From Alan
Yield farming is an umbrella term that describes the act of seeking yield in the DeFi space.
As users explore the DeFi space, some will begin to strategize to earn a higher return on their assets. We call that yield farming.
In this guide we cover the following:
- What is yield farming?
- What is incentive-based liquidity?
- What is an example of yield farming?
- What are the risks of yield farming?
What follows is not investment advice.
What is yield farming?
Yield farming does not refer to a specific process, but to the general idea of generating returns through a combination of staking, lending, and borrowing. These strategies give “farmers” additional returns. The opportunity for high rewards comes with risks.
The easiest way to yield farm is to use yield aggregators like Yearn to do the behind-the-scenes work for you. You can deposit a variety of assets with Yearn and they will use strategies to passively earn returns.
If you are interested in a more active strategy, you can choose your own way to balance risk and reward. DeFi users are not locked into one protocol. This allows users to create a yield strategy across different protocols. We will go through examples of yield farming strategies as well as the risks involved.
Yield farming is a more advanced topic within DeFi. Let’s look at a few terms:
- Liquidity Providers (LPs): LPs provide assets to a decentralized exchange (DEX) to enable trading. Check out our guide if this is a new concept to you.
- Borrow and Borrow: This is similar to lending and borrowing from a traditional bank. DeFi is about posting collateral (lending) and having the ability to borrow against it. Read our guide to lending and borrowing assets.
- Mark out: Staking means locking your tokens. This can be done to secure a proof-of-stake network. Staking can also be done at the log level to encourage users to hold a token. Our staking guide can be found here
What is incentive-based liquidity?
A common type of yield farming is when liquidity providers are incentivized to add liquidity to a platform. Let’s look at a simple example:
Odyssey wants to start a token $ODY. Users can go to a DEX like Sushiswap and add $ODY and ETH to a liquidity pool. If it is a new token, volatility will likely be high, leading to higher risk.
If Odyssey cannot increase liquidity, its token cannot be used in the market. Odyssey wants to offset the risk of LPs and is offering a reward of $ODY100,000/day for 20 days. This reward is split between liquidity providers. If there are only a few providers at first, everyone gets a big reward.
Experienced yield farmers will see this high yield and add liquidity to get a share of these rewards. This will increase the liquidity of $ODY. It may not be sustainable as the rewards are limited. LPs are not locked, so if they find better rewards elsewhere they can sell their tokens and move on at any time.
This is referred to as liquidity reduction. In addition to protocols offering rewards for specific pools, DEXs can offer rewards in their native token to attract capital to their platform. On SushiSwap you will see pools that pay out sushi token rewards.
Protocols that add incentives in their native token are not exclusive to DEXs. Lending and lending platforms use a similar incentive. Compound pays out their native $COMP token to depositors and borrowers to incentivize users.
These strategies mentioned above are simple versions of yield farming, some people choose to add complexity to get a higher return. Let’s look at an example.
What is an example?
We build on the example mentioned in the article: How to lend and borrow assets?
In this example, we deposited 10 DAI on Aave Polygon and borrowed 2.5 MATIC. Rather than keep the Matic simple, let’s look at how we can use it to generate additional returns.
1. Add borrowed Matic to SushiSwap Farm
We go to SushiSwap and see a MATIC and ETH farm with an APY over 14%. The term “farm” means a liquidity pool where you can stake your LP tokens to earn additional rewards. The fields below are TVL, Farm Rewards and APY.
The Farm Rewards column shows additional incentives for staking your LP tokens over and above trading fees. In this farm, a daily reward of 725.2 sushi and 12.09 matic is shared between all “farmers” using LP tokens.
First, we will exchange half of our MATIC tokens (1.25 MATIC) to WETH as shown below.
Then the same amounts are taken from MATIC and WETH and deposited into the liquidity pool.
Once we confirm adding liquidity, our wallet will ask us to confirm the transaction and the gas fee. We then get SLP, which are the tokens that represent our share of the liquidity pool.
The final step is to stake our SLP tokens as shown above. This allows us to earn the farm rewards of Sushi and MATIC.
In this yield farming example, we achieved yield in the following way:
- Earn a return on our deposit of 10 Dai in Aave
- Providing liquidity and earning trading fees of the pool with Matic and Ether
- Earn farming rewards by wagering our LP tokens
Our costs for this example are:
- Interest on the borrowed Matic tokens in Aave
- Gas fees for entering transactions and gas fees when we process transactions.
This example shows portability in DeFi. We can use multiple protocols and tokens to find additional returns, but it is not without risk.
The more protocols and smart contracts you use, the more risk you take.
What are the risks?
Risks of yield farming include:
- Smart Contract Risk: Cyber attacks and technology bugs, especially common in unverified code
- Inconstant Loss: Losses caused by price volatility in a liquidity pool
- liquidation of the borrower: If the value of the collateral falls below a certain threshold during the borrowing process, there is a risk that the collateral will be liquidated. Leverage increases risk.
- High transaction fees: Gas costs eat into returns, especially when multiple transactions are involved. This is most prevalent on the Ethereum mainnet
Yield farming is a delicate act of balancing risk and return on your capital. It is important to understand the risks associated with advanced strategies and leverage. Proceed carefully!
Next: How to avoid getting rect in DeFi?
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