In most cases of yield farming, cryptocurrency is lent out over the Ethereum network. When lending through banks with fiat money, the borrowed amount is repaid with interest. With yield farming, the concept is the same: cryptocurrencies that would otherwise sit on an exchange or in a wallet are lent out (or tied to smart contracts in Ethereum terms) via DeFi protocols to generate a return.
Yield farming is usually done with ERC-20 tokens on Ethereum, with the rewards being some form of ERC-20 tokens. Although this could change in the future, almost all current yield farming transactions take place in the Ethereum ecosystem.
How does yield farming work?
The first step in yield farming is to add funds to a liquidity pool, which are essentially smart contracts containing funds. These pools operate a marketplace where users can exchange, borrow, or lend tokens. Once you have added your money to a pool, you are officially a liquidity provider.
In exchange for locking your finds in the pool, you are rewarded with fees generated by the underlying DeFi platform. Note that, for example, investing in ETH itself does not count as yield farming. Instead, yield farming is lending ETH through a decentralized, non-custodial money market protocol like Aave and then receiving a reward.
Reward tokens themselves can also be deposited into liquidity pools, and it’s common practice for people to reallocate their funds between different protocols in order to earn higher returns.
It’s a complex thing. Yield farmers are often very experienced with the Ethereum network and its technicalities – and will move their funds to different DeFi platforms to earn the best returns.
It is by no means easy and certainly not easy money. Those who provide liquidity are also rewarded according to the amount of liquidity provided, so those who reap large rewards have correspondingly large amounts of capital.
A brief overview of yield farming
- 💰 Liquidity providers deposit funds into a liquidity pool.
- 💱 Deposited funds are usually USD-pegged stablecoins like DAI, USDT, USDC and more.
- 💸 Another incentive to add funds to a pool could be to accumulate a token that is not on the open market or has low volume by providing a pool with liquidity that rewards it.
- 📈 Your return is based on the amount you invest and the rules the protocol is based on.
- 🔗 You can create complex investment chains by reinvesting your reward tokens into other liquidity pools, which in turn provide other reward tokens.
What is special about yield farming?
The main advantage of yield farming is the profit potential. For example, if you arrive early enough to start a new project, you could generate token rewards that could skyrocket in value. Sell ​​the rewards for a profit, and you can treat yourself—or choose to reinvest.
Currently, yield farming can offer more lucrative interest rates than a traditional bank, but of course it also involves risks. Interest rates can be volatile, making it difficult to predict what your returns might look like in the year ahead – not to mention that DeFi represents a riskier environment in which to invest your money.
Why should we care?
Yield farming is important because it can help projects gain initial liquidity, but it’s also useful for both lenders and borrowers. It makes the world of borrowing easier for everyone.
Those who generate high returns often have a lot of capital at their disposal. But those looking to borrow have access to cryptocurrencies with very low interest rates — sometimes as low as 1% APR. Borrowers can also easily lock the money in a high yield account.
Even though the yield farming explosion has abated somewhat after the summer 2020 boom, there is still an opportunity to inflate returns on assets compared to traditional finance.
Yield farming has been a rather controversial topic in the cryptocurrency world. Not the whole community thinks it’s important – and some in the crypto community have advised people to stay away from it. For example, flash farms (yield farming projects that only appear for about a week) have been criticized by Ethereum developers for being high risk. Ethereum co-founder Vitalik Buterin himself has stated that he will stay away from yield farming investments.
Which projects are they?
There are currently a number of DeFi projects dedicated to yield farming. The current greatest value hidden in smart contracts is Aave, a project that allows users to borrow and borrow a range of cryptocurrencies.
Next is yearn.finance, which is working to move users’ funds between different lending and liquidity protocols (Compound, Aave, and dYdX) to get the best interest rates.
Then there’s Compound, a DeFi platform that allows people to make money from the cryptocurrencies they save.
Who can join?
Getting started in yield farming is difficult if you are new to the crypto world. Projects like Compound and yearn.finance are working to make the world of borrowing and lending accessible to everyone.
But because yield farming has led to high gas fees on the Ethereum network, those who make huge returns from lending their cryptocurrencies tend to be the ones with a lot of capital to start with.
What can you do with yield farming?
One strategy involves one of the world’s most popular DeFi platforms, Compound. The platform rewards investors with COMP tokens for both providing and raising capital, and many users maximize their returns by doing both:
- Borrowing funds on Compound gives you COMP tokens as a form of cashback. The more you borrow, the more COMP token is provided.
- If the cashback is worth more than the cost of the loan fees, you can continue to borrow to earn the cashback rewards.
- Since liquidity miners are compensated for both lending and borrowing, one strategy is to lend the asset with the highest interest rate, borrow as much as possible against the tokens, and then return the remaining assets to the loan pool.
- The bottom line (potential) is 100% APY instead of the 0.01% to 1.00% most banks offer, which is a very significant increase.
Detailed strategies are beyond the scope of this article, but essentially the method involves making a deposit and then taking out a loan. It goes without saying that it is extremely risky; As always, you should never invest in anything you cannot afford to lose.
Is yield farming sustainable?
As a number of Ethereum developers have told Decrypt, certain yield farming projects will not last and are simply not sustainable. These projects often bring in large sums of money in a short time and then fall into oblivion. Some have even been described as scams – particularly the flash farming projects.
Other yield farming “experiments” involved experimental – and unverified – code that led to unintended consequences.
For the time being, yield farming remains a high-risk and rewarding practice that might be worth pursuing, provided the necessary research and risk assessments are done in advance.
The views and opinions expressed by the author are for informational purposes only and do not constitute financial, investment or other advice.
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