Yield farming is a way to earn rewards by depositing cryptocurrency with decentralized financial services. Think of it as extreme couponing or Non-stop credit cards of the crypto world: Practitioners are weaving complex connections throughout the blockchain economy to squeeze out the highest possible returns.
Yield farming shares similarities with some well-established concepts in traditional finance. Interest on a savings account is a parallel. another is Sell stock optionsa way to make money off stocks you own by lending them to others.
But make no mistake: Yield farming is unlike anything offered by a bank or broker, and it can be far more risky than putting money in a savings account or making stock trades.
You will not find Federal Deposit Insurance Corp. Safeguards in decentralized finance. If the product you are using breaks, you are on your own. The crypto assets you deposit and the rewards you receive are all risky assets, and chaining them across multiple platforms can compound those risks.
Prospective yield builders should prepare for the potential for a total loss before they begin. But those who successfully master the risks sometimes secure higher returns than are offered by a bank.
How yield farming works
Before you begin, keep in mind that yield farming is not necessarily for crypto beginners. You need to be comfortable using your crypto without the help of centralization Exchange, like Binance.US or Coinbase. Instead, they use more complex decentralized exchanges whose users create their own cryptocurrency exchange markets.
There are many approaches to yield farming, but the common starting point is depositing crypto you already own on a decentralized finance platform that promises yield or returns. The accepted crypto types vary by platform, however stablecoins are widespread.
Deposit on a DeFi Platform is different from depositing at a traditional bank. If you deposit cash at a traditional bank, the bank could use it in a variety of ways, such as lending to other customers. The eventual use of your deposited dollars is unrelated to the mechanics of your deposit.
This is unlike DeFi platforms like Curve or Aave, where you instead choose from many options known as liquidity pools.
Liquidity pools: what they are and how to use them
Liquidity pools power decentralized exchanges. Liquidity pools serve as de facto trading partners with users of a decentralized exchange or DEX. In short, if a DEX supports trading between two or more cryptocurrencies, it must have a reserve of all of them to ensure users can trade at any time.
DEXs use algorithms to determine the price of a crypto at any given point in time. This differs from centralized exchanges, which match buyers with sellers to price and transact. Liquidity pools provide the financial backing behind these algorithms, allowing a client’s transaction to be executed on demand.
A single platform could have dozens of different pools. Each represents different combinations of cryptos. Each pool offers its investors its own (often variable) rate of return. So do your homework before deciding on a strategy: a long-standing pool that is consistently yielding reasonable rewards may offer more security than an untested pool that promises sky-high returns.
Example of yield farming
Yield farming might be easier to understand if you give an example of what you get when you make a deposit.
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When you deposit your funds, you allocate your crypto to a smart contract, a digital agreement that executes automatically when its conditions are met. On many platforms, you retain direct control of your cryptocurrencies and can withdraw at any time.
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You will receive a token representing your deposit. Think of it like the ticket you get when you check in a jacket at a cloakroom service. Only you can sell this ticket to someone else who can later redeem it for your jacket. So, for example, if you deposit supported crypto on Compound, you will receive a “cToken” version of that coin, which represents the value of your deposit. So if you deposit $100 worth of USD Coin (USDC), you will receive $100 worth of Compound USD Coin (CUSDC), which can then be sold or traded elsewhere.
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After allocating your funds to a pool, you will receive rewards for the duration your crypto is deposited. Rewards are sometimes issued in crypto, which is typical of the liquidity pooling service. For example, Compound gives COMP tokens as a reward, which are different from the “cTokens” you get for noting your first deposit.
How some yield farmers strive for higher yields
People looking to maximize returns take this core process – earning rewards for a deposit – one step further, often by employing the following strategies:
Pursue better prices. With rates constantly changing and you can withdraw funds at any time, some people are looking for more lucrative places to move their crypto. Just like going to several different grocery stores to get the best price for each item on your shopping list, you can get a better deal using this method, but it takes time and effort.
Earn rewards by depositing LP tokens elsewhere. Getting a token representing your deposit can be the first step in a long process. You may be able to deposit this token in a second pool to earn additional interest. If this second pool’s token, given as a receipt for depositing the first pool’s token, is accepted by a third pool of liquidity, the chain continues, earning interest at each step along the way. Yield farmers have found combinations of platforms and tokens that allow this process to be repeated multiple times.
borrow crypto. Borrowing to farm, sometimes referred to as “leveraged yield farming,” has some of the same risks and benefits as borrowing to invest in stocks: You’re betting that the growth of your investment will exceed the cost of repaying the loan plus interest becomes. However, this is a risky strategy with an already risky investment. With leverage, you could lose your entire investment and still incur debt to creditors.
🤓Nerdy tip
crypto staking uses your crypto to keep proof-of-stake networks safe and pays out like DeFi platforms. It can be as simple as pressing a button on a centralized exchange’s app, but the rewards may not be as great as yield farming.
Pros and cons of yield farming
Advantages
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Tempting returns. With double-digit returns in some cases, there’s an unmistakable appeal in watching your crypto stash grow without having to buy more.
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It’s automatic – once you set it up. Depositing crypto on a DeFi platform requires technical knowledge. But once you’ve deposited it, you don’t have to do anything until you’re ready to withdraw it.
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It’s a way to support crypto in general. Decentralized financial services need liquidity to provide a stable, reliable experience.
Disadvantages
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Rental pool services are still new. The history of cryptography is full of projects that have done this suddenly went broke, hacked, or otherwise imploded. For example, in May 2022, crypto website Cointelegraph reported that more than $1.6 billion had been stolen from DeFi users through hacks and fraud since January. For example, in 2022, the DEX Maiar Exchange was hacked and more than $100 million worth of crypto disappeared.
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The prices fluctuate constantly. Yield farming is only an investment strategy if you’re not particularly sensitive to the interest you’re receiving. Advertised returns may not last long as markets change, making some protocols less lucrative and others more.
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Whether yield farming is sustainable is controversial. Some experts have suggested that yield farming leads to grossly inflated prices that will eventually collapse.
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Errors in code can cause headaches. If you farm, don’t entrust your crypto to a custodian. Instead, it is linked to a smart contract. Smart contracts are executed automatically and are irreversible. If you lose some or all of your funds due to a bug in the code, there may be no remedy.
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