If you want to increase the return on your cryptocurrency investments, you may be interested in yield farming. Yield farming uses decentralized finance (DeFi) protocols to generate additional revenue from your crypto holdings.
In this article, you will learn what yield farming is, how it works, and the benefits and risks of using yield farming to increase your cryptocurrency returns.
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yield farming
When people talk about yield farming, they are referring to annual percentage yield (APY). This often leads to a comparison to the interest rate you might get on a savings account at a bank. And while bank rates are extremely low, yield farming can generate triple-digit APYs in some cases (although those returns come with significant risks and are unlikely to last long).
There are several ways to earn income from your crypto holdings. One option is to place your tokens on a blockchain. Blockchains that use a proof-of-stake system — like Solana (CRYPTO:SOL), Cardano (CRYPTO:ADA), and Polkadot (CRYPTO:DOT) — reward stakeholders for confirming transactions on the blockchain. Ethereum (CRYPTO:ETH) is also moving towards a Proof-of-Stake system with Ethereum 2.0 and will provide rewards for those who stake its cryptocurrency Ether.
The Proof-of-Stake system is an alternative to the energy-intensive Proof-of-Work system that rewards cryptocurrency miners.
The second option is to use a lending protocol to become a lender. Borrowers can use lending protocols — like Compound (CRYPTO:COMP) or Aave (CRYPTO:AAVE) — to borrow money for their crypto assets. Interest is made available to capital contributors. So if you are a depositor, you receive interest from the borrowers.
The last way we will discuss is to become a liquidity provider for a decentralized exchange – like Uniswap (CRYPTO:UNI) or Pancakeswap (CRYPTO:CAKE). By providing a pair of crypto tokens in equal amounts on a decentralized exchange, swaps can be made for investors looking to trade one cryptocurrency for another. In return, as a liquidity provider, you receive a portion of the fees charged by the exchange.
How yield farming works with staking
If you believe in the long-term potential of a blockchain project utilizing the proof-of-stake system, you might be interested in buying the native token and using it to earn additional rewards.
The way cryptocurrency staking works is that you pledge your tokens to a blockchain protocol like Solana. The protocol then selects a person from those stakes to confirm the next block in the blockchain. The more you stake, the more likely you are to be selected. The selected person will receive a reward for confirming the block.
In practice, the easiest way to earn rewards from wagering is to wager through your exchange, such as Coinbase (NASDAQ:COIN). The exchange takes care of all the technical details and adds any rewards you earn to your balance.
How yield farming with lending works
If you choose to integrate your crypto assets into a lending protocol, you can earn even greater returns. Several lending protocols have emerged, offering crypto holders the ability to access the value of their cryptocurrency holdings without having to liquidate their assets and pay taxes. They do this by offering over-collateralised loans. So, to get a $100 cryptocurrency loan, a borrower might need to post $200 of collateral.
When you become a lender under one of these protocols, you earn the interest that your asset’s borrowers pay. The interest rate is determined by supply and demand and can vary from minute to minute. Some protocols are designed to stabilize interest rates for lenders seeking a more consistent rate of return.
Yield farming as a lender requires you to use a DeFi protocol like Compound or Aave. If you want to lend, exchange the tokens you want to lend for matching tokens. The exchange rate of these tokens is constantly improving, as interest is charged on loans from borrowers. If you exchange your tokens back into your original cryptocurrency, you will receive more than what you originally exchanged.
Here is a simplified example: If you deposit 100 DAI (CRYPTO:DAI) worth $100 into Compound, you will receive cDAI worth $100 in return. Let’s say the exchange rate was 1:1 when you made your deposit. If the interest rate on DAI is 10% and stays there for a year, the DAI to cDAI exchange rate after a year is 1.1:1. If you remove your DAI from the log, you will get back 110 DAI worth $110.
How yield farming works with liquidity pools
Another way to earn additional income from your crypto assets is to become a liquidity provider for a decentralized exchange. For example, if someone goes to Uniswap to exchange their Ether for DAI, Uniswap will take some DAI from the liquidity pool and add the Ether that the user exchanges. This allows Uniswap to offer exchanges for just about any cryptocurrency pair you can think of without having to hold cryptocurrencies yourself.
Uniswap pays out fees charged by exchanges to liquidity providers. The amount each provider receives is proportional to their share of the protocol’s total liquidity pool.
For example, let’s say you allocate $100 Ether and $100 DAI ($200 total) to the liquidity pool, which has a total value of $20,000. Your share of the pool is 1%. If the fees collected in a day on Ether and DAI exchanges are $100, you will earn $1.
Note that the percentage of your trading pair can change over time, especially for more volatile cryptocurrencies. This can result in a temporary loss, meaning a decrease in the value of your holdings compared to if you had simply kept your cryptocurrency out of the liquidity pool.
Why is yield farming popular?
With interest rates on traditional bank savings accounts remaining extremely low, yield farming offers those participating in the decentralized finance ecosystem a way to earn better returns on their holdings. Additionally, the use of yield farming techniques also strengthens many of the systems used in cryptocurrencies and DeFi, improving the blockchain, increasing liquidity through lending, and ensuring decentralized exchanges can perform currency exchanges efficiently.
Benefits of yield farming
The advantages of yield farming are obvious. If you are already planning to hold a cryptocurrency for the long term, you can also try to increase the returns you can get from those holdings. Stakes and loans offer a low-risk way to earn additional returns on the same cryptocurrency you already own. Participation in a liquidity pool can result in even greater returns, but comes with greater risk.
As mentioned above, participating in yield farming activities also supports the entire crypto ecosystem.
Risks in yield farming
There are some risks to be aware of when it comes to yield farming.
As a liquidity provider, temporary loss is a key concept to understand. If the price of one part of the pair moves significantly relative to the other part, you will suffer a temporary loss. This happens when the proportion of assets in a liquidity pool has to change due to market demand and you receive less value from the pool than if you had not deposited the assets in the first place.
Another risk to be aware of is the possibility that lending rates will change. Because interest rates are determined based on supply and demand, a sudden increase in the supply for an asset can result in a sharp drop in the interest you, the lender, receive.
And as always, holding cryptocurrencies carries risk as their price is generally more volatile than other asset classes.
Is income farming safe?
Although yield farming can be viewed as an alternative to holding cash in a savings account, it is far less secure. Here are some reasons why:
- There is no insurance for your assets. Banks in the United States offer federal deposit insurance up to $250,000 per account.
- The smart contracts used in yield farming could be prone to bugs or hacked by malicious actors.
- If you use a less reputable protocol, you could become a victim of a scam or no-recourse scam due to the industry’s minimal regulation.
The safety of yield farming varies, but if you stick to reputable providers and understand what you’re getting into, you should be able to manage the risks appropriately.
Is Yield Farming Right For You?
If you’re a long-term buy-and-hold crypto investor, you should look into yield farming. You can minimize your risks by simply staking, or enter the world of DeFi by participating in credit or liquidity pools. There are many options to explore and it is possible that you can benefit significantly by increasing the returns on your crypto holdings.
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