Yield farming: what is it and how does it work?

Yield farming is a potentially lucrative way to generate income in the DeFi markets, but it comes with many risks.

Posted August 29, 2023 at 7:10 am EST.

Yield farming is one of the most popular yield generation opportunities in the global DeFi markets and allows you to generate potentially above-average returns by depositing crypto into yield farming protocols.

Read on to learn more about yield farming and how it works.

What is yield farming?

Yield farming is the process of depositing tokens into a liquidity pool on a DeFi protocol in order to receive rewards, typically paid out in the protocol’s governance token.

There are several ways to get income from farming. Most commonly, however, crypto assets are deposited in either a decentralized lending or trading pool to provide liquidity. In exchange for providing liquidity to these platforms, Liquidity Providers (LPs) receive a certain Annual Percentage Return (APY), which is usually paid out in real time.

DeFi projects enable yield farming to incentivize the use of their platforms and reward their community for providing liquidity, which is the lifeblood of most DeFi platforms.

How does yield farming work?

While the yield farming process varies from protocol to protocol, it generally involves liquidity providers, also known as yield farmers, depositing tokens in a DeFi application. In return, they receive rewards that are paid out in the token of the protocol.

Yields from agriculture are expressed as APY. These tokens are tied to a smart contract that programmatically rewards users with tokens when they meet certain conditions.

In general, the yield farming process works as follows:

1. Choose a yield farming protocol. Let’s take an automated market maker (AMM) like PancakeSwap for this example.
2. On the decentralized trading platform, you can click on “Liquidity” to go to the area for liquidity providers.
3. You then select which assets you wish to deposit into a liquidity pool. For example, you could deposit BNB and CAKE into the BNB/CAKE pool.
4. You deposit the two assets in the trading pool and receive an LP token.
5. You then take this LP token, go to “Farms” and deposit it into the BNB/CAKE yield farm to receive your yield farming rewards (on top of the transaction fees you get as a share of the liquidity pool).

Many DeFi protocols reward yield farmers with governance tokens that can be used to vote on decisions related to that platform and can also be traded on exchanges.

Benefits and risks of yield farming

Yield farming offers individuals the opportunity to do this earn passive income. However, there are also significant risks associated with the potentially high returns. Let’s take a look at the benefits and risks of yield farming.

Benefits of yield farming

• Passive Income: Instead of just holding, users can stake their holdings and earn rewards in the form of additional tokens and fee income without actively trading.
• Provision of liquidity: Yield farming enables efficient trading and reduces slippage on DEXs. By providing liquidity, users play a crucial role in the functioning of the DeFi ecosystem.
• High Yields: Some DeFi projects offer attractive returns that are higher than traditional financial instruments. Depending on market conditions, users can potentially earn significant returns on their capital.

Risks of yield farming

• Ephemeral Loss: Transient losses mainly occur with AMMs due to the mechanism used to maintain balanced liquidity between the tokens in the pool. If the prices of the tokens in the pool change significantly after you provide liquidity, the platform’s automated system can rebalance the pool by buying more cheaper tokens and selling more expensive ones. This compensatory measure can result in a loss for the yield farmers.
• Shortcomings in Smart Contracts: DeFi protocols are based on smart contracts. Hackers can exploit bugs or vulnerabilities in the code, resulting in loss of deposited funds.
• Fluctuating tariffs: Yields change based on supply and demand dynamics, making it difficult to predict potential yields in the future. For example, returns can collapse as more people contribute assets.
• Volatile prices: Cryptocurrency prices can be very volatile, affecting the value of the rewards and assets you deposit. If the value of the token you use to earn your rewards drops significantly, all of your winnings could be lost.

Is yield farming worth it?

While yield farming can be a lucrative way to generate income in the crypto market, it is also one of the riskiest activities you can undertake.

Even if you are yield farming with reputable DeFi protocols, the risk of smart contracts and hacks can still lead to a complete loss of funds.

Additionally, your potential yield farming profits are highly dependent on the price of the protocol token that you receive as a yield farming reward. Should the value of the protocol token decrease, your yield farming earnings could decrease slightly.

After all, the return you get today may not be the return you get tomorrow. High yields tend to shrink as more yield farmers start pouring money into a high-yield operation, affecting your yields.

If you can take the risk, yield farming can be an exciting way to generate income from your cryptocurrency. However, you should do your own research and never invest more than you can afford to lose.

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