
Two often-used measurements are annual percentage rate (APR) and annual percentage yield (APY). APR does not account for compounding — reinvesting gains to generate larger returns — but APY does.
Keep in mind that the two measurements are merely projections and estimations. Even short-term advantages are difficult to forecast with accuracy. Why? Yield farming is a highly competitive, fast-paced industry with rapidly changing incentives.
If a yield farming strategy succeeds for a while, other farmers will flock to take advantage of it, and it will ultimately stop yielding significant returns.
Because APR and APY are outmoded market metrics, DeFi will have to construct its own profit calculations. Weekly or even daily expected returns may make more sense due to DeFi’s rapid pace.
VolatilityVolatility 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.
What is impermanent loss?
During periods of high volatility, liquidity providers can experience impermanent loss. This occurs when the price of a token in a liquidity pool changes, subsequently changing the ratio of tokens in the pool to stabilize its total value.
Alice deposits 1 ETH and 2,620 DAI (US dollar stablecoins: 1 DAI = $1) into a liquidity pool because the value of one ether is $2,620 (at the time of writing). Say the pool only has three other liquidity providers who have each deposited the same amount to the pool, bringing the total value of the pool to 4 ETH and 10,480 DAI, or $20,960.
Each of these liquidity providers is entitled to 25% of the pool’s funds. If they wanted to withdraw at current prices, they would each receive 1 ETH and 2,620 DAI. But what happens when the price of ETH falls?
If the price of ETH starts to drop, that means traders are selling ETH for DAI. This causes the ratio of the pool to shift so that it is more ETH heavy. Alice’s share of the pool would still be 25%, but she would now have a higher ratio of ETH to DAI. The value of her 25% share of the pool would now be worth less than when she initially deposited her funds because traders were selling their ETH at a lower value than when Alice added liquidity to the pool.
This is called an impermanent loss because the loss is only realized if the liquidity is withdrawn from the pool. If a liquidity provider decides to keep their funds in the pool, the liquidity value may or may not break even over time. In some cases, the fees earned from providing liquidity can offset impermanent losses.
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.
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.