is yield farming a way for people to generate passive income by providing liquidity, i.e. cryptocurrency deposits, to DeFi liquidity pools or staking pools. In short, users lock their funds in a participating DeFi app, and in exchange for this service, the project automatically pays out crypto rewards to these “yield builders” over time.
These rewards are paid in the form of Governance Tokenthat DeFi projects sometimes use as equity-like tools to facilitate community governance feeslike the trading fees that all liquidity providers (LPs) earn on decentralized exchanges like Sushi and Curve.
Above all, DeFi projects offer yield farms an incentive to boot themselves by gaining LPs. These projects need to attract liquidity in an increasingly dense DeFi ecosystem in order to grow and materialize, which is why yield farming is synonymous with yield farming liquidity reduction.
In other words, a DeFi team is running a liquidity-removal program to incentivize LPs to bring in their capital, and LPs are doing this to “farm” those programs by “investing” their crypto assets in incentive pools. The resulting returns are token rewards and/or fees!
Brief history of yield farming
Synthetix, the on-chain synthetic asset protocol, pioneered yield farming with its launch in July 2019 Issuance of its SNX governance token of LPs for the sETH/ETH liquidity pool of the project on Uniswap V1.
A year later, lending protocol Compound Finance sparked the modern yield farming phenomenon when it announced the launch of its liquidity mining program around its COMP governance token. The ongoing program awards COMP tokens to Compound borrowers and lenders according to the activity levels of those users.
Compound’s launch of COMP yield farms sparked a surge of interest in liquidity mining, and that interest has since grown as these types of passive income opportunities routinely pop up throughout DeFi. In fact, yield farms are now the primary vehicle for emerging DeFi projects to inject liquidity into their projects.
How does yield farming work?
There are two main types of yield farming opportunities: LP farms And Staking farms.
Basically, both farming options require users to deposit cryptocurrencies into smart contracts. The differentiating factor is the type of smart contract.
LP farms
In an LP farm, a user deposits crypto into a smart contract that programmably enables a liquidity pool. Such a pool works as a decentralized trading pair between two or sometimes more cryptocurrencies, and trading is made possible by the cryptocurrency provided by LPs.
In return for deposits, DeFi apps reward LPs with so-called LP token – e.g. B. SLP tokens for sushi liquidity providers. These tokens allow you to withdraw your underlying deposits from the liquidity pool at any time, plus any interest you have accrued in the form of trading fees.
These LP tokens are important as DeFi apps are set up to run liquidity mining programs “Staking” interfaces to deposit these LP tokens. This will ensure your liquidity and you will automatically and continuously receive Governance Token rewards as long as your LP Tokens are deployed.
stilt farms
In a stake farm, users deposit crypto into a smart contract that programmably enables a stake pool. Instead of being a decentralized trading pair, A staking pool is similar to a decentralized vault for a single type of asset. It does not facilitate trading, but secures deposits.
These farms offer an easier experience for humans versus LP farms. This is because stake farms only require users to deposit a single asset to generate passive income as opposed to acting as an LP on a DEX and subsequently also staking LP tokens.
For example, Alchemix, a future earnings tokenization protocol, has launched a staking farm for its governance token, ALCX. The idea? You provide ALCX to this stake pool to earn more ALCX. This motivates users to support the ALCX price by holding and it helps Alchemix distribute its native token to its user community.
Other types of yield farming
When people talk about “yield farming,” they most often mean the practice of LPing, or using cryptocurrencies to generate passive income. However, as more and more DeFi projects have launched liquidity mining schemes, We have also started to see incentives for other types of participatory DeFi activity with governance tokens.
arbitrage mining
Arbitrage mining is yield farming Promote arbitrageurs in a targeted manner, i.e. traders capitalizing on market inefficiencies in DeFi. For example, decentralized liquidity insurer KeeperDAO was the first DeFi project to launch an arbitrage mining program. Arbitrageurs, known as “Keepers” in KeeperDAO slang, will receive the project’s ROOK governance token for trading via the protocol as part of its rewards campaign.
insurance mining
Insurance mining means yield farms that reward users who deposit assets decentralized insurance funds.
These funds are risky as successful insurance claims are paid out against them. In exchange for committing funds to save projects from sinking, these depositors receive governance tokens. An example of this system is the Liquidity Stability Pool. People provide the LUSD stablecoin to the pool as a backstop for Liquity’s lending protocol and earn the project’s LQTY tokens in return.
commercial mining
Trading mining is similar to arbitrage mining, except that: You just need to make simple trades to get token rewards instead of executing arbitrage strategies. One of the early adopters of this type of yield farming campaign is Integral, a hybrid decentralized order book/AMM exchange. Since the project’s launch in March 2021, ITGR governance tokens have been awarded to traders who have used its incentive pools.
Fuel for yield aggregators
Yield farming has given rise to yield aggregators, which are decentralized protocols Spread users’ deposits across multiple DeFi yield farms with the highest yields. The result? Depositors can achieve optimized yields through automated and automatic compounding.
This is made possible by the “vault” system used by yield aggregators. This Smart contract vaults are specialized in one goal, e.g. B. the accumulation of as many ETH as possible for depositors.
In such a vault, users’ deposits are distributed to powerful yield farms for strategies developed by an aggregator’s return strategists. For example, the “accumulation ETH” vault mentioned above could provide crypto deposits into Compound to farm COMP and then continuously dump those COMP for ETH, with the resulting ETH revenue flowing back to depositors.
What is TVL?
TVL stands for “total locked.” In the context of yield farming, TVL is used to indicate the amount of crypto that has been deposited into a yield farm’s underlying liquidity pools or stake pools.
Accordingly, people in DeFi use TVL similar to that assets under management (AUM) metric is used in traditional finance. If you see that a particular yield farm has a TVL of $500 million, that means there is currently $500 million paid into that farm.
Understand APY vs. APR
In the DeFi ecosystem, projects use annual percentage rate (APR) or annual percentage rate (APY) calculations to show users how much interest they earn on their yield farm deposits.
The APR simply tracks how much interest a depositor will earn from their cryptocurrency over the course of a year. If a yield farm consistently offers a 5% APR and you lend it $100, after a year you’ll have $105.
On the other hand, the APY tracks how much a deposit will earn in a yield farm throughout the year if its interest income is continually reinvested into the yield farm throughout the year.
Regardless of whether a project is using APR or APY to track its revenue opportunities, keep in mind that revenue farm revenue is constantly fluctuating based on changes in participants, token distribution schedules, and trading fees. With that in mind, think of a yield farm’s Annual Percentage Rate or APY as merely a snapshot of current yield performance and not as a static rate.
The advantages and disadvantages of yield farming
Income farming has its benefits and risks. For DeFi farmers, the main pros and cons are as follows.
Advantages
- Allows people to easily earn passive income from crypto.
- Offers a range of opportunities from conservative, low-yielding operations to aggressive, high-yielding operations.
- Provides users with the ability to participate in DeFi protocol decisions via governance token rewards.
- Helps users gain DeFi knowledge, building a base of skills that will help people master future DeFi innovations.
Disadvantages
- Can be vulnerable to commercial attacks or software exploits depending on the project.
- Can be prone to “rug pulls” where a liquidity pool creator (usually one or more rogue administrators) pulls most of the ETH out of their liquidity pool
- When you deposit funds into farms, you don’t have instant access to that liquidity until you release the underlying cryptocurrency.
- Some projects use token vesting schedules, so in these cases you won’t be able to access your farmed token rewards until weeks, months, or sometimes years in the future.
The future of yield farming
As DeFi and yield farming become more popular, users will be drawn to opportunities where they can transact cheaply and quickly.
A handful of Layer 2 (L2) scaling solutions such as Arbitrum, Optimism, and zkSync are emerging in the Ethereum ecosystem to offer such ultra-cheap and ultra-fast transactions. These L2s, which inherit their security directly from Ethereum and have fees denominated in ETH, become hubs for yield farming due to their powerful scaling abilities.
Additionally, alternative scaling solutions such as the Polygon sidechain, which is explicitly aimed at Ethereum users, will continue to gain prominence as more DeFi users begin yield farming across multiple chains and L2s.
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