What is yield farming?
Yield farming is a high-risk, volatile investment strategy in which investors stake or lend cryptocurrency assets on a decentralized finance (DeFi) platform to earn a higher return. An investor can receive payment in additional cryptocurrency for the return.
Yield farming has become increasingly popular due to applications such as liquidity mining, where crypto assets are loaned to a decentralized exchange in exchange for incentives. Yield farming was once the biggest growth driver of the fledgling DeFi sector, but has lost most of its hype in 2020 following the collapse of the TerraUSD stablecoin in May 2022.
The central theses
- Yield farming is a high-risk, volatile investment strategy in which an investor stakes or lends crypto assets on a decentralized finance (DeFi) platform to earn a higher return.
- An investor receives the return in additional cryptocurrency.
- Yield farming is the biggest growth driver of the DeFi sector and is estimated to be worth $6 billion in 2022.
How does yield farming work?
Yield farming allows investors to earn yield by placing coins or tokens on a decentralized application or dApp, thereby providing liquidity to different token pairs. Some examples of this include cryptocurrency wallets, decentralized exchanges (DEXs), and decentralized social media.
Yield farmers typically rely on DEXs to lend, borrow, or stake coins – an exercise that allows them to earn interest and speculate on price fluctuations. Smart contracts across DeFi are paving the way for yield farming.
The top-yielding farming protocols include Aave, Curve Finance, and Uniswap.
History of cash crop farming
In June 2020, the Ethereum-based lending market known as Compound began issuing COMP, an ERC-20 asset that enables community governance of the Compound protocol, to the protocol’s users.
This type of asset is called a “governance token” and offers holders voting rights, giving them power over platform changes. Interest in the token increased its popularity and propelled Compound to the leading position in the DeFi space. The term “yield farming” was then coined.
Roles played by yield farmers
A revenue farmer can perform several functions. They can be liquidity providers, lenders, borrowers and stakers.
A liquidity provider, which can work for exchanges like Uniswap or Pancakeswap, comes into play after users deposit two crypto coins to a DEX to facilitate trading liquidity. The exchange charges a fee for swapping these two tokens, which the liquidity provider then receives, or they may receive new liquidity pool (LP) tokens. A yield farmer is a lender when coin or token holders lend cryptocurrencies to borrowers using a smart contract and protocols such as Compound or Aave, ultimately earning a return on the interest paid on the loan.
On the other side, of course, are borrowers, which arise when farmers use one token as collateral and then lend them another token. This activity allows users to farm the yield using the borrowed coin(s). This means that the farmer retains his original possession, which could increase in value, and also receives a return on the borrowed coins.
The easiest way to become a staker and earn stake rewards is to do so through a crypto exchange like Coinbase. With proof-of-stake blockchains, the user earns interest when they pledge their tokens to the network as a security measure.
Cryptocurrency exchange Kraken has suspended its US stake-as-service business following regulatory action by the US Securities and Exchange Commission (SEC). Coinbase is also under regulatory scrutiny but claims that its staking services are not comparable to securities.
Another way to become a staker is for the user to earn double returns as they receive a payment for introducing liquidity into LP tokens, which they can also stake and thus earn more returns. They stake LP tokens that are accumulated by providing liquidity to DEXs.
Risks of cash crop farming
Yield farming poses financial risks for borrowers and lenders. For example, when crypto markets are volatile, users may experience losses and price outages.
Risks you should be aware of include:
- “Rug Pulls,” a type of exit scam in which a crypto developer raises investor funds for a project and then abandons it without returning the funds to investors;
- Regulatory risks, such as if the SEC or state regulators attempt to police yield farming and issue cease-and-desist orders against crypto lending sites like Celsius and BlockFi;
- Turbulence, which is market fluctuations and the tendency to move downwards, that can occur with most investments as they lose value.
What is Decentralized Finance (DeFi)?
Decentralized Finance (DeFi) is an emerging financial technology based on secure distributed ledgers similar to those used by cryptocurrencies. In the US, the Federal Reserve and the SEC set the rules for centralized financial institutions such as banks and brokers. DeFi challenges this centralized financial system by enabling individuals to have peer-to-peer digital exchanges through which they can buy, sell and transfer digital assets. DeFi also eliminates the fees that banks and other financial companies charge for using their services.
What are decentralized applications (dApp)?
Decentralized applications (dApps) are digital applications or programs that exist and run on a blockchain or peer-to-peer (P2P) network of computers rather than on a single computer. DApps (also called “dapps”) are therefore outside the jurisdiction and control of any single authority. DApps – which are often based on the Ethereum platform – can be developed for a variety of purposes, including gaming, finance and social media.
What are Bitcoin Decentralized Exchanges (DEX)?
Decentralized Bitcoin exchanges operate without a central authority. They enable peer-to-peer trading of digital currencies without the need for an exchange authority to process the transactions. The benefits of a decentralized exchange include: Many cryptocurrency users believe that decentralized exchanges better fit the decentralized structures of most digital currencies and that they require less personal information from their members than other types of exchanges. But such exchanges, like all cryptocurrency exchanges, must maintain a basic level of user interest in trading volume and liquidity.
The conclusion
Yield farming is a high-risk investment strategy in which the investor provides liquidity, staking, lending or borrowing in cryptocurrencies on a DeFi platform in order to achieve a higher return. Investors can receive payments in additional cryptocurrency. Its popularity has waned and returns have been muted since peaking in 2020 following the collapse of the TerraUSD stablecoin last year. But only the smartest investors can withstand drawbacks like volatility, rug pulls, and regulatory risks.
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