What is yield farming?
Yield farming is an investment practice where crypto is locked into a dApp (decentralized application) for tokenized rewards. Yield farmers deposit their tokens into DeFi applications for crypto trading, lending or borrowing. Because these investors improve liquidity in their chosen dApp, they are referred to as liquidity providers.
The crypto that farmers deposit into DeFi protocols will be locked into autonomous smart contracts. Until a yield farmer withdraws their funds, they receive crypto rewards for their service. This crypto can come from network fees, loan interest payments, or native token rewards. Each dApp has different rules for how long a yield farmer must wait when deciding to withdraw their funds.
Compound, a DeFi lending platform, is credited with inventing yield farming in 2020. However, Compound only introduced liquidity mining to the DeFi ecosystem.
yield farming And liquidity reduction usually go hand-in-hand, but the latter refers to unique protocol-specific token rewards. In addition to regular interest payments and fees, Compound began offering farmers its proprietary COMP governance token. It is common these days for DeFi platforms to offer their tokens via liquidity mining alongside yield farming opportunities.
For most DeFi protocols, yield farming is a strong incentive to generate liquidity. Success at DeFi can be measured by the Total Value Locked (TVL) in a dApp. TVL refers to the funds that investors locked into the protocol with the expectation of token rewards. The higher the TVL, the more money is used for a DeFi project.
New dApps require outside funding to scale their operations, and they are usually willing to pay high returns to early contributors. This is especially the case when new projects issue their tokens, as they control token issuance. Yield farmers must hope that these token rewards will increase in value as their DeFi protocol attracts more users.
How does yield farming work?
When someone starts crypto yield farming, they deposit their tokens in a DeFi protocol.
Once a yield farmer’s funds are in a smart contract, they are available to anyone using the dApp. For example, if someone adds crypto to a liquidity pool on a decentralized exchange (DEX), crypto traders can buy and sell their tokens. Web3 users can also borrow crypto that a yield farmer deposits on a DeFi lending site like Aave.
People are choosing to give their cryptos to DeFi platforms because they expect returns. Yield farmers typically receive a percentage of a network’s fees or interest payments deposited into their crypto wallet. Also, it is common for DeFi sites to send some of their governance tokens as a bonus.
Most DeFi sites report expected returns as annual percentage returns (APY). This percentage informs investors about the approximate annual returns they can expect for depositing their tokens in a selected DeFi liquidity pool. In general, higher APY means high risk, so individuals should be wary of advertised numbers well in excess of what could be sustainable.
Many yield farmers hop from log to log and act as mercenaries for higher APY. Many protocols increase rewards to attract liquidity. This creates an unstable environment as many protocols will collapse once their incentives cease and liquidity drains.
Remember that APY Crypto incorporates compound interest into its equation. However, Annual Percentage Rates (APRs) do not account for compound interest.
How to participate in yield farming
If you want to participate in yield farming, you need a private crypto wallet that connects to your favorite blockchain. Most yield farming activity takes place on Ethereum (ETH), so high quality Ethereum wallets like MetaMask are suitable for most yield farming dApps.
After setting up your crypto wallet, you can visit a DeFi site where you can add liquidity to the protocol. Those on DEXs like Uniswap can add a 50/50 token trading pair to a liquidity pool. Whenever someone trades the tokens in your pool, you receive a percentage of the trading fees.
When on Aave, you can borrow your crypto to earn an interest rate. Some DeFi sites allow users to stake governance tokens to secure their log. Since most DeFi sites use a Proof-of-Stake (PoS) algorithm, they typically require people locking the native cryptocurrency on-chain to secure their site.
Risks of Cryptocurrency Farming
Crypto yield farming attracts many investors thanks to the promise of high APYs. Three-digit APYs are not uncommon on yield farming sites, but they often get new users into trouble. But before depositing crypto into a liquidity pool, take a look at the risks associated with yield farming:
- Price volatility: Unless you use stablecoins, the market value of the tokens you deposit into liquidity pools will rise or fall over time. Even if you get 1,000% APY, what’s the point if the token you hold goes to zero? DeFi protocols often offer ridiculously high APYs because they are the ones issuing the token rewards. You must always hope that the crypto you receive will at least retain its value in order to earn your predicted APY.
- Temporary Loss: This refers to losing massive profits for the crypto you deposited in a yield farm. In other words, you would have made more money simply holding a cryptocurrency than the rewards you received for yield farming.
- Smart contract error: Smart contracts are only as secure as their underlying code. Yield farmers must always trust the smart contracts they use. For example, the contracts do not have any weaknesses that could potentially drain their funds.
- Rugpulls and Fraud: Given the lack of regulation in DeFi, it is relatively easy for scammers to market fake dApps promising high APYs to liquidity providers. Sometimes these dApp creators take the deposits of the crypto yield farmers and disappear (or pull the carpet). Liquidity providers need to be extra wary of fraud, especially for small projects.
What are yield farming logs?
Countless DeFi sites offer yield farming and liquidity mining, but here are some of the biggest (at the time of writing):
- Uniswap: Uniswap is based on Ethereum and is the first and largest DEX in DeFi. Anyone can deposit token pairs into Uniswap’s liquidity pools to provide users with tradable crypto assets. You need to deposit 50/50 of the two tokens you want to lock in Uniswap’s smart contracts to earn a portion of the trading fees.
- Curve financing: Curve Finance is another DEX on Ethereum, but this protocol prioritizes stablecoin trading. When crypto traders want to trade different stablecoins, they often use Curve Finance to enable safe trading with minimal slippage. People interested in earning rewards on stablecoins will be most interested in Curve Finance’s yield farming options.
- Spirit: Aave is also a large DeFi lending platform on Ethereum. Individuals interested in earning interest on Aave can borrow their cryptos via smart contracts. It also has a staking portal where AAVE token holders can earn rewards for securing its network.
- pancake swap: It is a prominent DEX on the BNB Smart Chain, almost identical to Uniswap. The only difference between Uniswap and PancakeSwap is that the latter offers BEP-20 token pairs. Many retail investors prefer PancakeSwap over Ethereum DEXs as gas fees are usually cheaper on the Binance Smart Chain.
Is crypto yield farming worth it?
Crypto yield farming can be profitable if investors are familiar with DeFi. However, providing liquidity to DeFi protocols with solid fundamentals, a strong community, and a commitment to transparency is usually only beneficial. APYs on top-tier platforms are unlikely to be as high as new DeFi protocols, but users are less likely to lose all their crypto as they are more battle-hardened and don’t rely as much on unsustainable incentives.
Keep in mind that yield farming is an inherently risky investment strategy. Even if you stick with top-tier DeFi sites like Uniswap, there’s no guarantee you’ll be making more crypto in the long run.
Wrap up
Yield farming allows crypto owners to earn passive income from their tokens without providing KYC data. However, remember that crypto yield farming comes with significant risks. Also, any profits you make from yield farming activities may be taxable.
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