- Yield farming offers crypto asset holders a way to earn passive income by tapping into the value held in their assets.
- The process can be complicated. The risk of loss is high for those who do not fully understand what they are doing.
- Yield farming involves depositing assets onto various protocols and liquidity pools in an effort to obtain the highest yields offered for a particular asset.
- Types of yield farming include providing liquidity, lending, borrowing and staking.
- Risks involved with yield farming include market volatility, smart contract bugs and exploits, rug pulls, and the possibility of a contagion effect that spreads across DeFi.
Decentralized finance (DeFi) has emerged as one of the most transformative sectors of the cryptocurrency market. Its permissionless nature allows anyone with an internet connection to access financial markets.
On top of bringing these services to the previously “unbanked,” DeFi has helped create a more level playing field by removing the need for trusted intermediaries and custodians who earn a living by skimming fees off the top.
Out of this new landscape, yield farming offers crypto holders a new way to earn rewards by putting assets to work in permissionless liquidity protocols. This offers users who have traditionally just HODLed their assets a way to continue to do so while also earning a little passive income on the side.
Here’s a deeper look at what yield farming is, how it works, and what kinds of yields a user can expect in exchange for the risk of relinquishing control of yield farming crypto assets.
What Is Yield Farming?
The most basic explanation of yield farming is locking up a cryptocurrency asset to earn rewards. This process is also referred to as liquidity mining. It can be compared to the process of staking minus the “securing the network” bit that staking is generally used for.
While the process is akin to staking because tokens become locked on a smart contract and are unavailable for trading, much more complexity is involved. The farm moves funds around to various liquidity pools for the highest yields.
Liquidity pools are smart contracts that contain funds used to facilitate token swaps. Fees earned from the swaps go back to liquidity providers.
Yield farms often work hand in hand with liquidity providers to simplify the liquidity mining process and create a reliable rate of return in exchange for helping to ensure ample liquidity.
A vast majority of the current yield farming activity occurs on the Ethereum network with ERC-20 tokens, but that is slowly beginning to change as other smart contract platforms like Solana and Avalanche grow in stature and offer cross-chain functionality with Ethereum.
The process of crypto yield farming can get quite intensive as farmers move their funds around frequently between different protocols in search of high-yield crypto opportunities. Many DeFi platforms offer additional incentives to attract more liquidity to their protocols, which can turn into a snowball effect as the higher the total value locked (TVL) gets, the more legitimacy a protocol has in the eyes of the public.
Is Yield Farming Legit?
Yield farming has gotten a bad reputation both in and outside of the crypto world. Leading outlets like the Wall Street Journal have decried the risk of “losing it all” while yield farming.
Like any activity involving money, there’s always the risk of scams or fraud. However, the concept of lending money to earn interest is also found within traditional finance. Billionaire Mark Cuban has even asserted that “Yield farming is not much different than buying high-dividend paying stocks or high-yield unsecured debt or bonds.”
Overall, countless crypto users have managed to profit safely through yield farming. Today, in a rapidly-maturing crypto ecosystem, there’s a vast range of legitimate yield farming platforms that crypto holders have used with great success.
What Is Total Value Locked?
One of the methods used to measure the overall health of a DeFi protocol is by looking at its Total Value Locked (TVL). This is a measure of how much the crypto locked on a specific DeFi protocol, such as a lending platform or money marketplace, is worth.
Put another way, a platform’s TVL is the aggregate liquidity in all of the available liquidity pools on that platform. It can also be used as a measure to judge the health of the DeFi ecosystem as a whole by tracking the value of all the liquidity deposited on DeFi smart contracts. Along those same lines, TVL can also be used to compare the “market share” held by each DeFi protocol.
How Does Yield Farming Work?
Yield farming goes hand in hand with automated market makers (AMM). They both utilize liquidity providers and liquidity pools to help the ‘plumbing’ of DeFi operate smoothly.
The process typically starts with liquidity providers depositing funds into a liquidity pool which powers a marketplace where users can lend, borrow or exchange tokens. Conducting transactions on these protocols involves a fee that is then paid to liquidity providers based on their share of the liquidity pool. This is the basic idea of how AMMs function.
Along with fees, protocols often offer additional incentives to attract liquidity such as an extra percent yield that is paid out in their native token or another token that is new to the market and has yet to develop deep liquidity for trading.
The amount liquidity providers earn varies from protocol to protocol, but the main thing to understand is that they earn a return based on the amount of liquidity they provide to the pool.
Yield farming helps to simplify the process for users by doing the leg work of moving tokens around and finding the best yields in exchange for a cut of the proceeds. On top of that basic function, the pooling of funds allows the farm to contribute a larger amount of liquidity to pools, thus earning a larger percentage of the trading fees generated by that pool.
Types of Yield Farming
- Providing liquidity to liquidity pools
- Lending - Depositing crypto assets on a smart contract that can then be borrowed by other users for a set yield.
- Borrowing - Using one crypto asset as collateral to borrow another, and then using those borrowed assets to yield farm.
- Staking - Depositing assets on a proof-of-stake network to earn rewards or staking liquidity provider tokens earned from depositing assets into a liquidity pool, thereby doubling the yield opportunity for the originally deposited assets.
How Are Yield Farming Returns Calculated?
Yield farming returns are generally calculated on an annual basis as an Annual Percentage Rate (APR) and Annual Percentage Yield (APY).
As an aside, while APR and APY are often used interchangeably, the APR metric doesn't account for the effect of compounding while the APY metric does. Compounding is the process of directly reinvesting the profits of an investment in order to generate more returns.
It's important for anyone interested in crypto yield farming to understand that the APY/APRs quoted by protocols are estimations that are likely to change over time depending on what happens in the volatile crypto market. Successful yield farming strategies tend to attract more farmers, which can then alter the yields offered and eventually lead to an end of the high yields. How come? Because well-funded liquidity pools no longer need to offer higher rewards to attract liquidity.
What Are the Risks Associated With Yield Farming?
The process of cryptocurrency yield farming is a complicated one, and the level of complexity only increases as yield farming strategies get more profitable. Additionally, heavy involvement in yield farming is usually only recommended for those who have a large amount of capital to deploy.
The main warning offered to those wishing to get involved with farming is that it's easy to lose money if you don’t understand what you are doing. Make sure to read all documentation and completely understand any yield farming risks laid out before depositing funds into any yield farm or liquidity pool.
Another risk to watch out for is issues related to smart contracts. There is a well-documented history of poorly written smart contracts resulting in permanently locked funds or contract exploits that allow a hacker to drain all assets deposited in the contract.
While there is little a user can do to ensure that a smart contract's code is free from any bugs, it's something that needs to be taken into consideration.
Rug pulls are another concern to be mindful of. It's important to do a good deal of research into a project before depositing any funds to determine if the protocol is legitimate and trustworthy.
A final risk to take note of is the composable nature of the DeFi ecosystem, meaning the way in which the various protocols are connected and work together. If just one of the key pieces of infrastructure for DeFi fails, there is a potential that the whole ecosystem could suffer as a result.
A good example of this was the collapse of Terra (LUNA) and its TerraUSD (UST) stablecoin, which sparked a contagion effect that spread across DeFi and crypto CeFi, eventually plunging the market into a crypto winter.
How to Start Yield Farming?
At first glance, yield farming might seem complex. However, learning how to yield farm is easier than many would think, since many protocols take care of the entire process themselves. As a prospective yield farmer, follow these steps to get started.
- Select Your Platform: Head over to the yield farming platform you’d like to stake coins with. Be sure to review the yield percentages for different pools along with other details before connecting a wallet.
- Link A Wallet: Next, you will want to connect your crypto wallet and decide how many coins you’d like to deposit. Be sure to approve the transaction (after reviewing the fees) by clicking ‘Confirm.’
- Add Liquidity: Finally, you will want to ensure you approve the transaction directly on the yield farming platform to provide liquidity. Once you’ve finished these steps, you’ve officially learned how to yield farm crypto and are ready for your assets to work for you.
Different yield farming platforms might have more complex instructions, but these three simple steps remain the same across any protocol. Many popular yield farming platforms offer plenty of user instructions and emphasize UI/UX, which makes the onboarding process easy even for those largely unfamiliar with crypto.
What Are Some of the Best Yield Farming Opportunities?
With so many yield farming platforms out on the market, it can be hard to know where the best opportunities may lie. Farms with the highest APY and APR potential are often smaller and newer.
Well-known ‘legacy’ yield farming platforms include PancakeSwap, Aave, and Curve Finance. Each of these protocols has many pools with solid APRs and strong reputations.
Like with any financial instrument, be sure to do your research, understand what you are getting into, and carefully study pool details in order to maximize your yield farming experience.
