By Kirsty Moreland
06/10/2021 | Updated October 26, 2022
| The central theses: |
| — Yield farming allows cryptocurrency holders to make money from their cryptocurrency by lending it to others via smart contracts.
— With decentralized finance as its foundation, yield farming means that individuals can both borrow and lend money without the need for a profit-hungry middleman to eat up most of the interest earned. — While it has the potential to be extremely lucrative, it does have its risks and there are many different strategies to approach yield farming, so make sure you’re armed with information. |
What is yield farming? If you’re taking your first DeFi steps, we’ve got your back!
Wouldn’t it be nice if there was a way for cryptocurrency holders to earn more crypto by lending their crypto? Well, with an exciting concept called yield farming, there is! Yes, you can earn cryptocurrency from your crypto holdings while helping others get loans. Winner winner, crypto pays for your dinner.
How does it work? Do I need special tools? Digital plows? online horses?
No, horses are not necessary for this. But we’re glad you’re asking the important questions. Let’s take a look at the field and find out what yield farming is!
What exactly is yield farming?
Simply put, yield farming is a way for you to earn additional cryptocurrency by directly lending your crypto assets to others using smart contracts. In exchange for the loan, you receive interest in the form of cryptocurrency. Passive income, hello!
You know, when you put your money in a savings account at the bank, the bank then lends that money to others who borrow. As compensation, you can accrue interest on your savings. The main problem with this, however, is that the bank takes a big chunk of that pie and leaves you with leftovers in return. And when you factor in inflation, you often lose purchasing power because banks don’t offer interest rates high enough to cover the difference.
Yield farming takes the middleman out of the lending process, which means you get the bulk of that pie instead. It’s a far tastier deal that highlights the benefits of the decentralized system and opening up of the financial industry. And thanks to this decentralized system, you retain full ownership of your cryptocurrency.
This means you can move your assets freely without having to seek approval from your banking authority and without limits on your savings accounts.
How does yield farming work?
This is where things get a little more complicated. There are many different ways to approach yield farming with different strategies and implementations. So, in the broadest sense, this is what happens:
The first part of the process in yield farming is putting funds into what is called a liquidity pool (which is basically a smart contract containing funds). This pool acts as a marketplace where users can borrow and lend tokens. So when you make loans and add money to the liquidity pool, you become a “liquidity provider” (congratulations, it’s a great title!).
From there, liquidity providers receive rewards for being added to the pool. Interest rates on the reward vary depending on a protocol’s available liquidity. Basically, prices are determined by supply and demand. This means that providing liquidity when it is scarce pays a higher interest rate than when it is plentiful.
Before you tell us, the choice is obvious – there is a small caveat: the more liquid protocols (we call it TVL – “Total Value Locked In”) tend to be more secure and legitimate. Although higher interest rates seem the most tempting on paper (for example, it’s hard to turn down an 800% interest rate), it comes with greater risk.
The opposite of this limitation is that you can still earn decent returns with protocols that have higher liquidity and lower interest rates. For example, earning up to 11% interest on stablecoins through protocols like Aave is still a much better deal than what you might get from your bank.
The merits and quirks of yield farming
The perks
A fairly obvious benefit of yield farming is the reward you get for your loan. It’s also great because you know you’re part of a process that is opening up the financial industry beyond the traditional system as we know it.
Another key benefit is that blockchain is as transparent as anything else in traditional finance, meaning you don’t have to suffer hidden fees or bias towards a specific player (like a banker). The immutability of the blockchain also means that the contract cannot be changed afterwards – so everyone involved can rest assured that no nasty “surprises” will arise.
The quirks
On the other side of the coin, however, is that yield farming is a complicated business. While anyone can participate in borrowing and lending, it can be difficult if you are just entering the world of crypto.
It is also a high-risk, high-reward practice. With volatility, smart contract risks, hacks and fraud opportunities, there are threats in this space worth considering.
It’s also worth noting that by eliminating the middleman, customer service is eliminated as well. So, with technology taking the driver’s seat, you have to trust the evolving technology.
The solution
To navigate the quirks, there are a few ways to choose the best direction:
- Do your own research (DYOR) on protocols that interest you. Find out important information such as:
- Who is behind the protocol and whether they have a trusted, legitimate background,
- Whether the smart contracts have been checked,
- What the community has to say about the network, and
- Whether there is a “lock-up period” (which means less volatility but also reduces freedom).
- Check how high the stored total value (TVL) is. The higher the better. It shows that more investors have confidence in the protocol.
- To be successful, avoid greed! A higher annualized return (APY), while tempting, is riskier. Keep in mind that the average (and safer) APY is still a better, bigger slice of the pie than you can get with the legacy system.
Is yield farming sustainable? What’s the future like?
It’s a somewhat volatile move at the moment, but one with incredible potential. As institutions begin to jump on board and test protocols, it wouldn’t be surprising to see the adoption rate increase significantly. And with decentralized insurance (like Nexus Mutual and Opium Insurance) to cover smart contract risks, we’re just looking at the tip of the iceberg for where this financial revolution may be headed – certainly leading the way.
In the meantime – if you decide to get into yield farming – just protect yourself with knowledge and we wish you high yields and happy farming!
Knowledge is powereR
Kirsty Moreland
Editor of Ledger Academy. Author and researcher on blockchain technology and all its use cases. Lovers of old music, bikes and find answers to questions.
Learn Crypto Trading, Yield Farms, Income strategies and more at CrytoAnswers
https://nov.link/cryptoanswers
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