Defi yield farming is a way to earn more crypto with your cryptocurrency. You lend your money to others using computer programs called smart contracts. In exchange for your service, you receive fees in the form of crypto. Quite simple, right? Well, not so fast.
Decentralized Finance (DeFi) has taken the world by storm due to the sheer innovation and flexibility it brings to traditional finance. One of the more exciting features of DeFi is yield farming. In this guide, you will learn in detail what yield farming is and how you can use it to generate passive income.
What is DeFi Yield Farming?
Yield farming is the practice of using or locking up cryptocurrencies in exchange for rewards. Users can earn either fixed or variable interest by investing crypto in a DeFi market. The idea is to lock funds in a liquidity pool – smart contracts that hold funds. The liquidity pools power the marketplace where users can exchange, borrow or lend tokens. Once you add your money to a pool, you officially become a liquidity provider.
The idea of farming emerged when developers began paying users a small portion of transaction fees for providing liquidity to a specific app such as Uniswap or Balancer. However, the most famous example of yield farming is Compound, where they issued COMP tokens to their lenders and borrowers for using their protocol. It was an instant success and once made Compound the largest DeFi project in the world.
How does yield farming work?
Yield farming could be achieved by following several processes. Let's look at some of the most popular ones.
#1 The standard AMM model
The entire yield farming model is closely linked to the Automated Market Maker (AMM) model, which includes liquidity providers (LPs) and liquidity pools. At its core, an AMM works as follows:
- The liquidity provider deposits funds into a liquidity pool
- The pool is used to operate a marketplace where users can lend, borrow or exchange tokens.
- When using the pools, the user incurs fees, which are then paid out to the liquidity providers.
Although this is the core concept, the implementation may vary from project to project. The total accrued fees are paid to LPs for their services.
#2 Liquidity reduction
Another interesting concept that economically incentivizes LPs is the distribution of a new token or liquidity mining. Let's say there is a token X and it is difficult to get it on the open market. However, by providing liquidity to a specific pool, the LP can receive X tokens as a reward. This could lead LPs to lock their tokens in a pool.
The rules that govern the distribution of these tokens depend on the protocol. However, the basic idea is that they receive a return based on the amount of liquidity they provide to the pool.
The funds locked in the pools are mainly stablecoins such as DAI, USDT, USDC, BUSD, etc. Some protocols may mint tokens that represent the coins you have deposited into their system. For example, if you lick up DAI in Compound, you will receive cDAI.
Yield farming returns: how do we calculate them?
Typically, yield farming returns are calculated on an annual basis. The metrics most commonly used to measure these returns are Annual Percentage Yield (APR) and Annual Percentage Yield (APY). APY typically offers you compound returns, meaning the profits made are directly reinvested to generate more returns. However, keep in mind that all of these APR and APY percentages are just estimates. DeFi is a crazy space and yield farming in particular is highly competitive. Therefore, rewards can fluctuate quickly.
Best Yield Farming Platforms
Now let’s take a look at some of the most popular yield farming platforms. Finally, doing a little research into what you can get through these platforms is a much more sensible strategy than simply blindly investing in them.
Connection
Sign: COMP
TVL: $5.25 billion
Let's start with what started it all. Compound has an algorithmic money market that allows users to lend and borrow assets. Prices in the market are adjusted depending on supply and demand. Anyone with an Ethereum wallet can provide assets to Compound’s pools.
MakerDAO
Tokens: MKR and DAI
TVL: $7 billion
A DeFi market leader and one of the most well-known protocols in the world, Maker is a decentralized lending platform that creates DAI – a stablecoin algorithmically pegged to the USD. Anyone can open a Maker Vault and lock collateral such as ETH, BAT, USDC or WBTC. Locking these collaterals allows users to generate DAI. Over time, generating DAI incurs a fee called a “stability fee.” The MKR token holders determine the interest rate of the fee.
Synthetix
Sign: SNX
TVL: $2.54 billion
Synthetix is a synthetic asset protocol that allows anyone to pledge the SNX or ETH tokens as collateral and mint synthetic assets against them. This makes the Synthetix platform extremely flexible, as any asset that has a reliable price feed is considered a synthetic asset.
Spirit
Sign: SPIRIT
TVL: $5.61 billion
The second largest protocol in the DeFi space is Aave, a decentralized lending and borrowing protocol. In exchange for their funds, lenders receive “aTokens.” Upon deposit, these tokens begin earning and earning interest immediately. One of the more notorious aspects of Aave is quick loans.
Uniswap
Sign: UNIVERSITY
TVL: $4.29 billion
Uniswap is a decentralized exchange (DEX) and was the first Ethereum DEX to exceed $100 billion in 24-hour trading volume. The DEX enables trustless token swaps, where liquidity providers deposit the equivalent of two tokens to create a market. Traders can then use these markets to transact their trades. As a reward for providing liquidity, LPs receive fees for trades that occur within the pool.
Curve financing
Sign: CRV
TVL: $4.30 billion
Another popular DEX protocol is Curve Finance, which is specifically designed for efficient stablecoin swaps. Since stablecoins are always in high demand, users can use Curve to conduct high-quality stablecoin swaps with little to no slippage.
Balancers
Sign: BAL
TVL: $1.48 billion
Balancer is a liquidity protocol that allows custom token allocations in a liquidity pool to create custom balancer pools instead of the traditional 50/50 pools required by Uniswap. Users can even use Balancer to create 98/2 pools! LPs receive fees for the trades that take place in their liquidity pool. Due to its customized nature, Balancer is quite well known in the industry.
Longing.Finances
Sign: YFI
TVL: $498 million
Yearn.finance is a decentralized ecosystem of lending service aggregators such as Aave, Compound, etc. Its main goal is to optimize token lending for its users by letting the algorithm find the most profitable lending service. Locked funds are converted into yTokens, which are regularly rebalanced to maximize profits. Yearn is very useful for farmers who want to automatically search for the most optimal pool.
The benefits of yield farming
Let's go over some of the key benefits of yield farming:
- The main advantage of yield farming is the profit opportunity it offers users. Early movers can benefit from the symbolic rewards of an emerging project. By choosing the right project for farming, significant profits can be achieved.
- Users can use a variety of different DeFi protocols to earn yield. Different protocols present different risks and opportunities. An educated user can skillfully switch between these platforms to get maximum rewards.
- Allows farmers to continuously farm and reinvest their profits to continually earn rewards.
- Since a significant amount of tokens are locked as stakes, the overall velocity of the tokens decreases significantly.
The Disadvantages of Yield Farming
- Yield farming is complex and not suitable for beginners. It requires an understanding of complex tactics and techniques.
- The amount of tokens you can farm can only be significant if you already have a significant amount of shares. Therefore, this strategy is more beneficial for whales, or at least those who already have significant crypto holdings.
- The DeFi space is evolving at breakneck speed. While this rate of innovation is impressive, it often results in flawed contracts that a hacker could easily exploit.
- Most DeFi applications are currently based on the Ethereum blockchain. Ethereum has still not achieved scalability. Therefore, the underlying protocol may not be robust and fast enough for sophisticated DeFi apps to function.
- With many tokens locked, yield farmers face significant liquidation risks due to the high volatility of DeFi.
Diploma
DeFi farming is one of the most exciting aspects of DeFi and crypto in general, which has led to massive adoption in a very short period of time. The DeFi space is now a $40 billion market. The main factor behind this exponential increase is yield farming. Although it carries risks, the benefits it offers can be very tempting. We recommend that you research the different farming platforms before you decide to get started.
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