You could say that yield farming is a quest for lifelong fulfillment. One need go no further than to recall the quote from billionaire investor Warren Buffett:
“If you don’t find a way to make money while you sleep, you will work until you die.”
As the saying goes, they are always easier said than done. However, blockchain assets within the decentralized finance (DeFi) continuum are offering yield farming opportunities like never before in history. Terra and Celsius Network may have gone down the toilet, but keep in mind that they were CeFi lending platforms, not DeFi.
Companies like Aave, Curve, and Uniswap still offer returns alongside staking on Ethereum that dwarf the average interest rate for savings accounts of 0.1%. This yield farming guide covers everything a passive income seeker needs to know to get started.
Yield farming vs. traditional banking
Yield farming is any process involving crypto assets for passive income generation. This income is usually represented as an APY percentage – Annual Percentage Yield, sometimes also referred to as EAR (Effective Annual Rate). It measures a future profit from an initial investment.
For example:
- Adam deposits $500 into a DeFi protocol with an APY of 6%.
- The interest rate of 6% is compounded every quarter.
- The calculation formula is APY= (1 + r/n)n – 1, where “r” is the annual interest rate and “n” is the number of compounding periods.
Since compounding occurs quarterly (every three months) and the year has 12 months, n=4. At r = 6% (0.06) and n = 4, APY on a $500 deposit means a yield farming profit of $30.68, increasing the initial deposit from $500 to $530.68.
There is one more metric to consider when it comes to yield farming – APR (Annual Percentage Rate). Unlike APY, APR does not account for compound interest, which is just an interest rate accrued on both the initial deposit and the periodic interest accrued.
With traditional savings accounts, this would mean depositing an amount of money for a set period of time and receiving an interest rate for that period. Unfortunately, due to Federal Reserve monetary policy discouraging savings, such bank accounts yield up to 1.58% APY at best. This may increase further if the Fed decides it is necessary to fight inflation.
Certificates of deposit (CD) yields have steadily declined as the Fed’s money supply and government debt have risen. Source: BankRate.com
In other words, we’re at the point where low-yielding APY savings accounts are not just normalized, they’re considered high-yielding.
This is in stark contrast to a new form of finance based on blockchain networks and smart contracts. In the last two years, this new finance 2.0 has exploded, going from under $1 billion to over $82 billion locked in smart contracts in different categories.
Ethereum is by far the largest blockchain network topped DeFi, with $45 billion worth of crypto assets locked in its smart contracts. Since crypto assets are not connected to the central bank’s system of manipulation, DeFi smart contracts that replicate financial services in a decentralized manner offer dramatically higher APY yields.
Whether Uniswap, Aave or Compound, APY yields in DeFi rarely fall below 2%. That is already three times the national savings bank average. However, not all DeFi yield farming is created equal.
Of course, there are always risks, and there’s no better example than what happened with the Terra ecosystem’s anchor protocol. The Anchor Protocol played a major role in the now infamous incident, resulting in massive falls in value.
The anchor protocol offered massive interest rates on UST deposits – nearly 20% annually. Without going into too much detail, setting up this stablecoin deposit caused the LUNA token to surge massively in a very short period of time. But things really took a turn for the worse when massive UST liquidations took place, leading to even more panic and selling and consequent UST depegging.
As UST was withdrawn en masse on Anchor, the Anchor protocol’s own ANC token began to crash as users began exiting the platform. Eventually, many Terra users were left with their bags. The lesson here is that just because something has attractive yields doesn’t necessarily make it good.
Types of yield farming
With traditional banking, there isn’t much to consider other than depositing money and receiving an interest rate. It is then up to the bank to decide how to use those funds across its range of financial products.
There are no financial institutions in DeFi. They have been replaced by smart contracts stored on blockchain networks and there is a wide range of yield farming opportunities:
Mark out: Smart contract blockchain networks like Ethereum, Cardano, Algorand, Solana, Fantom, and Avalanche use Proof-of-Stake (PoS) consensus algorithms to secure and verify their respective networks.
Any validator running a PoS node (a computer that holds the entire blockchain record) uses staked crypto funds for transaction validation. Consequently, when traders use the blockchain, the validators get a share, which is a form of yield farming.
Provision of Liquidity: If you want to swap token A for token B, e.g. E.g. ETH vs USDT, a liquidity provider would lock their funds to both sides of this trading token pair. For example, one could go to Uniswap and add USDT to a liquidity pool. Like tokens themselves, liquidity pools are smart contracts but perform the function of bank vaults. So if someone wants to exchange tokens, they would tap into such a liquidity pool and provide liquidity providers (LPs) with a yield farming income.
Borrow and Borrow: Liquidity providers can lock their crypto funds in pools for other traders who want to borrow instead of token swapping. Aave, Maker, Compound, InstaDapp, dYdX, and SushiSwap are just a few of the DeFi protocols that offer yield farming income to lenders.
It is common for yield farmers to be both borrowers and lenders. This is popular because borrowed coins allow you to yield farm and count on volatile assets to offset borrowing costs.
Because of this, the bulk of the assets on loan are made up of stablecoins (up to 90%), while the collateral is usually made up of volatile cryptocurrencies (up to 75%).
Therefore, yield farmers who borrow and lend money would keep the initial deposits.
Of course, if the volatile asset loses value, the holders would have to liquidate. Stablecoins generally produce the highest APY returns as supply is low and demand is high. In fact, to get the better of the current rate of inflation, one would have to go higher for profitable yield farming. The inflation rate tells you how much the dollar has lost in value in a year. For example, if a computer monitor cost $300 a year ago, you would now have to pay up to $25 more for the same monitor. Why? Because of inflation.
Imagine what the effect would be if a developer decides to pump that much into an altcoin. The same principles of supply and demand apply.
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