Decentralized finance, or DeFi, is undoubtedly one of the most innovative applications of crypto and blockchain technology. It is incredibly popular, too — at the time of writing, there were over 40 billion dollars locked in various DeFi protocols. Yield farming, which we will be discussing in this article, has been a major contributor to this industry’s success.
How Does Yield Farming Work?
Yield farmers don’t till any land — instead, you can imagine them as agricultural magnates who rent out fields and wait for the crops to grow in demand and thus become more valuable. In a way, yield farming can be seen as any other investment: buying assets and waiting for their price to grow while also earning some interest along the way.
A brief overview of how yield farming works
However, unlike traditional bank deposits, yield farming operates using smart contract technology. To put it simply, yield farming is a way to earn a passive income from your cryptocurrency funds. It involves crypto investors putting their tokens and coins in decentralized applications, or dApps. These apps can be crypto wallets, decentralized exchanges (DEXs), and more.
The investors who deposit their funds — stake them or lock them up — are called liquidity providers. They are incentivized by things like the percentage of transaction fees, interest, or income in governance tokens. All of their potential returns are expressed with the APY metric — the annual percentage yield.
The more liquidity providers a liquidity pool (a place that yield farmers lock their assets in) has, the fewer rewards each investor receives.
Yield Farming vs. Staking
Yield farming may seem very similar at first glance — and, in fact, staking can be a form of yield farming. The two are not completely the same, however. In general, staking is a lot more beginner-friendly than yield farming. Here are some of the other key differences between the two.
Staking is typically used with proof-of-stake cryptocurrencies, while yield farming requires automated market makers (AMMs).
Yield farming is a lot more volatile than staking: with the latter, you always know how much you will get. Your rewards from yield farming, on the other hand, will depend on your chosen liquidity pool and the assets you’ve invested in.
As yield farming is generally more rewarding than staking, it is naturally riskier, too. After all, your rewards will depend on how well the assets you’ve locked up will perform.
Staking requires you only to earn interest on one token, while yield farming lets you lock up trading pairs. Additionally, yield farming typically does not have a minimum lock-up period — unlike staking, which often does not allow investors to withdraw their funds right after they’ve staked them.
Please note that yield farmers have to deposit an equal amount of both coins/tokens in the trading pair they’re locking up.
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Yield Farming Metrics
When you start researching DeFi protocols, you might run into abbreviations that you don’t recognize. Here are the top 3 most common ones.
Total Value Locked (TVL)
TVL, or the total value locked, is the total amount of cryptocurrency locked in a particular protocol. Usually expressed in USD, it is essentially the amount of users’ funds currently deposited on the DeFi platform.
Annual Percentage Yield (APY)
APY, or the annual percentage yield, is the estimated rate of return that can be gained over a period of one year on a specific investment.
Annual Percentage Rate (APR)
APR, or the annual percentage rate, is the projected rate of return on a particular investment over a period of one year. Unlike APY, it does not include compound interest.
Compounding is the act of reinvesting your gains to get bigger returns.
Types of Yield Farming
There are several ways in which you can engage in yield farming.
1. Liquidity provider
Liquidity providers are users that deposit two cryptocurrencies to a DEX to provide liquidity. Whenever somebody exchanges these two tokens or coins on a decentralized exchange, the liquidity provider gets a small cut of the transaction fee.
2. Lending
Investors can lend their tokens and coins to borrowers using smart contracts. This allows them to earn yield from the interest that borrowers pay on their loans.
3. Borrowing
Investors can lock up their funds as collateral and take a loan on another token. This borrowed token can then be used to farm yield.
4. Staking
Staking in DeFi comes in two flavors: staking on proof-of-stake blockchains that we have already mentioned above and staking the tokens you earned by depositing funds to a liquidity pull. The latter allows investors to earn yield twice.
How to Calculate Yield Farming Returns
The first thing you need to know about yield farming returns is that they’re usually annualized: this means they are calculated for a one-year period.
Yield returns are typically measured using the APR (annual percentage rate) and the APY (annual percentage yield). Please note that, unlike the latter, the former does not account for compound interest.
The APR formula is fairly simple:
APR = (Annual Return / Investment) * 100%
The APY is a little harder to calculate. First of all, you will need to know how often your interest will be compounded — how often your returns will be reinvested into the liquidity pool.
Here’s the formula for it:
APY = Invested Amount * {(1 + Rate / Number of Compounding Periods) ^ Number of Compounding Periods – 1}
Please note that in most cases, you won’t have to use the formula yourself because most platforms nowadays automatically calculate projected returns for you.
Yield Farming Protocols
There are a lot of yield farming protocols out there. Although going for the most popular ones is usually the best idea for beginners, some of them may not suit you as an investor.
Here is a short overview of some of the biggest yield farming platforms.
MakerDAO
MakerDAO is one of the most popular yield farming protocols: at the time of writing this article, it had the largest amount of value locked in it worldwide. Like many other similar protocols, it was built on Ethereum.
Maker (as it is also called) allows anyone to generate debt in DAI (its token) against collateral such as ETH or BAT. DAI you borrow incurs an interest paid to the investor when they repay the loan.
PancakeSwap
PancakeSwap is one of the biggest decentralized exchanges in the industry. Built on the Binance Smart Chain, it is used for swapping BEP-20 tokens. PancakeSwap uses the AMM model.
This protocol focuses on the gamification aspect of crypto and blockchain and heavily invests in lotteries, team battles, and NFTs.
Curve Finance
Curve Finance is a decentralized exchange that lets users swap stablecoins taking advantage of low fees, low slippage, and fair rates. Built on the Ethereum blockchain, Curve Finance uses its own unique market-making algorithm.
As this protocol mostly has stablecoin pools, it generally has lower APY than other platforms on this list. However, it also is a lot safer, as there is less chance that it can lose its peg.
Compound
Compound, an algorithmic money market protocol, focuses on enabling users to borrow and lend digital assets against collateral. Apart from letting investors earn adjusted compound interest rates, it also provides them an opportunity to earn its governance token, COMP.
Compound’s rates are adjusted automatically based on supply and demand. It has a lot of markets, including but not limited to USDC, ETH, and BAT.
Aave
Aave is an open-source non-custodial lending and borrowing protocol built on the Ethereum blockchain. The yield users can earn on any crypto assets they supply to the platform is adjusted automatically and algorithmically and is based on supply and demand.
Aave supports so-called “flash loans” — borrowing and repaying an asset within one-block time. The protocol has a governance token, AAVE.
Uniswap
Uniswap is one of the world’s most famous decentralized exchanges and AMMs. Its fame is partially due to its mascot, a white-and-pink unicorn, and partially due to its reliability as an exchange for ERC-20 tokens and Ethereum itself.
On Uniswap, any user can create a liquidity pool for a trading pair made up of ETH and one of the ERC-20 tokens. The pool creator can then set the exchange rate, which will be adjusted by the protocol’s signature constant product market maker mechanism. When the liquidity of one side of the trading pair reduces in relation to the other, the price changes. This generates more trading opportunities for investors.
Yield Farming Risks
Like any other investment venture that can bring you 1,000% profits, yield farming is incredibly risky.
In addition to being reliant on cryptocurrency prices, yield farming also has a few other risks associated with it. One of the biggest ones for beginners is the inherent complexity yield farming has: it is not something that you can jump into unprepared. This type of passive income has a high entry barrier both in terms of general knowledge and understanding of how yield farming platforms work.
Luckily, a lack of knowledge is one of the easiest problems to solve. Other risks, however, aren’t as easy to mitigate: some of them will remain, no matter how good your strategy is. Still, there are definitely ways to minimize the chances of them causing you to lose your funds.
Rug Pulls
A rug pull happens if the development team of a cryptocurrency project decides to abandon their project out of the blue and sells/removes its liquidity. This risk is especially common in DeFi projects, which are easier to create and are not regulated.
One second before disaster
If the rug pull happens and liquidity dries up, all investors who deposited their funds to the project will be unable to sell their tokens at a fair price — or at all.
To avoid rug pulls, pay attention to the team behind the protocol: are they overhyping their project on social media despite it not being active or popular for that long? Do they have a good reputation and history? Are the project’s tokenomics, roadmap, and so on sound and transparent?
DYOR and thoroughly examine every project you are planning to invest in to minimize the risk of losing your funds to a rug pull.
Smart Contract Issues
Although smart contracts are a relatively reliable technology, hacks are still incredibly common. As they are the foundation of all yield farming, it is only natural that any issues with them put yield farmers’ investments at risk.
This is not something that can be mitigated since even investing in the most reliable and mainstream liquidity pools may not save you from potential smart contract hacks. However, researching any platform before working with it is still a good idea that can save you from potential theft. And if you can’t judge how good their security is yourself, you can read reviews online.
Regulatory Risk
This form of risk is a bit weird. On the one hand, the crypto industry as a whole and DeFi, in particular, are so-called gray zones: they are not regulated that strictly yet, but governments are certainly keeping an eye on them and thinking about how to keep the market in check.
However, decentralized finance was built to withstand regulation pressure and government control, so it should not be heavily affected by new laws and legislation.
FAQ
What is the best cryptocurrency to yield farm?
Yield farming involves investing in liquidity pools that contain trading pairs, not individual crypto tokens or coins. The best digital asset to farm will always be the one that suits your yield farming strategy.
Where can I yield farm crypto?
The most popular yield farming platforms include PancakeSwap, Uniswap, Curve Finance, Maker DAO, and more.
Is yield farming still profitable?
Yield farming can still be profitable as long as you manage your investments and the risk well.
Disclaimer: Please note that the contents of this article are not financial or investing advice. The information provided in this article is the author’s opinion only and should not be considered as offering trading or investing recommendations. We do not make any warranties about the completeness, reliability and accuracy of this information. The cryptocurrency market suffers from high volatility and occasional arbitrary movements. Any investor, trader, or regular crypto users should research multiple viewpoints and be familiar with all local regulations before committing to an investment.
