What is yield farming?

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The world of crypto can be complex at times, but some users have learned tactics to maximise the revenue they can generate from their cryptocurrency. And yield farming is one of those tactics. Let’s take a look at how to earn rewards and interest on your ctypto.

Yield farming key features:

  • With yield farming, you can earn interesting on your staked crypto
  • Yield farming can offer significantly higher annual percentage yields (APY) compared to traditional financial instruments
  • Yield farming platforms often allow for the swapping of one type of token for another, facilitating diverse investment strategies

What is yield farming?

Yield farming is the DeFi equivalent of putting your money to work, but instead of a 9-to-5 grind, your digital assets are the ones breaking a sweat. In layman’s terms, it’s the practice of staking or lending your crypto assets to earn more crypto. Think of it as the high-octane version of a traditional savings account, but with the potential for much higher returns (and risks). It’s similar to depositing money in a bank, with yield farming you lock your cryptocurrency for a certain period of time, called staking.

Yield farming allows for passive income generation on cryptocurrency assets through decentralized finance (DeFi) platforms, although the process is seldom passive. Commonly known as yield farmers, users frequently employ intricate tactics, transferring digital currencies across various platforms to optimize gains while sacrificing liquidity. Lately, DeFi platforms offering leveraged yield farming have begun providing uncollateralized loans to liquidity providers and yield farmers, enabling them to borrow crypto assets to amplify both risks and rewards.

Since its start in 2020, users have achieved returns in the form of annual percentage yields (APYs) that can reach triple digits. However, this potential return comes with a high risk, as protocols and coins are subject to extreme volatility and scams called rug pull – when developers abandon a project and run away with investors’ funds.

Fun fact: Yield farming has given rise to various food-themed DeFi projects, such as PancakeSwap, SushiSwap, and BakerySwap, making the DeFi space sound deliciously interesting.

How does yield farming work?

Simply put, yield farming involves lending cryptocurrency over the Ethereum network. When loans are made through fiat money banks, the amount lent is returned with interest. In yield farming, the concept is the same: cryptocurrency that would otherwise be sitting on an exchange or in a wallet is lent out via DeFi protocols (or locked into smart contracts), with the intention that the user receives a return. Yield farming is usually done with ERC-20 tokens on Ethereum, and the rewards are a form of ERC-20 token. Although this may change in the future, almost all current yield farming transactions are conducted in the Ethereum ecosystem.

Yield farming is built on the backbone of smart contracts in the DeFi ecosystem. Here’s how it works:

  • Liquidity pools: You start by depositing your crypto assets into a liquidity pool. This pool is essentially a smart contract that contains funds from various users.
  • LP tokens: Once you’ve deposited your assets, you receive LP (Liquidity Provider) tokens. These tokens represent your share of the pool and can be used to claim rewards or even participate in governance votes in some protocols.
  • Yield rewards: The protocol uses your assets to facilitate lending, trading, or other financial services. In return, you earn rewards, usually in the form of additional tokens, thus increasing your yield.

Here we have to note that these are quite complex things. Yield farmers are often very experienced with the Ethereum network and its technical features – and will move their assets to different DeFi platforms to get the best returns. This is by no means easy and it is certainly not easy money. Those who provide liquidity are also rewarded according to the amount of liquidity provided, so those who farm large rewards also have correspondingly large amounts of capital behind them.

Types of yield farming

  1. Single-asset staking: Single Asset Staking is the most straightforward form of yield farming. You stake a single type of token—be it ETH, BTC, or a stablecoin like USDC—in a smart contract. In return, you earn rewards, usually in the form of additional tokens. You deposit your chosen asset into a smart contract on a DeFi platform, then the smart contract locks your assets and starts calculating your rewards based on the staking period and amount. All that is left to do now is harvest. After a predetermined period, or sometimes whenever you choose, you can claim your rewards.

Popular platforms: MakerDAO, Aave, and Compound are some of the big names here.

  1. Liquidity provision: here, you’re not just staking one asset; you’re providing a pair of tokens to a liquidity pool. This is often done to facilitate decentralized trading. Choose a pair of tokens you want to provide as liquidity. This could be ETH/USDC, BTC/ETH, etc. Then add an equal value of both tokens to the liquidity pool. You’ll earn a portion of the trading fees from the pool, and often additional rewards in the form of governance or utility tokens.

Popular platforms: Uniswap, SushiSwap, and PancakeSwap are the go-to platforms for liquidity provision.

  1. Complex strategies: This involves multiple steps, like staking LP tokens to farm other tokens, which are then staked again in another protocol. It’s basically yield farming inception.

Popular platforms: Yearn Finance and Harvest Finance offer automated strategies that can help you navigate these complex scenarios.

What is a yield aggregator? There are platforms known as yield aggregators that automate the yield farming process, essentially doing the “farming” for you, like a virtual agricultural robot.

Pro tip: As with any financial venture, yield farming comes with its own set of risks. These can range from smart contract vulnerabilities to impermanent loss. Always remember: the higher the potential reward, the higher the risk.

Why is yield farming so popular?

  • Atractive returns: Well, ne of the most obvious reasons yield farming is so attractive is the potential for high returns. Traditional finance is offering interest rates that are laughably low, often below the rate of inflation. Yield farming, on the other hand, can offer double or even triple-digit annual percentage yields (APYs).
  • Compounding: In yield farming, you’re not just earning interest on your initial investment; you’re often earning additional tokens that can be reinvested to generate even more yield. This compounding effect can turn a modest investment into a small fortune over time, assuming, of course, that you’re aware of the risks and manage them effectively.
  • Governance: Many DeFi protocols offer governance tokens as rewards for yield farming. These tokens give you a say in the future development of the protocol. It’s like being a shareholder and a user at the same time. This sense of community and influence is a unique feature that makes yield farming even more appealing.
  • Flexibility: The DeFi space is incredibly innovative, with new protocols and yield farming strategies popping up like mushrooms after a rainstorm. This gives yield farmers a wide array of options to choose from, allowing them to tailor their farming strategies to their risk tolerance and financial goals.

At the moment, yield farming can provide more profitable interest than a traditional bank, but of course there are risks involved. Interest rates can be volatile, so it’s hard to predict what your returns will be in the coming year – not to mention that DeFi is one of the riskier environments in which to invest your money.

Calculating yield in yield farming

Understanding the difference between APY and APR is crucial for any yield farmer. Here’s the lowdown:

  • APR (Annual Percentage Rate): This is the basic annual rate without considering the effect of compounding. It’s straightforward but may underestimate your actual returns if the yield is compounded.
  • APY (Annual Percentage Yield): This takes into account the effect of compounding, providing a more accurate picture of your potential returns over a year.

Alright, let’s talk about how you can calculate your yield without breaking out the calculator. Many DeFi platforms actually do the heavy lifting for you. They’ll display the estimated APY or APR right on their dashboard. But remember, these are estimates and can fluctuate based on a variety of factors like market demand and liquidity. When you decide to take on yield farming, follow next steps:

  • Check the Rate: Look for the APR or APY rate on the DeFi platform where you’re considering yield farming.
  • Consider Compounding: If the platform shows APR, ask yourself how often you plan to reinvest your earnings. The more often you reinvest, the closer your actual returns will be to APY.
  • Factor in Fees: Don’t forget about transaction fees, especially on networks like Ethereum where gas fees can be high. These will eat into your profits.
  • Watch for Rewards: Some platforms offer additional rewards in the form of governance or utility tokens. These can add to your overall yield but remember to check their market value.

Remember that yield farming is hard to calculate. Even short-term benefits are difficult to predict accurately. Why? Yield farming is a highly competitive and fast-moving industry with rapidly changing incentives. If the strategy is successful for a while, other farmers will quickly flock, and eventually the project will cease to deliver significant returns. As APR and APY are outdated market benchmarks, the DeFi industry will have to develop its own profit calculations. Weekly or even daily expected returns may make more sense given the fast pace of DeFi.

How can I start yield farming?

1.     Do your own research (DYOR)

The first and most crucial step is to do your own research. Not all yield farming opportunities are created equal, and some come with higher risks than others. Know the risks involved, such as smart contract vulnerabilities, impermanent loss, and market volatility. Also make sure the protocol you’re considering is reputable. Look for audits, strong governance, and a transparent team.

2.     Choose your assets

The next step is to decide which assets you want to farm. This could be a stablecoin like USDC, a major crypto like ETH, or even a governance token from another DeFi project. Diversification is very important here; don’t put all your eggs in one basket. Diversifying your assets can help mitigate risks.

3.     Pick your farming strategy

As we mentioned before, there are various types of yield farming strategies, from simple single-asset staking to more complex liquidity provision. Choose one that aligns with your risk tolerance and financial goals. Single asset staking is good for beginners, has lower risk but also generally lower returns. On the other hand, liquidity provision offers higher potential returns but comes with the risk of impermanent loss.

4.     Get your crypto wallet ready

To interact with DeFi protocols, you’ll need a crypto wallet that supports Ethereum or other blockchain networks where yield farming is available. MetaMask, Trust Wallet, and Coinbase Wallet are some of the most commonly used wallets for yield farming.

5.     Start farming and monitor investment

Once everything is set up, you’re ready to start farming. Deposit your chosen assets into the protocol and start earning yield. But remember, farming requires attention. Keep an eye on your returns and any updates from the protocol. Be ready to adjust your strategy as needed.

Popular yield farming platforms

Before we delve into the list, let’s talk about what makes a yield farming platform popular. It’s not just about high returns; it’s also about security, user experience, and community engagement. A popular platform usually has:

  • Audited smart contracts: To ensure security and trust.
  • High liquidity: More funds in the pool mean less slippage and better rates.
  • Strong community: An active community can be a good indicator of the platform’s credibility and potential for growth.

That being said, here are the top yield farming platforms:

Uniswap

Uniswap is an automated market maker (AMM) that allows for decentralized token swaps. It’s one of the most popular platforms for yield farming. Its popularity is simple: it’s been around, and it has high liquidity. Plus, it offers governance tokens, UNI, that give you a say in the platform’s future. But it’s not just about ease of use; Uniswap also offers high liquidity. Being one of the first platforms to offer automated market making, it has attracted a large pool of liquidity providers, which means better rates and a more seamless experience for yield farmers.

Aave

On the other side of the ring, we have Aave, a platform that has carved out its niche as a leading lending protocol in the DeFi ecosystem. What sets Aave apart is the wide range of assets it supports. Whether you’re looking to stake a stablecoin like USDC or a more volatile asset like ETH, Aave has got you covered. But it’s not just about the variety; Aave also scores high on the security front. The platform has undergone multiple audits and has a robust governance model, making it one of the safer havens for yield farming in the often risky DeFi landscape.

Yearn Finance

Unlike traditional platforms where you have to manually choose pools and strategies, Yearn Finance automates the process. The platform scans various DeFi protocols to find the most profitable farming opportunities and automatically reallocates assets to maximize yield. This level of automation has made Yearn Finance a hit among users who prefer a hands-off approach. However, it’s worth noting that the platform’s complex strategies come with their own set of risks, including smart contract vulnerabilities and market volatility. So, while the returns can be lucrative, it’s essential to understand the risks involved.

Sushiswap

SushiSwap started its journey as a fork of Uniswap but has since evolved into a full-fledged DeFi platform with its own unique features. One of the standout aspects of SushiSwap is its focus on community governance. The platform has been designed to give users a say in its development and future direction, which has garnered a strong and engaged community. But it’s not just about governance; SushiSwap also offers a variety of yield farming opportunities. From staking SUSHI tokens to providing liquidity in various pools, the platform offers multiple avenues for earning yield.

Pancakeswap

PancakeSwap has emerged as a force to be reckoned with, especially for those looking to escape the high gas fees of the Ethereum network. Operating on the Binance Smart Chain, PancakeSwap offers a similar experience to Uniswap but at a fraction of the cost. The platform has become a hub for yield farmers thanks to its ‘Syrup Pools,’ where users can stake CAKE tokens to earn additional tokens from various projects. The lower transaction fees and fast block times on the Binance Smart Chain make PancakeSwap an attractive option for those who are new to yield farming or are operating with smaller portfolios

Honorable mentions: Curve Finance, Harvest Finance, Doxee

Yield farming: Risks

Ok, now instead of talking about the sky-high yields and mouth-watering returns, we’re going to discuss the darker side of yield farming—the risks.

  • Smart contract vulnerabilities

One of the most significant risks in yield farming comes from smart contract vulnerabilities. These are the coded contracts that govern everything in the DeFi space. While they eliminate the need for intermediaries, they’re also prone to bugs and exploits. A single error in a smart contract can lead to millions of dollars being drained from a protocol overnight. And because these contracts are immutable, once they’re deployed, they can’t be easily fixed. So, if you’re putting your assets into a yield farming protocol, make sure it has been audited by reputable firms and has a strong track record.

  • Impermanent loss

If you’re providing liquidity to a decentralized exchange, you’re exposed to something called “impermanent loss.” This occurs when the price of the tokens in the liquidity pool changes, affecting your share of the pool. In simple terms, you could end up with less value than you initially put in, especially in volatile markets. While the term “impermanent” suggests the loss can be reversed, that’s not always the case, and you could end up with a permanent dent in your portfolio.

  • Volatile market

The crypto market is notoriously volatile, and this volatility can significantly impact your yield farming returns. A sudden crash in the price of the token you’re farming could wipe out any gains you’ve made, and then some. Similarly, a sudden surge in demand could lead to skyrocketing gas fees, making it expensive to move your assets or claim your rewards. Market risks are something you can’t entirely avoid but can mitigate through diversification and careful strategy planning.

  • Regulatory risks

As DeFi gains popularity, it’s also attracting the attention of regulators. While the decentralized nature of these platforms offers some level of protection against regulatory actions, it’s not a foolproof shield. A sudden regulatory clampdown could lead to a mass exodus from a platform, causing liquidity to dry up and potentially resulting in significant losses for yield farmers.

Yield farming is a concept that divides the crypto community

On one side of the divide, we have the yield farming evangelists. These are the folks who see yield farming as nothing short of revolutionary. And it’s easy to see why. Yield farming offers returns that are unheard of in traditional finance. We’re talking about annual percentage yields (APYs) that can sometimes reach triple digits. For these enthusiasts, yield farming is the epitome of financial democracy, a way to earn substantial returns without relying on traditional financial institutions. It’s seen as a way to truly unlock the potential of decentralized finance (DeFi), providing liquidity, enabling decentralized lending, and creating a more inclusive financial ecosystem.

On the other side, we have the skeptics(we could count Buterin among them), who view yield farming as a high-risk venture teetering on the edge of sustainability. These individuals point to the inherent risks involved, such as smart contract vulnerabilities, impermanent loss, and market volatility. They argue that the high returns are a reflection of these high risks and that the system is ripe for exploits and manipulations. For skeptics, yield farming is a bubble waiting to burst, a system that promises high rewards but could leave many burned in the process.

Conclusion

At its core, yield farming is about putting your crypto assets to work to generate more crypto. It’s the DeFi answer to traditional interest-bearing accounts, but with the potential for much higher returns. Yield farming allows you to provide liquidity or participate in a lending protocol to earn rewards in the form of additional tokens. It’s a financial alchemy that has the potential to turn your existing assets into a growing portfolio. From Uniswap to Aave, from SushiSwap to Yearn Finance, the yield farming landscape is rich with platforms offering a variety of strategies to maximize your returns. While the returns can be eye-popping, it’s crucial to remember that yield farming is not a risk-free endeavor. Smart contract vulnerabilities, impermanent loss, market volatility, and even regulatory risks can turn your yield farming dreams into a nightmare. The key to successful yield farming lies in understanding these risks and taking steps to mitigate them. And you know the saying – never invest more than you are willing to lose.

FAQ

Is yield farming profitable?

Yes, it can be, but it depends on how much money and effort you are willing to put in. Although some high-risk strategies promise significant returns, they usually require a thorough knowledge of DeFi platforms and protocols to be effective.

Is yield farming risky?

The concept carries a number of risks that investors need to understand before they start. Scams, break-ins and losses due to volatility are not uncommon, so it is a good idea to educate yourself first.

What platforms are popular for yield farming?

Some of the most popular platforms include Uniswap, Aave, SushiSwap, Yearn Finance, and PancakeSwap. Each has its own set of features, risks, and rewards.

What is impermanent loss?

Impermanent loss occurs when you provide liquidity to a decentralized exchange and the price of the tokens in the liquidity pool changes. This can affect your share of the pool and potentially result in a loss of value.

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