Note: This article is not financial advice. The Hubble protocol does not support any tokens or platforms mentioned in this article.
The central theses
- Yield farming involves providing liquidity on a DEX.
- Users earn reward tokens in addition to the fees they earn from trading while yield farming.
- Yield farming can be risky and produce mixed results due to several factors.
Yield farming is a decentralized finance (DeFi) primitive introduced in the summer of 2020. It’s a way for projects to incentivize users to provide liquidity, and it’s also a way a user can earn a project’s tokens to hedge the risks of becoming a Liquidity Provider (LP).
Providing liquidity to a project that will be rewarded with that project’s tokens is one of the most widely used strategies in DeFi. When users believe in a project’s mission, they want to keep that project’s tokens; Otherwise, they can also trade the tokens they receive to get instant rewards.
The Basics of AMM Crypto Swaps
DeFi swaps rely heavily on user-provided liquidity. A Crypto Automated Market Maker (AMM) is one of DeFi’s most decentralized tools for exchanging tokens without the need for an intermediary (like a centralized exchange).
AMMs have historically been the most commonly used models for Decentralized Exchanges (DEXes). However, an AMM requires users to provide tokens to facilitate exchanges or it may not work. This is where liquidity providers play a role in a DEX.
Providing liquidity usually involves escrowing a project’s token and another token, typically a stablecoin, in a DEX liquidity pool, such as Raydium or Orca on Solana. When users provide liquidity on an AMM, they receive an LP token as a “receipt” of their deposit.
Raydium Solana Exchange: one of the largest decentralized exchanges for creating liquidity pools on Solana.
Token users deposited in a liquidity pool are used to facilitate swaps and users earn trading fees on each swap utilizing this pool. In return, the LP token charges fees in tokens from users performing swaps utilizing its liquidity. When a liquidity provider returns its LP token to a DEX, it receives its deposited tokens plus additional tokens from fees.
However, to incentivize their own pools and attract liquidity, AMMs and protocols can offer additional token rewards to depositors. This way, users are incentivized to deposit into these pools to earn more rewards on top of trading fees. This mechanism is known as “yield farming”.
Use liquidity to participate in yield farming
Once users provide liquidity to a DEX liquidity pool, they receive a deposit receipt in the form of an LP token. This token can stay in a user’s wallet until they redeem it for their escrowed tokens, or they can “farm” it by wagering the LP token to earn rewards.
Earning token rewards by staking an LP token is the foundation of DeFi yield farming. There are several places where users can deposit their LP tokens to earn liquidity mining rewards.
Example of a USDH-USDC Saber LP token. When users add liquidity to this pool, they receive this LP token in their wallet as proof of deposit.
The DEX, where users provide liquidity, can provide their own token as a reward for depositing LP tokens on their platform. For example, if a user deposits their LP token on Raydium, they may be able to earn $RAY rewards.
The project they provided liquidity for can also reward users for depositing an LP token. For example, if users deposit X tokens on Orca, they may be able to earn X token rewards in addition to the $ORCA rewards.
Steps to Earn Crypto Yield Farming Rewards
DeFi yield farming requires several mouse clicks to get started. Here is a quick overview of the steps needed to get started with DeFi yield farming:
- Acquire a project’s tokens and the same amount of stablecoins.
- Deposit project tokens and stablecoins in a DEX liquidity pool to get an LP token.
- Stake the LP token to earn rewards for mining liquidity from a DEX and/or other protocol.
- Start earning yield farming token rewards as soon as LP tokens are wagered.
Here on Atrix Finance, the user can see how much $LDO rewards they earn after using Atrix stSOL-SOL LP.
Users can typically collect, claim, or harvest rewards at any time. They can keep these reward tokens to support the project, or they can exchange these rewards for stablecoins or other tokens at the time of receipt.
Another option is to combine yield farming crypto rewards into one LP position. This increases the amount of liquidity provided and increases the earning potential for rewards for providing more liquidity.
There are projects like the Tulip Protocol on Solana that automatically compound rewards so users don’t have to.
Tulip’s Auto Vaults: Auto compound liquidity pool rewards on Solana.
Yield Farming VS Staking
Yield farming and staking are two different strategies to generate income in crypto. As mentioned earlier, yield farming in DeFi is a way to attract liquidity and bootstrap crypto swaps.
On the other hand, staking is essential for Proof of Stake (PoS) blockchains like Solana. Staked Layer 1 tokens, like $SOL or $ETH, are used to validate transactions on the blockchain, and users who stake tokens are rewarded for helping the blockchain function securely.
For example, Solana’s staking validators currently offer a staking yield to any $SOL delegator who provides tokens for staking. This income can be variable and is compensated in $SOL.
Ultimately, yield farming incentivizes people to help DEXs run token exchanges, while staking incentivizes people to validate a PoS blockchain’s transactions.
The Risks of Crypto Yield Farming
DeFi yield farming may seem like a way to earn passive income, but it’s far from a “set and forget” strategy. Users should monitor their yield farming crypto position and make sure they have a plan as to why they are providing liquidity in a pool.
Impermanent Loss (IL) is one of the biggest risks in yield farming. This happens when the total value of tokens deposited by users (e.g. SOL-USDH) deviates from their original price upon entry.
This loss is impermanent because if the LP token recovers its original price, the loss is negated or minimal. Yield farming rewards can help reduce the impact of IL on a user’s position.
It is also useful to know that studies have shown that most yield farmers leave their positions within the first 48 hours of the bounty program starting. Rewards will decrease as more people participate in the same yield farming pool, and as many of these users trade their reward tokens for stablecoins, the token’s market value may decrease.
Users should always do their own research (DYOR) before yield farming. As always, never participate in DeFi with more than you can afford to lose.
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