Definition and example of yield farming
Yield farming is a system whereby users can deposit cryptocurrency in a pool with other cryptocurrency users to earn investment returns, most typically through interest earned by lending the pooled cryptocurrency. Yield farming is a very risky strategy with high reward potential.
The central theses
- Yield farming is a method of investing in cryptocurrencies for additional returns.
- Yield farms are decentralized financial investment vehicles based on smart contracts.
- For investors who prioritize aggressive returns, yield farms can offer high interest rates, including in excess of 100%.
- Participating in income farming involves the risk of losing your entire investment.
You can find yield farms through decentralized finance (DeFi) platforms like PancakeSwap or cryptocurrency exchanges like Bitrue.
For example, PancakeSwap offers the opportunity to join yield farms with interest rates ranging from around 2% to over 200% APR. Bitrue also offers yield farms with interest rates in excess of 100% Annual Percentage Rate (APR). These high APRs come from transaction fees, lending rates, or joining a proof-of-stake liquidity pool. But beware: it is possible that you lose your entire investment.
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Cryptocurrencies are a high-risk asset class. It is possible to lose your entire investment, so evaluate every opportunity before investing. The risk and complexity of yield farms make them unsuitable for many investors.
How yield farming works
In many ways, yield farming works like a savings account, where you deposit money with a bank, which then pools and on-lends depositors’ money while you earn interest on the funds you deposit. But instead of being converted into a mortgage or business loan, the cryptocurrency will be invested in smart contract applications in a yield farm.
Smart contracts are types of computer programs that use the blockchain technology that powers most digital currencies.
In yield farming, users pool their currency — the cryptocurrency equivalent of a deposit — with others investing in the same farm. Staking may require you to keep your money invested for a certain period of time. Your cryptocurrency can then be used as collateral or to provide liquidity to mining pools depending on how it is invested.
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Cryptocurrency prices are volatile. It is possible for the value of a currency to fall rapidly while your funds are locked in a liquidity pool or yield farm. This is called a temporary loss.
Yield farming starts with creating a pool of cryptocurrency assets. These are the steps that take place to facilitate yield farming:
- Liquidity pool is created: The first step in yield farming is to create a liquidity pool. This relies on a smart contract that facilitates all investments and borrowing for that specific yield farm.
- Investors deposit assets: Investors can connect their digital wallets to deposit currencies into the liquidity pool. This is sometimes referred to as ‘staking’. This is somewhat similar to how clients make a deposit at a bank or invest in a mutual fund or ETF.
- Smart contract enables borrowing: The smart contract can facilitate several processes including adding liquidity to a cryptocurrency exchange market or lending to others.
- reward payout: Interest, bonuses and rewards may vary depending on the yield farm. They can be paid periodically or on a specific date in the future.
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You may have to pay a small fee when you “harvest” your yield farming rewards.
Examples of yield farming platforms
Yield farms require the use of certain cryptocurrencies that allow participation. Each yield farming provider may have their own rules and protocols. Here are some yield farming providers with unique offerings:
- Spirit: The Aave app allows you to connect your wallet to use or borrow supported currencies. Ethereum-based cryptocurrencies top the list in terms of asset count and liquidity on Aave.
- Connection: Compound is a market where you can borrow Ethe, Dai and other currencies with lower interest rates up to around 3% APY.
- SushiSwap: SushiSwap is a decentralized exchange with opportunities to collect or collect income both by providing liquidity and by lending your currency.
Yield farming vs staking
Staking is a process of depositing cryptocurrency. Any time you earn rewards by holding certain cryptocurrencies, it can be viewed as a form of staking. Depending on the exchange and currency, this may be automatic or require additional steps to make a staking deposit.
Here are some basic differences between staking and yield farming:
| Mark out | yield farming | |
|---|---|---|
| Operation | governance or security of a blockchain or smart contract; pledged cryptos typically used to validate transactions. | Pledged cryptos are typically used to provide liquidity to market makers or DeFi lending platforms. |
| Reward | Staking rewards are usually new cryptos generated as a result of validation. | Yield farming rewards are usually in the form of APR. |
| Multiple pools | Staking pools usually compete with each other as a larger stake allocated to a pool increases its chances of winning the next block. | Yield farmers can use multiple interconnect pools to generate returns through yield aggregators. |
However, staking and yield farming are often used interchangeably as both are effectively ways to earn rewards for pooled cryptocurrency. However, there is one subtle and important nuance worth highlighting here. Some cryptocurrency holders do not wish to receive a return on lending due to belief-based values that prohibit the use of usury or interest from lending. In this case, staking may be an option for them rather than yield farming.
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Not all staking methods are yield farming, but all yield farms rely on some form of staking.
Pros and cons of yield farming
Advantages
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Potential to earn high interest online
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Managed by smart contracts
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Part of the global DeFi system
benefits explained
- Potential to earn high interest online: Yield farms potentially have the potential to generate returns in excess of 100% APY.
- Managed by smart contracts: Smart contracts cut out intermediaries and allow anyone to participate if they have a compatible cryptocurrency wallet.
- Part of the global DeFi system: New decentralized financial applications enable innovative financial products across international borders.
Disadvantages explained
- Risks of Temporary Losses: If a cryptocurrency loses value while you have it locked in a yield farm, your losses are known as fickle losses.
- cheating and fraud: As with other parts of the cryptocurrency ecosystem, bad actors are out to steal funds through fraudulent yield farming and other scams.
- Tax reporting challenges: Cryptocurrency transactions require somewhat complex tracking and reporting, and yield farming only adds to this challenge.
How to start yield farming
These are the steps to take part in yield farming yourself:
- Research investments in farm yields: Start researching potential yield farm investments. You can choose from many different DeFi providers or centralized exchanges to access yield farming markets.
- Connect your wallet or fund your account: You must have a compatible account with the correct currency to participate in a yield farm. For decentralized yield farms, you need to use a compatible wallet like MetaMask or Coinbase wallet. You should buy the currency you want for yield farming from an exchange or transfer it to your account.
- Put your cryptocurrency to work: Once connected or funded, navigate to the relevant yield farm to use your funds. After staking, your currency can be locked in the farm for a certain number of days.
- Gather your earnings: Depending on the yield farm and deposit method, you may need to return to the yield farm website to retrieve your earnings.
Is yield farming worth it?
Yield farming is an interesting way for cryptocurrency enthusiasts to earn a return on their cryptocurrency investment, not just by increasing the value of the currency. However, due to the risks involved, yield farming may not be worthwhile for many investors, especially new investors.
The idea of earning 100%, 200% or more in annual interest can be tempting. However, you should not participate if you do not fully understand how yield farming works and the risks involved. Conduct your due diligence on the exchanges, the coins, and the teams behind the yield farming engagement you will be making. All of these are requirements to mitigate the risks associated with this investment.
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