What is Yield Farming? A Quick Guide

Yield farming is the process of maximizing returns through the use of decentralized finance (DeFi). On a DeFi platform, users lend or borrow cryptocurrency and earn cryptocurrency in exchange for their services.

Farmers who want to increase their yield output can use more complex strategies. Yield farmers, for example, can constantly shift their cryptos between multiple loan platforms to maximize their profits.

Fast Facts:

• Yield farming is the process by which token holders maximize their rewards across multiple DeFi platforms
• Yield farmers provide liquidity to various token pairs while earning cryptocurrency rewards
• Aave, Curve Finance, Uniswap, and other high-yield farming protocols are among the best
• Yield farming can be risky due to price volatility, rug pulls, smart contract hacks, and other factors

How Does Yield Farming Work?

Yield farming allows investors to earn a return by investing in a decentralized application, or dApp. Crypto wallets, DEXs, decentralized social media, and other dApps are examples.

Decentralized exchanges (DEXs) are commonly used by yield farmers to lend, borrow, or stake coins in order to earn interest and speculate on price swings. Smart contracts — pieces of code that automate financial agreements between two or more parties — facilitate yield farming across DeFi.

Types of Yield Farming

• Provider of liquidity: To provide trading liquidity, users deposit two coins to a DEX. To swap the two tokens, exchanges charge a small fee, which is paid to liquidity providers. This fee is occasionally paid in new liquidity pool (LP) tokens.

• Lending: Using a smart contract, coin or token holders can lend crypto to borrowers and earn interest on the loan.
• Borrowing: Farmers can use one token as collateral to obtain a loan from another. The borrowed coins can then be used to farm yield. In this manner, the farmer retains their initial holding, which may grow in value over time, while also earning a yield on their borrowed coins.

• Staking: In the world of DeFi, there are two types of staking. The most common form is on proof-of-stake blockchains, where a user is compensated for pledging their tokens to the network in exchange for security. The second option is to stake LP tokens earned by providing liquidity to a DEX. Users can earn yield twice because they are paid in LP tokens for supplying liquidity, which they can then stake to earn more yield.

Calculating Yield Farming Returns

Annual percentage rate (APR) and annual percentage yield (APY) are two commonly used measurements. APR does not take into account compounding (reinvesting gains to generate higher returns), whereas APY does.

Remember that the two measurements are only projections and estimates. Even short-term benefits are difficult to predict with precision. Why? Yield farming is a fiercely competitive, fast-paced industry with constantly shifting incentives.

If a yield farming strategy is successful for a period of time, other farmers will flock to take advantage of it, and it will eventually cease to yield significant returns.

Leading Yield Farming Protocols

Curve

Curve has nearly $19 billion in total value locked on its platform, making it the largest DeFi platform in terms of total value locked. The Curve Finance platform uses locked funds more than any other DeFi platform, thanks to its own market-making algorithm — a win-win strategy for both swappers and liquidity providers.

Curve offers a comprehensive list of stablecoin pools with attractive APRs that are linked to fiat currency. Curve maintains high APRs ranging from 1.9 percent (for liquid tokens) to 32 percent. Stablecoin pools are quite safe as long as the tokens do not lose their peg. Impermanent loss can be completely avoided because their costs do not differ significantly from one another. Curve, like all DEXs, risks temporary loss and smart contract failure.

Curve has its own token, CRV, which is used to govern the Curve DAO.

Aave 

Aave is one of the most popular stablecoin yield farming platforms, with over $14 billion in value locked up and a market capitalization of more than $3.4 billion.

AAVE, Aave’s native token, is also available. This token encourages users to use the network by offering benefits such as fee reductions and voting power in governance.

When it comes to yield farming, it is common to find liquidity pools collaborating. The highest-earning stablecoin available on Aave is the Gemini dollar, which has a deposit APY of 6.98 percent and a borrow APY of 9.69 percent.

Uniswap

Uniswap is a DEX system that allows for trustless token exchanges. To create a market, liquidity providers invest the equivalent of two tokens. Traders can then execute transactions against the liquidity pool. Liquidity providers receive fees from trades that occur in their pool in exchange for providing liquidity.

Uniswap has become one of the most popular platforms for trustless token swaps due to its frictionless nature. This is beneficial in high-yielding agricultural systems. UNI, Uniswap’s DAO governance token, is also available.

Risks

Yield farming is a complex process that puts both borrowers and lenders at risk of financial loss. Users face an increased risk of temporary loss and price slippage when markets are volatile.

The following are some of the risks associated with yield farming:

Rug pulls

Rug Pulls are a type of exit scam in which a cryptocurrency developer collects investor funds for a project and then abandons it without repaying the investors’ funds. According to a CipherTrace research report, rug pulls and other exit scams, to which yield farmers are particularly vulnerable, accounted for approximately 99 percent of big fraud during the second half of 2020.

Regulatory uncertainty

Cryptocurrency regulation remains a source of consternation. The Securities and Exchange Commission has declared that certain digital assets are securities, bringing them under its jurisdiction and granting it the authority to regulate them. State regulators have already issued cease and desist orders against centralized cryptocurrency lending platforms such as BlockFi, Celsius, and others. If the SEC declares DeFi lending and borrowing ecosystems to be securities, the sector could suffer.

While this is accurate, DeFi is designed to be independent of any central authority, including government regulations.

Volatility

The degree to which the price of an investment moves in either direction is referred to as volatility. A volatile investment is one that experiences a large price swing in a short period of time. While tokens are locked up, their value may fall or rise, posing a significant risk to yield farmers, particularly during a bear crypto market.

Final thoughts

Depending on how much money and effort you are willing to invest in yield farming it can be profitable. Although certain high-risk strategies promise significant returns, they generally necessitate a thorough understanding of DeFi platforms, protocols, and complex investment chains to be most effective. This quick guide is a start but do your own research.

If you want to earn some passive income without investing a lot of money, try putting some of your cryptocurrencies into a time-tested and reliable platform or liquidity pool and seeing how much it earns. After you’ve established this foundation and gained confidence, you can move on to other investments or even directly purchase tokens.

Yield farming entails a number of risks that investors should be aware of before getting started. Scams, hacks, and losses due to volatility are all too common in the DeFi yield farming industry. The first step for anyone interested in using DeFi is to research the most reliable and tested platforms and never invest or put more money at risk than you can afford to lose.