What is yield farming?
The simple answer is that yield farming is a way to earn rewards for deposited crypto assets. The more complete answer is that yield farming, rather than simply holding crypto assets, is a way for enterprising people to maximize returns from their holdings. Projects offer these rewards to people to use their assets temporarily. Typically projects use deposits to increase liquidity, but there are other use cases such as staking.
High liquidity is one of the most important attributes for any financial market as it allows for quick and efficient financial transactions. For a thorough introduction to liquidity, read this article. Yield farming is a good strategy to increase liquidity. New projects can boost their liquidity and established projects with declining liquidity can reverse the trend by offering generous incentives.
How does yield farming work?
DApps attract people’s crypto assets by giving out rewards for deposits. When a person decides to deposit, they send cryptoassets to a smart contract that holds the assets and tracks the rewards earned. The smart contract issues the depositor with a token that acts as a kind of receipt. The token will be used to realize pending rewards and withdraw cryptoassets from the smart contract.
Common types of yield farming
Provision of liquidity: Liquidity providers, or LPs for short, contribute cryptoassets to a decentralized exchange (DEX) and receive a percentage of exchange fees from trading. LPs must deposit equal amounts of two cryptoassets into a trading pair, for example VERSE-WETH. All LPs of the same asset composition are pooled together, hence they are referred to as pools or sometimes liquidity pools. When someone trades between two cryptoassets, VERSE and WETH in the example above, the corresponding LPs receive a percentage of the exchange fees from the trade.
Mark out: There are different types of staking in crypto. The first type happens at the protocol level of a proof-of-stake blockchain. People lend a portion of the blockchain’s native cryptoasset (ETH on the Ethereum blockchain, AVAX on the Avalanche blockchain, etc.) to the network to secure it. In return for this important service, they receive a percentage of the blockchain’s new token issuance.
The second type of staking is typically a temporary opportunity to earn additional income to act as a Liquidity Provider (LP). When you provide liquidity on a DEX, you receive an LP token, a type of receipt that is used to collect earned fees and redeem the cryptoassets in a pool. Some projects allow people to “stake” LP tokens by depositing them into a staking smart contract. This allows LPs to earn returns twice, first for providing liquidity in a pool and second for staking LP tokens on the DEX. DEXs do this type of staking to attract liquidity.
For example, Verse Farms offers yield farming without custody. Deposit selected liquidity pool tokens into Verse Farms and earn additional rewards on top of trading fees earned by providing liquidity.
Loan: DeFi allows people to borrow cryptoassets from a pool of lenders. The lenders receive a return on the interest payments made by the borrowers. If you are new to the idea of lending or borrowing, please read the following article: What is Crypto Lending?
The benefits and risks of yield farming
The main advantage of yield farming is obvious: you can hold your cryptoassets and earn an additional return on top of that.
Income farming involves several risks. The most common risks come from DApp developers, smart contracts, and market volatility. DApp developers could steal or waste deposited assets. Smart contracts can have bugs or exploits that lock or allow for theft of funds. Market volatility can cause what is known as impermanent loss, which largely affects DEX liquidity pools.
The best way to mitigate the risks of yield farming is to research projects before you deposit anything and stick to projects that have a long track record of success.
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