Yield Farming

Yield farming has revolutionized how individuals generate passive income within the dynamic world of decentralized finance, often referred to as DeFi. This innovative yet complex strategy allows you to put your crypto assets to work, earning significant rewards in the form of additional cryptocurrency. It emerged as a leading trend during the “DeFi summer” of 2020, rapidly expanding the sector from a market capitalization of $500 million to an impressive $10 billion in that year alone. Today, it continues to drive substantial growth, with the total value locked in liquidity pools consistently reaching new heights.

What Exactly is Yield Farming?

At its core, yield farming involves staking or lending your cryptocurrency assets to DeFi protocols to earn high returns. Imagine it as a digital form of farming where you plant your crypto seeds in a liquidity pool, and in return, you harvest more crypto as a reward.

DeFi protocols incentivize individuals, known as liquidity providers, to deposit and lock up their crypto assets in smart contract-based liquidity pools. These incentives can take various forms, including a percentage of transaction fees generated, interest paid by borrowers, or even governance tokens specific to the protocol. These returns are typically expressed as an Annual Percentage Yield (APY), giving you an estimate of your potential earnings over a year.

Initially, many yield farmers focused on staking well-known stablecoins like USDT, DAI, and USDC. However, as the DeFi landscape evolved, most popular protocols now operate on the Ethereum network and introduce what is known as liquidity mining. This process allows participants to earn token rewards as additional compensation, a concept that gained prominence when Compound began issuing its governance token, COMP, to users on its platform. These governance tokens are often tradable on both centralized exchanges, such as Binance, and decentralized exchanges like Uniswap.

It is important to understand that as more investors contribute funds to a particular liquidity pool, the value of the issued returns can decrease proportionally.

How Yield Farming Works

Yield farming operates by having you provide your cryptocurrencies to DeFi platforms, typically through liquidity pools. Think of these pools as digital vaults where users deposit their crypto assets, making them available for others to access, for instance, for trading or lending.

When you contribute your assets to a liquidity pool, you are providing crucial liquidity to the protocol. In exchange for this service, you receive rewards. These rewards commonly come in the form of interest or specific “reward tokens,” which are often the protocol’s own governance tokens.

Smart contracts are the backbone of the entire yield farming process. These self-executing digital contracts automate transactions and ensure everything runs securely and automatically, removing the need for traditional intermediaries like banks. When you engage in crypto lending and provide your assets to a DeFi protocol, your tokens are securely stored within one of these smart contracts. Once predefined conditions are met, your rewards are automatically distributed to you.

The Annual Percentage Yield (APY) plays a crucial role in yield farming as it helps you estimate potential returns. APY shows how much yield you can earn within a year and uniquely factors in compounding interest, meaning your earned rewards can also start generating additional returns, as they are often distributed regularly.

A prime example of a platform utilizing yield farming is Uniswap. On Uniswap, one of the largest DeFi platforms and a widely popular decentralized exchange (DEX) and automated market maker (AMM), you provide liquidity by depositing cryptocurrencies into a pool. In return, you earn a portion of the transaction fees generated from trades, which are paid out in UNI tokens, the platform’s governance token. Liquidity providers on Uniswap typically stake both sides of a liquidity pool in a 50/50 ratio.

The Allure of High Returns: Benefits of Yield Farming

Yield farming presents an attractive proposition for those seeking to maximize their crypto holdings beyond simply holding them. One of the most significant advantages is the potential for exceptionally high returns. By contributing liquidity to DeFi platforms, you can earn both interest and additional farming tokens as rewards. Popular protocols and liquidity pools, in particular, often present opportunities to generate attractive yields that can be substantially higher than traditional investment avenues.

Furthermore, yield farming offers access to an innovative investment method that operates decentrally via smart contracts. This decentralized nature means you participate in a system free from central control, fostering transparency and autonomy in your financial activities. You are not just holding assets; you are actively participating in and earning from the growth and functionality of decentralized finance.

Navigating the Volatility: Risks of Yield Farming

While the potential for high returns is enticing, yield farming is a complex strategy that carries significant financial risk for both lenders and borrowers. It is crucial to understand these risks thoroughly before participating.

Cryptocurrency Volatility and Impermanent Loss

One of the biggest risk factors in yield farming is the inherent volatility of cryptocurrencies. If the value of the coins or tokens you deposit into a liquidity pool fluctuates significantly, you can experience impermanent loss. This phenomenon occurs when the value of your deposited assets decreases compared to simply holding those cryptocurrencies outside the pool. Price changes between the tokens within the pool create an imbalance that can lead to this type of loss.

To mitigate impermanent loss, some strategies involve choosing less volatile token pairs or utilizing stable pools, which primarily consist of stablecoins. Stablecoin pools are generally considered safer as stablecoins aim to maintain a pegged value to fiat currencies, thus reducing price swings.

Smart Contract Vulnerabilities

Another critical risk involves potential vulnerabilities in smart contracts. These digital contracts, while designed to be secure and automated, can sometimes contain coding bugs or exploits. If exploited, these vulnerabilities can lead to your assets being stolen or frozen, resulting in severe financial losses. The fierce competition among protocols often pushes developers to launch new contracts and features quickly, sometimes without sufficient auditing or by copying code from others, which can introduce these risks.

A well-known historical example of such a vulnerability is the DAO hack in the Ethereum network in 2016, where an exploit in a smart contract led to the theft of millions of dollars. More recently, the Yam protocol experienced a critical bug shortly after raising over $400 million, and Harvest.Finance lost over $20 million in a liquidity hack in October 2020. Since blockchain transactions are immutable by nature, DeFi losses are most often permanent and cannot be undone.

High Gas Fees and Network Dependencies

Yield farming often incurs high gas fees, especially on congested networks like Ethereum. These transaction fees can significantly reduce your earned yields or even lead to net losses if the gains do not cover the costs of adding or removing liquidity from pools. For this reason, engaging in yield farming is typically worthwhile only if you provide thousands of dollars as capital.

Furthermore, DeFi protocols are permissionless and rely on several underlying applications to function seamlessly. If any of these foundational applications are exploited or fail to work as intended, it can impact the entire ecosystem of applications, potentially resulting in the permanent loss of investor funds.

Risky Protocols and Rug Pulls

The space has seen a rise in risky protocols that issue meme tokens, often named after animals or fruits. These tokens promise extremely high APY returns, sometimes in the thousands of percent. You must be cautious with these protocols. Their code is often unaudited, and their returns are vulnerable to sudden liquidation due to extreme volatility. Many of these liquidity pools are complex scams. In a “rug pull,” developers suddenly remove all liquidity and run off with investors’ funds.

Given these substantial risks, it is strongly advised that you familiarize yourself thoroughly with the risks of yield farming and conduct your own extensive research before committing any capital.

Prominent Yield Farming Protocols: A Crypto List

Yield farmers often utilize a variety of different DeFi platforms to optimize returns on their staked funds. These platforms offer various forms of incentivized lending and borrowing from liquidity pools. Here is a list of some of the most popular and well-known yield farming protocols:

Aave (AAVE)

Aave is an open-source, non-custodial decentralized lending and borrowing protocol operating mainly on the Ethereum blockchain. It creates “money markets” where users can borrow assets and earn compound interest for lending, paid in its native AAVE token (formerly LEND). Aave has held the highest Total Value Locked (TVL) among all DeFi protocols, exceeding $21 billion as of August 2021. Users can potentially earn up to 15% APR for lending assets on Aave. Aave distinguishes itself with its unique “flash loans” feature.

Compound (COMP)

Compound functions as another significant money market for lending and borrowing crypto assets. Users earn algorithmically adjusted compound interest rates and the governance token COMP. Compound is widely recognized for its robust security standards, having undergone audits and reviews. Its total supply exceeded $16 billion as of August 2021, with APYs ranging from 0.21% to 3%. It is known for its simple user interface and broad support for various cryptocurrencies.

Curve Finance (CRV)

Curve Finance is a decentralized exchange (DEX) specifically designed for users and other decentralized protocols to exchange stablecoins with low fees and minimal slippage. It achieves this efficiency using a unique market-making algorithm. Curve is the largest DEX in terms of TVL, with over $9.7 billion locked. Its base APY can reach as high as 10%, while rewards APY can exceed 40%. Its focus on stablecoin pools makes it a generally safer option as stablecoins typically do not lose their pegged value.

Uniswap (UNI)

Uniswap is a hugely popular decentralized exchange (DEX) and automated market maker (AMM) that enables users to swap almost any ERC20 token pair without intermediaries. Liquidity providers stake both sides of a liquidity pool in a 50/50 ratio. In return, they earn a proportion of transaction fees and the UNI governance token. Uniswap has two live versions, V2 and the newer V3, which boasts a growing protocol ecosystem with over 200 integrations. TVL for V2 was $5 billion, and for V3, it was over $2 billion as of August 2021.

Instadapp

Instadapp stands out as an advanced platform designed to leverage the full potential of DeFi. It allows users to manage and build their DeFi portfolios, and developers can construct DeFi infrastructure using its platform. As of August 2021, over $9.4 billion was locked on Instadapp.

SushiSwap (SUSHI)

SushiSwap originated as a fork of Uniswap and generated considerable community attention during its liquidity migration process. It has since evolved into a comprehensive DeFi ecosystem, featuring a multi-chain automated market maker (AMM), lending and leverage markets, on-chain mini Dapps, and a launchpad. The TVL on the platform was $3.55 billion as of August 2021.

PancakeSwap (CAKE)

PancakeSwap is a decentralized exchange (DEX) built on the Binance Smart Chain (BSC) network, primarily for swapping BEP20 tokens. It operates using an automated market maker (AMM) model where users trade against a liquidity pool. PancakeSwap boasts the highest TVL among BSC protocols, with over $4.9 billion locked as of August 2021. It heavily incorporates gamification features, including a lottery, team battles, and NFT collectibles, and its APYs can soar to over 400%.

Venus Protocol (XVS)

The Venus Protocol is an algorithmic-based money market system aiming to bring a lending and credit-based system to the Binance Smart Chain. Users supply collateral to the network and earn APY for lending, while borrowers pay interest. Venus offers a unique feature: you can use the collateral supplied to the market not only to borrow other assets but also to mint synthetic stablecoins with over-collateralized positions, which protect the protocol. A basket of cryptocurrencies backs these synthetic stablecoins. TVL on Venus Protocol was over $3.3 billion as of August 2021.

Balancer (BAL)

Balancer functions as an automated portfolio manager and trading platform. Its liquidity protocol distinguishes itself through flexible staking, as it does not require lenders to add liquidity equally to both sides of a pool. Instead, liquidity providers can create customized liquidity pools with varying token ratios, even up to eight cryptocurrencies. Over $1.8 billion was locked as of August 2021. Rewards are distributed in BAL tokens.

Yearn.finance (YFI)

Yearn.finance is an automated decentralized aggregation protocol that allows yield farmers to utilize various lending protocols like Aave and Compound to find the highest yields. So, Yearn.finance algorithmically seeks out the most profitable yield farming services and employs “rebasing” to maximize profit. Yearn.finance made headlines in 2020 when its governance token, YFI, climbed to over $40,000 in value at one stage. Users can earn up to 80% APY in Yearn, and $3.4 billion was locked in the protocol as of August 2021.

Yield Farming for Bitcoin

Many crypto enthusiasts wonder if yield farming is possible for Bitcoin. While no direct DeFi yield farming protocols exist specifically for Bitcoin, Wrapped Bitcoin (WBTC) effectively brings Bitcoin onto the Ethereum blockchain and into DeFi applications. By learning how to wrap Bitcoin, holders of Bitcoin can earn a few percent of yield by lending their WBTC out on protocols such as Compound.

You can also find the best yield farming pools across various DeFi protocols through resources like CoinMarketCap’s DeFi Yield Farming Rankings. These rankings track liquidity pools across many protocols including Venus, Curve, Sushi, Synthetix, Yearn, and PancakeSwap. They provide information on the crypto pair involved, the Total Value Locked (TVL), the reward type, estimates for impermanent loss, and the Annual Percentage Yield (APY).

Yield Farming vs. Staking: Choosing Your Strategy

Yield farming and staking are two distinct strategies for earning returns with cryptocurrencies, with their key difference lying in how they generate those yields.

Staking involves locking up cryptocurrencies in a network that uses a proof-of-stake consensus mechanism. You hold your assets for a certain period, and in return, you earn interest. This process often creates new coins or tokens, which increases the total supply, making staking an inflationary process. Staking is ideal for investors who are looking for stable and predictable returns, as the yields are usually fixed. For example, some platforms offer up to 40% APY for staking.

Yield farming, on the other hand, operates differently. Instead of generating new coins, you provide existing tokens to liquidity pools, which are then used for decentralized trading or lending. The rewards you earn from yield farming depend heavily on liquidity demand within the market and crypto market trends. Generally, yield farming rewards are often higher than staking rewards, but this comes with correspondingly greater risks.

The choice between yield farming and staking ultimately depends on your individual goals and risk tolerance. Staking is more suitable for those seeking stable, lower-risk returns, prioritizing predictability and consistent income. In contrast, yield farming on DeFi platforms is more attractive for experienced investors who are willing to take on more risk in pursuit of potentially much higher yields.

Frequently Asked Questions About Yield Farming

What Yield Farming Tokens Are There?

Some of the most well-known yield farming tokens in the crypto market include AAVE (Aave), COMP (Compound), UNI (Uniswap), YFI (Yearn.finance), and BAL (Balancer). Protocols frequently distribute these tokens as rewards for providing liquidity.

How Much Does Yield Farming Cost?

The costs associated with yield farming vary depending on the specific DeFi platform you use. These costs typically include transaction fees, also known as gas fees, especially on busy networks like Ethereum. Additionally, you may encounter exchange fees if you need to swap tokens to acquire the specific cryptocurrencies required for a liquidity pool. It is also important to remember that losses due to cryptocurrency price fluctuations can significantly reduce your overall yield farming returns.

What Role Do Governance Tokens Play in Yield Farming?

Governance tokens such as AAVE, COMP, and UNI are frequently distributed as rewards in yield farming protocols. They serve a crucial purpose: holding these tokens allows you to vote on important protocol decisions, such as proposed changes to rules, adjustments to reward distributions, or new features. Additionally, you can trade these tokens on the broader crypto market, offering another potential avenue for returns.

How Can You Participate in Yield Farming?

To start yield farming, you need some cryptocurrencies and a digital wallet that works with DeFi protocols, like MetaMask. Once you have your assets and wallet ready, choose a DeFi platform. Then, deposit your coins or tokens into a liquidity pool on that platform. You simply follow the specific instructions provided by the protocol, and in return for your liquidity, you will receive rewards.

Is Yield Farming Safe?

While yield farming offers high potential for returns, it inherently comes with significant risks. These include the volatility of cryptocurrencies, the possibility of impermanent loss, and vulnerabilities in smart contracts, any of which can lead to substantial financial losses. You can certainly improve your security by conducting thorough research into protocols and using trusted, well-audited platforms. However, it is essential to understand that some level of risk will always remain when engaging in yield farming.

Conclusion: Is Yield Farming Worth It?

Whether yield farming is worth it depends on the protocol and how much crypto you’re willing to commit. In principle, it offers high return potential. It lets you passively earn coins or tokens by providing liquidity to decentralised platforms. Through this process, investors can consistently earn interest or additional token rewards.

However, you must conscientiously consider the inherent risks, such as cryptocurrency volatility and the potential for smart contract vulnerabilities. As a result, yield farming on DeFi platforms is best suited for experienced investors who possess a higher risk tolerance and a deep understanding of the decentralized finance ecosystem. Diligent research and a cautious approach are paramount to navigating this innovative, yet often risky, investment landscape.