If you have been researching the DeFi (decentralized finance) space, you have probably heard the term “yield farming.” However, the term is used quite loosely and it is not always clear what it refers to.
Yield farming is the practice of using DeFi protocols to earn token rewards by providing liquidity, staking, or lending tokens. Experienced yield farmers often combine multiple DeFi protocols to maximize yield. Yield farming typically refers to more passive investment strategies and not day trading.
We give you an overview of yield farming and explain where the term comes from. Additionally, we will explain the different types of yield opportunities available in DeFi.
What is Yield Farming?
The term “yield farming” began gaining traction in 2020 during the “DeFi summer,” a time in cryptocurrency markets where decentralized finance protocols became increasingly popular. One of the key events that sparked the DeFi boom in 2020 was the launch of the Compound Protocol's COMP token, which was distributed to the protocol's users based on their on-chain activity.
Worldwide search interest for “Yield Farming”. Image source: Google Trends
To attract users, other DeFi protocols have also launched programs to distribute tokens (typically a governance token for the protocol itself) to liquidity providers. Such programs are commonly referred to as “liquidity mining.” For example, users who provided liquidity to Balancer’s token pools could earn the protocol’s governance token BAL.
DeFi participants began using the term “yield farming” to refer to strategies for maximizing yield in DeFi through opportunities such as liquidity mining, staking, and lending. Meanwhile, developers began building products that helped users automatically maximize their DeFi returns. The most notable example is Yearn Finance.
Although the term “yield farming” is not used quite as much today as it was during the height of the DeFi summer, the concepts behind it still apply and savvy users can make solid profits by participating in liquidity mining, staking and similar programs achieve.
As an interesting side note, we can point out that many DeFi protocols used names related to fruits and vegetables, for example Yam Finance. This could have been a playful reference to yield farming.
How can I earn returns with DeFi?
Now let’s go over the different types of yield opportunities available to users in the decentralized finance space.
Liquidity reduction
Liquidity is of utmost importance for DeFi protocols. High liquidity protocols enable efficient transactions between different token types with minimal impact on price. However, the market is already saturated with a large number of DeFi protocols trying to capture their share of the liquidity pie.
Many projects have chosen to introduce liquidity mining to increase the liquidity of their protocol. In most cases, liquidity mining programs require users to provide liquidity to specific liquidity pools. In addition to the standard liquidity provision rewards, which come from the trading fees generated by the liquidity pool, liquidity providers also receive the protocol's governance tokens.
You can easily identify liquidity mining opportunities using DeFi aggregators like DeFi Llama or APY.Vision.
Lending
DeFi lending protocols allow you to earn yield by lending your tokens to other users. Typically, the highest returns are offered for borrowing stablecoins, while borrowing other types of tokens is less lucrative. The best DeFi lending protocols to explore include Aave and Compound. Of course, you can also borrow tokens from these protocols, but interest is charged.
Mark out
Although we are broadening the definition of DeFi a bit here, it is also possible to earn returns through staking rewards. If you don't have the 32 ETH required to start your own Ethereum validator, you can stake your ETH through a decentralized protocol like Lido. Liquid staking protocols like Lido provide you with tokens that represent your staked ETH, which you can use as you wish.
The Benefits of Crypto Yield Farming
The most attractive aspect of yield farming is that it allows you to passively grow your crypto supply, making it a compelling option if you don't want to sell your crypto, but rather put it to work.
The barriers to entry are usually very low. As long as you have your own wallet with some crypto, you can start yield farming. There are typically no capital requirements to participate in yield farming, so you can start with small amounts of capital.
When you use DeFi protocols, you have better control over your funds as you have to approve all transactions from your wallet. In contrast, using centralized yield-generating products like Binance Earn requires a lot of trust.
The risks of cash crop farming
Typically, every way to make a profit comes with its own risks, and crypto yield farming opportunities are no different.
An important risk to consider when interacting with DeFi protocols is smart contract risk. If a smart contract has vulnerabilities in the code, clever hackers can exploit them to steal funds from the protocol. These smart contract exploits can easily result in tens of millions of dollars in losses. Because blockchain transactions are irreversible, users often have very little option to get their money back.
Unless you have extensive knowledge of smart contracts, you probably won't be able to identify vulnerabilities on your own. Therefore, it might be a good idea to stick with DeFi protocols that have been in operation for a long time and have a good track record when it comes to security. The problem is that the most attractive returns are typically offered by relatively new and untested protocols, so the choice of which protocol to use depends on your risk tolerance.
When you use DeFi to farm for yield, you typically need to hold tokens with significant price volatility. If the market value of your tokens drops sufficiently, you may incur an overall loss, even if you have technically increased your token holdings through yield farming.
Providing liquidity through Automated Market Maker (AMM) protocols like Uniswap carries the risk of temporary loss – in some cases, simply holding tokens will produce better results than depositing them into a liquidity pool. The risk of temporary loss is lower when you provide liquidity for assets that tend to be capped in price.
Conclusion: Yield farming is a great way to make money passively with DeFi
As we have shown, yield farming refers to various methods of generating income in decentralized finance through avenues such as liquidity mining, lending, and staking. By participating in liquidity mining programs, you can earn a protocol's governance tokens in exchange for providing liquidity to specific pools. Meanwhile, you can also lend your crypto through DeFi lending protocols or stake your ETH to earn staking rewards.
Although yield farming can be potentially lucrative, it is important to recognize the risks associated with DeFi. The biggest risks facing yield farmers are price volatility and smart contract exploits.
If you're looking for other types of passive investments, check out our list of the best dividend stocks for long-term investors.
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