YIELD FARMING FOR DUMMIES [Strategies and Risks] | by FiatToCrypto

11 min read

·

Jan 28, 2022

WHAT IS YIELD FARMING AND HOW DO PEOPLE EARN FROM IT

Table of contents:

What is yield farming

How income farming works in DeFi

How to make money yield farming

How is the profitability of farming calculated?

Income Farming Strategies

Risks and benefits of income farming

Platforms and protocols for income farming

Conclusion

In simple words, yield farming is a set of tools and methods that allow you to make a profit on digital assets using decentralized protocols. To put it simply, DeFi users actually rent out their coins or tokens, for which they receive rewards in the manner established by the protocol.

Opportunities for creating a decentralized finance market appeared back in 2015, when the Ethereum platform was launched, introducing smart contracts to the world. This allowed the creation of autonomous decentralized applications such as DEX exchanges, landing pages and AMM protocols.

The term DeFi itself was coined in 2018 by Ethereum founder Vitalik Buterin and entrepreneurs from Dharma. It refers to agriculture, which is used in farming: holders (conditionally) need to sow seeds in order to grow crops.

2020 was a landmark year for decentralized finance (DeFi): the sector’s capitalization exceeded $10 billion for the first time. And now, as of January 2022, according to the DeFi monitor Llama, the total TVL (the total amount of funds locked in DeFi protocols) already exceeds $186 billion.

In profitable farming, all work is based on smart contracts. There are two main methods of farming — lending and liquidity mining. Liquidity mining is the act of providing liquidity to traders, for which the holder also receives a reward. Lending is when a cryptocurrency is leased out for a fee.You can use these methods to generate additional income rather than just keeping cryptocurrencies in your wallet. We’ll discuss them more in depth later on.

Reducing to a common denominator, holders turn into liquidity providers and block part of their assets in a smart contract in order to start receiving income from them. Initially, income was generated only from interest paid by borrowers, or commissions for swaps on decentralized exchanges. Furthermore, the yield is known in advance and is determined by the ratio of supply and demand, which corresponds to the APY (Annual Percentage Yield).

A breakthrough in this direction was made by the developers of the Compound protocol, which rewarded creditors not only with accrued interest for the use of borrowed funds, but also with their own COMP tokens, which made it possible to increase the yield from the landing. Later, this idea was picked up by other protocols, which became one of the main reasons for the growth in the popularity of DeFi.

Lending blockchain protocols provide an opportunity to issue loans secured by cryptocurrency.

It works like this:

• Suppliers (lenders) form a common pool that creates liquidity for borrowers by blocking coins in a smart contract.
• Users provide collateral with accrued interest, which is also blocked in the smart contract, and in return receive borrowed tokens that must be returned with interest. Maker, for example, sets the margin to 1:2, meaning you have to lock in $200 in ETH to receive $100 in DAI tokens.

Then two scenarios are possible:

1. In the event that the user does not return the borrowed funds or liquidation occurs (an event in which the value of the collateral is close to the amount of borrowed assets), the coins blocked by the borrower in the smart contract are transferred to the lender’s wallet.
2. If the user returns the loan funds, the smart contract will unlock his collateral assets and return them to the wallet.

The rewards are distributed among the pool participants: the larger the amount of blocked assets (TVL), the lower the yield will be, and vice versa. This approach allows you to freely add and remove assets from the pool if they are not fully used.

Another common way to farm in DeFi is liquidity mining. It is often simply referred to as farming. This method made a splash in the cryptocurrency market, as many projects at an early stage of development provided an annual return of up to several thousand percent.

Let us briefly describe the principle of liquidity mining:

• Holders form a liquidity pool that traders use to exchange. At this point, the owners become liquidity providers. Once assets are added to the pool, liquidity tokens (LP) are issued to providers that determine rewards based on their pool share.
• For each exchange for DEX, the trader pays a commission, which is accrued as a reward to liquidity providers and is distributed among them in proportion to the invested share.

Farming profitability consists of trading fees for swaps on the exchange and accrued protocol tokens, if they were issued, and depends on two factors:

• Demand — the higher the demand for swaps, the higher, respectively, the yield of the post
• Supply — if the supply increases, then the yield will decrease. How to make money on yield farming

First you need a crypto wallet. Any client that supports the tokens of the chosen blockchain will do, but it is most convenient to use mobile multi-currency wallets such as Trustee.

Note. Trustee wallet not only supports a large number of cryptocurrencies and tokens from different blockchains, but also allows you to quickly buy cryptocurrency at a better rate right in your wallet. Therefore, you do not need to create an account on the exchange to buy and sell digital assets.

After that, all you have to do is fund your wallet, connect it to the platform using WalletConnect, and add liquidity to earn landing or liquidity mining rewards. A little later, I will share passive income strategies for yield farming.

DeFi protocols use APY (Annual Percentage Yield) and APR (Annual Percentage Rate) to calculate returns. APY determines the rate of return earned by an investor over the course of a year. This takes into account the cumulative interest that is regularly accrued for depositing funds.

Liquidity mining income is often measured in APR. This measure is similar to APY, but the difference is that APR does not take into account the frequency with which interest is compounded. To incentivize investors, protocols charge their native yield farming token, which allows for higher yields, but because of this, tokens are subject to increased volatility.

Cryptocurrency profitable farming provides for various strategies that differ in profitability and risk level. As a rule, the more profitable the method, the higher the risks. Consider popular investment strategies used in farming or farming.

Strategy 1: Single asset farming

If you invest in any cryptocurrency, then you have the opportunity to benefit from this additional benefit. Some platforms use or issue their own tokens backed by the main cryptocurrency, such as Balancer’s sETH and PancakeSwap’s WETH.

Let’s say you hold 10 ETH. On the Balancer platform, you can exchange 5 ETH for the equivalent amount of sETH tokens and then add the ETH/sETH pair to the liquidity pool to earn income.

Strategy 2: Lending and farming

Often, the profitability of staking exceeds the APY of the landing, so some investors take out a loan, and the received borrowed tokens are sent to staking. But, if you want to farm cryptocurrency without selling your assets, you can use lending too.

Let’s say you have 10 ETH. In order to add funds to the ETH/USDT liquidity pool, you need to own both assets of the pair. But in this way, you can miss out on potential profits when the ETH rate rises. In this case, you can lock ETH to get USDT and then add the pair to the pool. Then you will receive income both from the growth in the value of Ethereum and from mining in the liquidity pool. But the risks will be higher, since if the ETH rate falls, your collateral may be liquidated. The complexity of the method is that you will need to correctly calculate the shares, taking into account the security. For example, if the collateral is 1:2, then you need to leave ⅔ ETH as collateral, and then add the remaining coins along with the received USDT to the pool.

Strategy 3: Lending + deposit

The method is similar to the previous one, but instead of staking, you make a deposit of cryptocurrency.

For example, you can deposit UST stablecoin and earn up to 20% per annum on the Anchor Protocol platform in the Terra ecosystem. If you hold LUNA tokens, then they must be pledged to receive UST, which are then deposited.

Strategy 4: Farming + staking

Typically, staking means that you lock tokens in a smart contract and receive rewards in the same asset. But DeFi protocols have created single pools that accrue income for staking various assets.

For example, on the PancakeSwap exchange, you can stake BNB, BUSD, USDT and other tokens to receive CAKE. This strategy will be based on this. Let’s say you have BNB and USDT in your wallet. You can add assets to the BNB-USDT liquidity pool, for which you will receive CAKE. The accrued tokens can then be staked into a single pool to generate more rewards.

Strategy 5: Lending + lending

Some platforms, such as Anchor Protocol, reward not only lenders, but also users who take out loans secured by cryptocurrencies. Thus, you can first take out a loan, and then lend the received tokens, in both cases, receiving income.

Here’s how it works: Pledge LUNA tokens and get UST Provide UST on credit. This method can be used for arbitrage: for example, you can borrow at a low rate on Compound and then lend on another platform at a higher rate, earning income on the difference in interest rates.

Behind the impressive yield of yield farming lies a lot of risks that must be taken into account before you start making money on DeFi. There are general risks for all ways to make money on DeFi and those that apply to specific types of farming. Let’s look at the general ones first.

Protocol hacking and asset theft

Analyst company Elliptic estimated the damage to users of DeFi projects at $10.5 in 2021. This is a record figure, which was achieved due to the rapid growth of the sector. As a result, many projects come out with vulnerabilities that hackers use to steal investors’ funds. Cybercriminals discover backdoors in the source code and then transfer the assets of liquidity providers from the smart contract to their wallet. Unlike CEX exchanges, decentralized platforms cannot prevent this or rollback the protocol in any way.

Note. A similar puncture led to the appearance of the Ethereum fork: in order to return investors’ funds due to The DAO hack in 2016, the developers decided to fork the main network with a stable state. And the original blockchain continued to work and was renamed Ethereum Classic.

Volatility

Cryptocurrencies can rise and fall in price by tens of percent in a few hours. In a year, the $100 you invested can turn into $10,000 or $1. It depends on many factors:

• Platform development
• Market trends
• Competition
• Random events
• Partnerships and more

To reduce the risks of volatility, you need to follow the rules of risk management, such as diversification and rebalancing of investment portfolios. Now let’s talk about private risks.

Liquidation

This type of risk is exposed to those who receive and provide loans in cryptocurrencies. Liquidation means that when the rate reaches a certain level, the loan is automatically closed and the collateral is unlocked for the lender. To determine the level of liquidation, the ratio of loan to value of collateral is used — loan-to-value (not to be confused with TVL). The higher it is, the higher the risk of liquidation of collateral will be. For example, you borrowed USDT with ETH coins as collateral. If the price of Ethereum falls to a certain level, then the collateral will be written off in favor of the creditor.

Impermanent losses

Liquidity providers on DEX exchanges face this risk. Intermittent losses occur due to strong volatility when the rate of one of the cryptocurrencies in the pair changes sharply. If at this point the holder withdraws assets from the liquidity pools, then the losses will become permanent.

• High Yield
• Even on stablecoins, you can earn up to 20% per annum or more.
• The APY of decentralized financial products exceeds the return on bank deposits, which barely exceeds the rate of inflation, and sometimes even below it.
• Opportunity to increase profits from investments in cryptocurrencies. If you already hold cryptocurrencies, then farming will bring additional passive income.

There are more than a thousand different protocols for farming, and the TVL of each of the seven largest DeFi platforms exceeds $10 billion. In this variety, it is difficult to choose the right platform: often beginners “chase” high percentages and forget about the risks associated with new protocols. Large projects have lower profitability, but they are more reliable, because they are regularly audited and monitor all kinds of vulnerabilities.

The first DeFi protocols appeared on the Ethereum blockchain, but as the industry developed, platforms appeared on other networks, such as Binance Smart Chain, Tron, Solana, Polkadot, Near Protocol, Waves, and others. Let’s list the most famous and popular DeFi platforms for yield farming.

Curve Finance

The largest protocol on Ethereum with a capitalization that recently exceeded $20 billion. Back in 2020, Curve Finance was not even in the top five, but after expanding the number of pools, it began to grow rapidly and outperformed even such large platforms as AAVE and Uniswap. Another reason for such popularity of Curve is the presence of its own unique algorithm, which provides a low level of slippage and commission when exchanging assets.

Maker DAO

The second largest platform in the DeFi sector by capitalization, which continues to hold its position in the top three in terms of volume of funds blocked. TVL Maker Dao exceeds $17.8 billion. It was on this platform that one of the first DAI stablecoins was issued, which is used in lending.

AAVE

The AAVE protocol rounds out the top three currently with a TVL of almost $15.5 billion. Holders lend their assets to other users and receive AAVE tokens in return. This platform has one of the highest annual returns among landing protocols and reaches 15%.

Convex Finance

The capitalization of Convex Finance began to grow rapidly in May 2021. The project was supported by Curve Finance. One of the advantages of Convex Finance is the ability to boost yields for Curve (CRV) holders in liquidity pools.

Instadapp

A platform aimed at unlocking the potential of DeFi. With Instadapp, users can create and manage a DeFi portfolio, and developers can create infrastructure for decentralized finance, which is simplified thanks to the SDK provided by the platform.

Compound

The first landing protocol with the lowest interest rates in the DeFi market, ranging from 0.08% to 5.40%. Compound users receive additional income by accruing COMP tokens.

Uniswap

One of the first and largest decentralized crypto exchanges in the ecosystem. Initially, Uniswap was created on the Ethereum blockchain, but more recently it also supports Binance Smart Chain.

PancakeSwap

Unlike the protocols listed above, the PancakeSwap AMM exchange operates on the Binance Smart Chain blockchain and is the largest platform in this ecosystem. PancakeSwap stands out in that, in addition to trading BEP-20 tokens, it provides access to other services, such as a lottery. The exchange also released its own NFTs and plans to launch a marketplace.

Investing in DeFi farming offers many advantages for cryptocurrency investors, but also carries many risks related to the young age of the industry, as well as many problems with the organization of the structure, as well as decentralization, which in this regard, does not benefit investors.

Congratulations, you are done with the Yield Farming for Dummies.

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This guide is designed to make sure you avoid mistakes that many people including myself can make while trying to get into Yield Farming.

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