Have you heard people talking about yield farming but have no idea what they are on about? In this blog we will simply define and explain it.
A Simple Definition Of Yield Farming
Yield farming is the practice of maximizing returns on cryptocurrency investments. This is achieved by borrowing or lending cryptocurrency on a decentralized platform (DeFi). It can be extremely profitable but also carries significant risk.
How Does Yield Farming Work?
Yield farming began in 2020 and is a bit like earning interest at a bank with a term deposit. It is a way to earn passive income from your cryptocurrency assets. But it is much more speculative than a term deposit. Cryptocurrency holders use a decentralized exchange (DEX) to lend, borrow or stake coins and tokens, speculating on price swings. The process is governed by smart contracts which automatically facilitate financial agreements between parties. Investors who deposit their crypto are called Liquidity Providers (LPs) and earn interest, often in the form of governance tokens, as well as a percentage of transaction fees. Critically, the more liquidity providers there are in a liquidity pool, the more diluted the returns to each of the investors.
Types Of Yield Farming
There are a number of ways to invest money on the blockchain which all fall under the umbrella of yield farming.
Liquidity provider – users deposit two cryptocurrencies in the liquidity pool of a DEX. Whenever someone exchanges these tokens or coins, the liquidity provider takes a small percentage of the transaction fee. That fee may also be paid in new tokens in the pool.
Lending – Owners of coins or tokens can lend cryptocurrency to borrowers via a smart contract and earn more crypto from interest.
Borrowing – Yield farmers can use the cryptocurrency they own as collateral to borrow more crypto. They can then farm yield with their borrowings.
Staking – There are two types of staking:
- The most common is where a user is paid interest for depositing tokens on a proof-of-stake blockchain that provides security to the protocol.
- The alternative is to stake tokens earned from the supplying of liquidity to a DEX. This allows users to effectively double dip and earn yield twice. They are paid for supplying liquidity in tokens which they can then stake to earn more yield.
The Rewards Of Yield Farms
Yield farming can be a very profitable venture and a wildly exhilarating ride full of fast-paced twists and turns. It’s very competitive and incentives can change quickly as the fortunes of liquidity pools change. That’s because word quickly gets around if a yield farming strategy is succeeding. When too many farmers catch on, it stops being as lucrative. Returns are calculated annually and normally expressed as an annual percentage rate (APR) or annual percentage yield (APY). APR does not take into account compounding whereas APY does. Both are merely projections and not guarantees.
The Risks Of Yield Farming
Yield farming can also be a risky business for both borrowers and lenders. The most significant risks facing yield farmers are:
Volatility – It can be a white knuckle ride during times of extreme market volatility with crypto investments potentially crashing or booming while locked up.
Impermanent loss – Your cryptocurrency value can rise or fall while it is staked, causing temporary unrealized gains or losses. Losses may be crystallized on withdrawal of coins with interest earned not covering the fall in their value.
Smart contract hacks – Code vetting is improving the security of smart contracts but they remain susceptible to hacks. Great research and caution is advised before selecting a DeFi platform.
Fraud – Yield farmers may be coerced into investing their coins into schemes that fold, taking all of the funds with them.
Rug pulls – Similarly, a rug pull is where a cryptocurrency developer collects funds from investors, only to abandon the project without repaying the investments.
Regulatory risk – The cryptocurrency marketplace remains unregulated but the Securities and Exchange Commission is attempting to change that by declaring some digital assets are securities. Further developments could impact their profitability.
Popular Yield Farming Protocols
There are many DeFi platforms that yield farmers can use to maximize the returns on their stakes and all offer different incentives. Here are some of the biggest:
Curve Finance – a liquidity pool on Ethereum with more locked value than any other DeFi platform.
Uniswap – liquidity providers have to stake both sides of the pool in a 50/50 ratio on this decentralized exchange.
Aave – users can lend and borrow crypto and can also use deposited coins as collateral.
PancakeSwap – an AMM on the Binance Smart Chain that deals largely with the gamification of cryptocurrency and blockchain, investing heavily in lotteries and NFTs.
MakerDAO – very popular protocol for yield farming on the Ethereum blockchain. Allows users to generate debt with collateral such as ETH and BAT.
Want To Know More About Yield Farming?
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