What Is Yield Farming in DeFi?

What Is Yield Farming in DeFi?

For Newbies
April 24, 2021 by Leo Webb
6903
Since 2020, yield farming has become one of the most important concepts in decentralized finance (DeFi). Simply put, yield farming is a practice that enables you to use your cryptocurrency to make more cryptocurrency. This concept is based on lending funds to other users from the network through smart contracts. In return, you can earn
yield farming

Since 2020, yield farming has become one of the most important concepts in decentralized finance (DeFi). Simply put, yield farming is a practice that enables you to use your cryptocurrency to make more cryptocurrency. This concept is based on lending funds to other users from the network through smart contracts. In return, you can earn fees.

Although the concept of yield farming may seem pretty straightforward, yield farmers use complex strategies to maximize their returns and distribute their cryptocurrency across different marketplaces. Many yield farmers keep their best strategies in secret because the more people know about a certain strategy, the less effective it becomes. Yield farming is a rapidly developing area of DeFi. In this article, we will consider it in more detail and take a look at both advantages and disadvantages of yield farming.

What Is Yield Farming in Decentralized Finance?

The concept of yield farming was born after an Ethereum-based project Compound started to distribute its governance tokens to the users of the protocol. The demand for the COMP token increased because of the structure of automated distribution and resulted in Compound moving to the leading positions in DeFi. Now, the term “yield farming” is used when talking about different strategies that involve lending crypto assets to various applications in order to earn a return.

Also known as liquidity mining, yield farming quickly became a buzzword in the world of blockchain and cryptocurrencies. Those who are new to the cryptocurrency industry might feel that something big is happening in the industry now, and the reason is that yield farming quickly evolves, and new applications intended for yield farmers appear here and there all the time. Let’s consider yield farming and DeFi in more detail.

What Is DeFi?

Decentralized finance is one of the most rapidly developing areas of the cryptocurrency industry. DeFi mostly focuses on recreating and reinventing traditional financial tools in a decentralized way, with no outside control from governments and companies. DeFi offers a more transparent approach and reduces some operational risks associated with the traditional financial tools.

In 2020, tokens like COMP and UMA enabled users to borrow and lend their funds within a decentralized ecosystem. Now, the DeFi industry demonstrates an unexpectedly quick growth, with a total value locked of about $50 billion. Compared to traditional finance, DeFi offers more transparency because it doesn’t utilize banks and other institutions as a source of trust. Instead, all operations are regulated by self-executing smart contracts. The DeFi concept also fosters innovation and encourages developers to come up with new unique approaches.

What Is Yield Farming?

Yield farming, or liquidity mining, is a process of locking up crypto assets in return for rewards. Yield farming has something in common with staking but its background mechanisms are much more complex. Usually, yield farming relies on liquidity providers who provide their crypto funds for liquidity pools. Simply put, a liquidity pool is a smart contract with cryptocurrencies. Underlying DeFi platforms generate fees and use them to reward liquidity providers.

There are many liquidity pools, and all of them are different. Some liquidity pools reward liquidity providers with different types of tokens. After this, users can deposit these reward tokens to other liquidity pools to get rewards there. As a result, liquidity providers often create very complex strategies to maximize their return. Yield farming is mostly based on ERC-20 Ethereum tokens, and the reason is that the majority of DeFi projects are Ethereum-based.

At the same time, cross-chain bridges and other technologies enable developers to create DeFi applications that can support different types of smart contracts and run on different blockchains. Yield farmers usually move their funds from one liquidity pool to another all the time, using different protocols to find the highest yield. As a result, developers of DeFi solutions implement new cross-chain features and create various economic incentives to attract more liquidity providers to their platform.

How Does It Work?

The concept of yield farming is closely related to automated market makers (AMM). Liquidity providers deposit their cryptocurrency into liquidity pools that are used by marketplaces to enable users to borrow, lend, or exchange tokens. Such platforms charge fees and these fees are used to reward liquidity providers. The amount of rewards usually depends on liquidity providers’ share of the pool. This is how AMMs work in a nutshell, but different platforms may have different mechanisms of rewarding and lending. Besides, AMMs are a new technology so we certainly will see more new solutions in the future.

Rewards are not the only reason why people add their cryptocurrency to liquidity pools. For example, DeFi platforms often use new tokens as incentives. Some tokens may be very difficult to buy on the open market while being available as rewards for providing liquidity to a certain pool. The way tokens are distributed depends on the implementation of the protocol by a particular platform. Most often, the deposited funds are stablecoins “pegged” to USD, which means that their value closely follows the value of USD. The most common stablecoins in DeFi are USDT, DAI, BUSD, USDC, and others.

Many platforms not only provide rewards for liquidity providers but also mint tokens that represent the tokens deposited by liquidity providers. For example, if you deposit ETH into Compound, you will get Compound ETH — cETH. The best thing about this approach is that you can deposit these new tokens into other protocols, receiving more income in fees and getting new tokens. For example, you can deposit ETH, get cETH, then deposit cETH, get another token, etc. As a result, yield farming strategies are often very complicated and consist of many levels. For example, some users make a deposit and then borrow against these tokens. Obviously, such strategies are especially risky.

Advantages of Yield Farming

The main advantage of yield farming is that it can be very profitable. Yield farming is definitely a more profitable solution than storing cryptocurrencies in savings accounts. Holders can lock their cryptocurrencies in DeFi protocols and get additional passive income. If you’re an early adopter of a new crypto project, you can generate rewards in tokens that will quickly grow in value. Then, you can sell these tokens at a profit and reinvest these funds again.

Even though yield farming is a relatively new practice, it’s already much more lucrative than using traditional banks because yield farming offers much higher interest rates. The most successful yield farmers earn up to 100% of the annual percentage rate (APR), and traditional banks cannot offer anything comparable to such profits. However, it’s important to keep in mind that the most successful yield farmers usually have a lot of capital behind them, and they often use high-risk strategies.

How To Become a Farmer

To become a yield farmer, you should add liquidity to liquidity pools, which are basically smart contracts with cryptocurrencies. You should add your funds to a liquidity pool, and as soon as you do it, you will become a liquidity provider. After this, you’ll be able to get rewards with fees that come from swaps on the underlying DeFi platform. It’s important to understand the difference between simply investing in cryptocurrencies and yield farming. For example, investing in ETH isn’t yield farming, while lending your ETH on a decentralized protocol and getting a reward is what yield farming is all about.

Once you’ve got your reward, you can deposit these tokens in another liquidity pool to maximize your returns. Usually, yield farmers constantly move their cryptocurrencies around to get the most profit. However, yield farming isn’t an easy solution if you’re looking for a source of extra income. Most DeFi solutions are based on the Ethereum blockchain, so if you’re looking for the best returns, you should know all the ins and outs of Ethereum, choosing the right DeFi platforms. In addition, liquidity providers are usually rewarded based on the amount of liquidity they provide. Therefore, if you want to maximize your returns, you should deposit large amounts of capital.

The Risks of Yield Farming

Not only should you have a lot of money to succeed in yield farming, but you should also be careful because yield farming is quite risky. The most profitable strategies are very complex so they are recommended for experienced blockchain users only. If you don’t understand what you’re doing, you can lose your money very quickly. First, when borrowing funds, you should cover your loan with collateral, and if the value of collateral drops below the limit established by the protocol, the collateral can be liquidated on the open market. The only way to avoid liquidation is to add more collateral.

Besides, you should keep in mind that DeFi smart contracts are created by small teams of developers with limited budgets, and they may contain bugs. Even well-known protocols that are audited by auditing firms have some vulnerabilities. The world of cryptocurrencies has already seen many DeFi failures. In 2020, the most devastating incident involved MarkerDAO and was dubbed Black Thursday. If you decide to invest in yield farming, you should understand that it is risky.

Ethereum developers say that some yield farming projects are not sustainable. Some projects manage to raise a lot of money quickly but then lose momentum and get forgotten, while others may turn out to be scams. There are also yield farming projects that utilize unaudited code, which sometimes can lead to unpredicted consequences.

The Most Popular Yield Farming Platforms and Protocols on Ethereum

  • Curve
    Curve Finance is a decentralized protocol developed specifically for efficient swapping of stablecoins. The main advantage of Curve compared to other platforms of this kind is lower slippage, and this protocol is often used for high-value swaps. Stablecoins play an especially important role in yield farming, so there’s no surprise that Curve pools are a very valuable element of the yield farming infrastructure.
  • Uniswap
    This is another decentralized exchange protocol intended for trustless swaps of tokens. To create a market, liquidity providers deposit value equivalent to two tokens. After this, this liquidity pool enables traders to trade against it. Liquidity providers get fees from trades that occur in their liquidity pools. A lack of friction made Uniswap one of the most popular token swap platforms, and it is also appreciated by yield farmers.
  • Compound
    This is an algorithmic financial market where users can borrow and lend their assets. If you have an Ethereum wallet, you can provide liquidity for the Compound liquidity pool and receive rewards that are immediately compounded. Depending on the levels of supply and demand, the rates are algorithmically adjusted. The importance of Compound for yield farming is hard to overestimate, as this is one of the key protocols of the entire yield farming ecosystem.
  • Sushiswap
    Sushiswap is basically a fork of Uniswap, and it offers the same features. Just like with Uniswap, you can earn rewards for providing liquidity. SUSHI tokens are distributed among liquidity providers of specific Uniswap pools who can deposit Uniswap LP tokens into Sushiswap staking contracts and earn SUSHI.

Wrapping Up

Yield farming is a highly profitable area of decentralized finance that enables liquidity providers to earn rewards in fees. Although yield farming can be very profitable, it’s also very risky, especially considering the amount of possible losses. To succeed in yield farming, you should have a lot of cryptocurrency because your income directly depends on how much liquidity you provide. If you have enough funds and experience, yield farming can be a good source of income. However, yield farming is not the best solution for beginners because, to maximize profits, you should move your funds among different pools, know a lot about DeFi projects, and use complex strategies.

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