What is yield farming?

In the dynamic realm of digital finance, crypto trading stands out as a potential avenue for generating returns. Yet, a more innovative strategy has captured the attention of savvy traders — yield farming. This approach, distinct from traditional trading, empowers traders to explore earnings by actively engaging in decentralized finance (DeFi) ecosystems. This article explores the nuances of yield farming, unraveling its mechanisms and potential benefits.

What is yield farming?

To simplify this term, yield is the interest, similar to interest offered by banks or financial houses on locked savings. In farming, traders can employ several strategies to maximize their yields (interest). Yield farming is integrated into the DeFi space due to its flexibility compared to traditional finance.One main aspect that distinguishes yield farming from conventional interest strategies is its yield, which takes the form of crypto assets that are volatile in nature.Yield farming, also known as liquidity farming, can be referred to as lending, borrowing, or staking cryptocurrencies into a liquidity pool (LP) through DeFi protocols to potentially generate high returns. Instead of using a proprietary service like the bank, yield farming is executed using smart contracts on a blockchain network. Users can lend crypto assets to earn fixed or variable interest, while others can borrow these coins for use elsewhere. DeFi initiatives also use yield farming to encourage platform adoption and acknowledge community members for providing liquidity — a crucial element for the sustainability of many DeFi platforms.

How yield farming started

Most yield farming is offered on the Ethereum network. This is due to the network’s first mover advantage (FMA) as a smart contract network and its fluidity and openness compared to the Bitcoin network.

However, the concept originated in June 2020 through the Ethereum-based product “Compound,” where the service distributed its native token COMP to its users. As a governance token, holders could vote on proposed projects on the Compound platform. Demand for COMP tokens rose, creating a buzz that scaled it to a leading position in finance at that time.

After a short while, traders began lending crypto assets via the Ethereum network and got paid back with interest — this created the term yield farming.

How does yield farming work?

The yield farming architecture can be broken down simply. Traders start by adding or depositing funds to a liquidity pool, which takes the form of smart contracts on the DeFi protocol. Liquidity pools are important because they act as decentralized money markets that enable traders to exchange, lend, or borrow tokens seamlessly via decentralized apps (DApps).

Once funds are successfully added to a pool, traders are officially regarded as liquidity providers (LPs). Other traders can borrow the liquidity or increase their holdings to catch large market swings. The LPs are then rewarded for providing liquidity through fees generated in their pool.

Other profit-yielding methods include lending interest and earnings made from joining a Proof of Stake (PoS) liquidity pool. In yield farming, traders can earn as much as 100% annual percentage yield (APY), depending on the protocol. But this is fluid and can change depending on the trading volume of assets.

Yield farming metrics

Like all financially powered enterprises, yield farming comes with its own set of terminologies. While they may seem familiar to several readers, they vary slightly from the regular ways they're used. Below, we explore the most popular yield farming metrics and what they mean.

Annual percentage rate (APR)

Annual percentage rate (APR) is the rate of return expressed in percentages. APRs are interest rewards eligible to traders that make their cryptocurrency tokens available for loans.

Additionally, APR gives yield farmers a figure that compares the rates of other protocols. APRs don't take into consideration earnings from compounded holdings over the course of the year.

Annual percentage yield (APY)

Annual percentage yields (APY) are annual compounded returns expressed in percentages. APY comprises of compounded interest on the initial amount and interest accrued on the amount.

In simpler words, APY expresses interest earned on interest. This means that acquired interest rates automatically contribute to calculating the next interest rate.

Total value locked (TVL)

Total value locked (TVL) refers to the total funds locked by traders in a DApp with the expectation of rewards in the form of tokens. For most DeFi protocols, yield farming is a great way to generate high liquidity, especially for low-volume assets.

Success in a DeFi protocol is measured via the total value locked in it. The higher the TVL, the greater money there is.

Types of yield farming

There are four ways in which traders can engage in yield farming in a bid to maximize their crypto returns.

1. Liquidity provider

Liquidity providers are traders that deposit up to two cryptocurrencies into a decentralized exchange to provide liquidity on the underlying assets. When other traders exchange these two crypto tokens or coins on a decentralized exchange, the liquidity provider gains interest in the form of a small percentage of the transaction fees.

2. Lending

Traders keen to participate in yield farming can opt for lending to generate extra income. Traders can lend their crypto assets to borrowers using smart contracts. A certain percentage of interest is paid back as yield when borrowers pay back on their loans.

3. Borrowing

Borrowing is another notable option in the yield farming space. Traders can opt to lock their assets as collateral to take a loan on another token or coin. The borrowed asset can then be used to participate in other yield farm options.

4. Staking

Staking is arguably the simplest and most accessible form of yield farming for new or intermediate crypto traders. It's the act of locking up crypto assets for a defined or undefined period with the aim of obtaining rewards in the form of interest or extra tokens initially staked. The motive is to secure the underlying network, as the staked funds are recorded as transactions on the blockchain protocol.

Staking is usually done via pools, but several centralized exchanges like Binance provide a streamlined means for traders to stake their idle crypto assets.

The risks of yield farming

While yield farming has been recognized for its potential within the crypto space, it's essential to acknowledge the associated risks inherent in the practice. Despite the opportunities it presents, there are significant considerations and potential challenges that warrant careful evaluation. This section explores the various risks associated with yield farming.

Volatility

Because the cryptocurrency market is volatile, the value of tokens that traders deposit in liquidity pools will fluctuate over time. Even if an APY of 1,000% is estimated on a crypto asset, traders will always have to hope that the asset will maintain its initial value to earn the stated APY.

Impermanent loss

Yield farming may result in huge losses on massive gains on crypto assets deposited. This is largely due to impermanent loss. The concept occurs when an asset’s value drops due to market volatility while still being locked in the liquidity pool.

In simpler words, traders stand to receive a lower dollar valuation of their assets when they want to withdraw.

Scams

The DeFi space’s lack of regulation makes it easy for scammers to program fake platforms that promise high APYs to potential traders. There have been cases where DeFi platform creators take in traders' deposits and disappear, essentially executing a rug pull. Fundamental research should be done before using yield farming protocols to avoid this.

Top three yield farming protocols

There are hundreds of DeFi protocols that offer yield farming. Here are a few of the most reputable and largest.

Compound (COMP)

COMP is an algorithm protocol deployed on the Ethereum blockchain. It allows for the lending and borrowing of crypto assets against collateral. Compound allows traders to earn interest rates based on activities in its liquidity pool.

Yield farmers are also given the opportunity to earn its governance token — COMP.

AAVE (AAVE)

AAVE is a decentralized lending and borrowing protocol that runs on the Ethereum blockchain. It integrates smart contracts to facilitate the process, with preset rules on how crypto assets are distributed, how transaction fees are assessed, and how collateral is handled. The protocol also features a governance token, AAVE, which can be traded on most decentralized and centralized exchanges or staked in the Aave protocol to earn interest.

Yearn.Finance (YFI)

Like COMP and AAVE, Yearn.Finance is a group of protocols based on the Ethereum blockchain that enables users to optimize their returns on crypto holdings through a series of lending and trading services ranging from Earn and APY data tables to Vault and Zap trading platforms.

Additionally, it integrates a native token, YFI, used as an incentive for traders.

The final word

Navigating the cryptocurrency market to make informed decisions can be a challenging task. Yield farming emerges as a compelling option, supporting the best interests of traders and providing potential rewards. It's crucial to recognize, however, that the allure of higher potential gains goes hand in hand with increased volatility. As crypto traders explore the possibilities of yield farming, maintaining a nuanced understanding of the associated risks and rewards is key to making sound decisions in the dynamic world of cryptocurrency.

FAQs

Is yield farming a wise choice?

Yield farming does present opportunities in the crypto space with appealing annual percentage yields, interest rates, and token rewards. However, it's vital to recognize the inherent volatility of crypto assets. Therefore, users should approach yield farming with caution and only allocate funds they're prepared to lose.

Can you generate income through yield farming?

Participants (liquidity providers) can potentially earn attractive annual yields, often exceeding 100%, through their involvement. An added advantage is that yield farming operates through smart contracts, eliminating the need for intermediaries or third parties. Additionally, the mechanism allows users to earn interest on their earnings, leveraging borrowed coins to yield returns on alternative platforms. It's important to note that while these possibilities exist, participants should approach yield farming with a realistic understanding of the associated risks and market fluctuations. Always do your own research (DYOR) before embarking on any crypto activity.

Yield farming vs. staking: what's the difference?

Yield farming involves earning interest on various trading pairs, while staking requires a deposit of a single crypto asset. The key distinction lies in their interest rates, with yield farming rates typically being higher than those associated with staking.

What are the risks of yield farming?

While yield farming offers various benefits, it isn't without risks. Potential challenges include impermanent loss, the presence of fake DeFi smart contracts, fluctuating lending interest rates, volatility in crypto assets, and more. This high-risk strategy requires careful consideration, especially during bearish market conditions, as price fluctuations can lead to substantial slippage, smart contract liquidation, or impermanent loss.