CoinCodex on Binance Feed: What is Yield Farming in Crypto? DeFi yield farming explained

If you’ve been around the DeFi (decentralized finance) space, you’ve probably heard the term “yield farming.” However, the term is used quite loosely and it is not always clear what it refers to.

Yield farming is the practice of using DeFi protocols to earn token rewards by providing liquidity, staking or lending tokens. Often, savvy yield farmers combine multiple DeFi protocols to maximize yield. Yield farming usually refers to more passive investment strategies rather than day trading.

We give you an overview of yield farming and explain where the term comes from. In addition, we will outline the different types of income opportunities available in DeFi.

What is yield farming?

The term “yield farming” began to gain traction in 2020 during the “DeFi summer,” a time in the cryptocurrency markets when the popularity of decentralized finance protocols exploded. One of the major events that started the DeFi craze in 2020 was the launch of the Compound protocol’s COMP token, which was distributed to the protocol’s users based on their on-chain activity.

Worldwide search interest for “yield farming”. Image source: Google Trends

To attract users, other DeFi protocols also launched programs to distribute tokens (usually a governance token for the protocol itself) to liquidity providers. Such programs are commonly referred to as “liquidity mining”. For example, users who provided liquidity to Balancer’s token pools were able to earn the protocol’s governance token BAL.

DeFi participants began using the term “yield farming” to refer to strategies for maximizing yield in DeFi through opportunities such as liquidity mining, staking, and lending. Meanwhile, developers started creating products that would help users to automatically maximize their DeFi yields, with the most notable example being Yearn Finance.

Even if the term “yield farming” isn’t used as much today as it was during the height of the DeFi summer, the concepts behind it still apply and savvy users can earn solid profits by participating in liquidity mining, staking, and similar schemes.

As an interesting side note, we can point out that many DeFi protocols used names related to fruits and vegetables, for example Yam Finance. That could have been a playful reference to yield farming.

How can I earn returns in DeFi?

Now let’s go through the different types of income opportunities available to users in the decentralized finance space.

liquidity reduction

Liquidity is paramount for DeFi protocols. High liquidity protocols enable efficient transactions between different types of tokens with minimal price impact. However, the market is already saturated with a multitude of DeFi protocols looking to grab their share of the liquidity pie.

Many projects have chosen to adopt liquidity mining to increase the liquidity of their log. In most cases, liquidity mining programs require users to provide liquidity to specific liquidity pools. In addition to the standard rewards for providing liquidity derived from trading fees generated by the liquidity pool, liquidity providers also receive the protocol’s governance tokens.

You can easily spot liquidity mining opportunities by using DeFi aggregators like DeFi Llama or APY.Vision.

loan

DeFi lending protocols allow you to earn income by lending your tokens to other users. Typically, the largest returns are offered for stablecoin lending, and lending other types of tokens is less lucrative. Some of the best DeFi lending protocols to explore are Aave and Compound. Of course, you can also borrow tokens from these protocols, but you will have to pay interest.

Mark out

While we’re expanding the definition of DeFi a bit here, it’s also possible to earn returns through staking rewards. If you don’t have the 32 ETH needed to start your own Ethereum validator, you can deploy your ETH through a decentralized protocol like Lido. Liquid staking protocols like Lido provide you with tokens representing your staked ETH to use as you please.

The Benefits of Crypto Yield Farming

The most appealing aspect of yield farming is that it allows you to passively grow your crypto stash, making it a compelling option if you don’t want to sell your crypto but want to get it working.

The barriers to entry are usually very low. As long as you have your own wallet with some crypto, you can start yield farming. Typically, there are no capital requirements to participate in yield farming, so you can start with small amounts of capital.

When using DeFi protocols, you have more control over your funds as you have to approve all transactions from your wallet. In contrast, a lot of trust is required when using centralized revenue-generating products like Binance Earn.

The Risks of Yield Farming

Typically, any opportunity to make a profit comes with a number of risks, and the crypto yield farming opportunities are no different.

An important risk to consider when interacting with DeFi protocols is smart contract risk. If a smart contract contains vulnerabilities in its code, savvy hackers can exploit it to steal funds from the protocol. These smart contract exploits can easily result in tens of millions of dollars in losses. Because blockchain transactions are irreversible, users often have very few options to get their funds back.

Unless you have a very in-depth knowledge of smart contracts, you probably won’t be able to identify vulnerabilities yourself. Therefore, it might be a good idea to stick with DeFi protocols that have been in operation for a long time and have a good track record when it comes to security. The problem here is that the most attractive returns are usually offered by relatively new and unproven protocols, so the choice of which protocol to use depends on your risk appetite.

When using DeFi to farm, you typically need to hold tokens with significant price volatility. If the market value of your tokens falls sufficiently, you could still incur an overall loss, even if you’ve technically increased your token holdings through yield farming.

Providing liquidity via automated market maker (AMM) protocols like Uniswap carries the risk of temporary loss – in some cases simply holding tokens yields better results than depositing them into a liquidity pool. There is less risk of temporary loss when you provide liquidity for assets that tend to range in price.

Conclusion: Yield farming is a great way to earn passively with DeFi

As we have shown, yield farming refers to various methods of yield generation in decentralized finance through opportunities such as liquidity extraction, lending and staking. By participating in liquidity mining programs, you can earn a protocol’s governance tokens in exchange for providing liquidity to specific pools. In the meantime, you can also lend your crypto through DeFi lending protocols or stake your ETH to earn staking rewards.

While yield farming can be potentially lucrative, it is important to recognize the risks associated with DeFi. The biggest risks for yield farmers are price volatility and smart contract exploits.

If you’re looking for other types of passive investing, check out our list of the best dividend stocks for long-term investors.

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