If you're not new to the decentralized finance (DeFi) space, you've probably heard something about yield farming. For long-time crypto users, it’s one of the ways to earn interest on their digital assets. For newbies, however, it’s a little bit confusing concept. So, here we consider what is yield farming in detail and why is so much money being poured into this sector.
Key Takeaways
Yield farming is a strategy of earning rewards from providing liquidity to some DeFi platform, e.g. exchange or lending protocol.
Users usually gain returns from transaction fees and governance tokens, which are then paid based on how much they add to a liquidity pool.
However, yield farming is also concerned with certain risks, such as impermanent loss, smart-contract exploits, and scams, such as rug pulls, therefore, due diligence and risk management are crucial for it.
Yield farming can take different forms such as liquidity provision, staking LP tokens, and using yield automation to maximize gains.
Understanding Yield Farming
Yield farming is a way to make your cryptocurrency holdings earn you a return. Instead of just holding, you can put your tokens to hot use supplying them to a DeFi protocol with a demand for liquidity. In return, you get more tokens or interest. DeFi services take your assets and use them to either improve market liquidity or lend them out to other users.
This whole setup is controlled by smart contracts — self-executing computer code that automatically handles deposits, withdrawals, and rewards without the need for intermediaries, such as banks.
How Yield Farming Works
So, what is farming in crypto? Yield farming means depositing cryptocurrency into a product or service and getting rewards in return. A liquidity pool lets others borrow, trade, or stake assets, and as a contributor, you collect a portion of the platform fees or incentive tokens for staking. The yield farming rewards you earn will vary by platform and liquidity pools.
Most of the platforms issue governance tokens and they not only have value but also allow you to rule the protocol. Many DeFi protocols utilize Annual Percentage Yield (APY) to calculate possible profits, which is a way of measuring earnings over a one-year period that includes the compounding effect of receiving rewards multiple times each day.
Image credit: IdeaSoft.io
Yield farming utilizes smart contracts, meaning at every stage of the process everything is secure and automated. When you lend your crypto to a protocol, it’s locked in a smart contract, and rewards are automatically issued as conditions are met.
Providing Liquidity (AMM Model)
Now, let’s consider the role of Automated Market Makers (AMMs). These are decentralized platforms that enable you to lend or trade cryptocurrencies. AMMs rely on smart contracts to automatically determine the price of assets, avoiding the use of traditional order books.
You contribute to trading activity by providing your assets to a pool, thereby maintaining a healthy market. Once your funds are in the pool, other people can trade or borrow the funds through a decentralized exchange (DEX) that runs on the same AMM protocol as the platform.
Image credit: Fintech Ruminations
Trading fees are levied on these exchanges, and the proceeds are shared between all liquidity providers of the pool. Although it’s not necessary to supply an equal amount of each token for an LP pool, you earn rewards in proportion to the amount you have provided because you provided more liquidity.
Receiving & Staking LP Tokens
LP (Liquidity Provider) tokens are the assets you get when you deposit a pair of tokens in a liquidity pool of a DEX such as Uniswap, PancakeSwap, or SushiSwap. For example, you add ETH and USDC in a pool. In exchange, you get ETH-USDC LP tokens that represent your stake in that pool.
Receive LP tokens
To receive LP Tokens, navigate to the platform that has liquidity pools, pick a pair (ETH/USDC for example), and deposit tokens into the pool at the right ratio. The DEX mints LP tokens and ships them to your wallet.
Stake LP tokens
As for the staking of LP tokens, the assets are blocked by a staking contract to receive rewards (usually in the platform’s native token). To stake your tokens, navigate to the staking area on your DEX or the DeFi platform, and approve your LP tokens. Then plant them into the appropriate pool.
What Is APY in Yield Farming??
In yield farming, APY (Annual Percentage Yield) is the estimated annual return on investments that takes into account the effect of compounding on the interest earned. It gives you a nice and clear view of how much you are earning with your crypto assets in a year when you engage in DeFi activities such as staking or providing liquidity.
APY helps investors estimate the potential return of a specific yield farming strategy or platform. It provides the means to compare various possibilities, including schedules that compound interest at different intervals. However, it is an estimate, not a promise. Returns may be higher or lower as a consequence of market risk, platform risk, or events beyond our control, such as hacks or impermanent loss.
Harvesting Rewards (APY Auto-Compound)
In the context of DeFi, to harvest rewards means to collect the tokens or yields you have gained from staking or providing liquidity. This operation may be both manual and automated depending on the platform.
Users receive rewards (often in the form of tokens) for things like adding liquidity, staking, or participating in protocol governance. Once the harvest is made, the reward can be withdrawn or even reinvested into the platform.
In short, harvesting means how you get your DeFi rewards — either by claiming them by yourself or by automated systems (in many cases with the option of reinvesting them to earn higher returns later).
Types of Yield Farming
There is a variety of DeFi investment strategies allowing users to earn rewards by participating in the crypto ecosystem. The common yield farming types are:
Providing liquidity: Add crypto to DEX liquidity pools, and earn a cut of trading fees (and perhaps platform tokens).
Lending: Deposit your assets in DeFi protocols to accrue interest over time.
Staking: Stake tokens to secure a blockchain network and receive staking rewards.
Yield aggregators: Yield harvesting automatization that manages your funds, maximizes return, and ensures you never have to lift a finger!
Leveraged Bitcoin yield farming: Leverage money to maximize profits. You borrow money to increase the rate of return. Profits can also be higher, but so can the risks.
Governance tokens: A lot of the protocols give those users governance tokens, giving them a voice in the platform management process.
Now, with yield farming explained, let’s turn to the strategies.
Strategies to Maximize Yield
To maximize returns from yield farming, investors should use high-level risk management practices as well as tactical positioning. Here are some strategies to keep in mind to maximize rewards.
Auto-Compounding Vaults (Yearn-style)
The heart and soul of Yearn’s ecosystem is yVault — an automated platform that optimizes how users gain yield on their crypto assets through intelligent investment schedules. Each vault is powered by one or multiple investment strategies that can evolve to maximize returns.
yVault is a smart contract vault that seeks to automatically maximize the yield of the token deposited. Vault tokens are also prefixed with “yv” (e.g., yvETH, yvDAI, yvUSDC) to indicate that the corresponding tokens are in the respective vaults.
Layered Strategies: LP + Staking
Another strategy is leveraged yield farming, or borrowing to add to the size of a liquidity position and amplify potential returns. This can add a nice chunk to profits on favorable markets. However, such underweighting also increases the potential for losses, especially during market declines.
The positive thing about borrowing is that you get a higher return, but on the flip side, you will get a double hit if the asset prices plunge. Appropriate risk control, prudent capital usage, and a good grip on the mechanics are a must for those who are contemplating this strategy.
Popular Yield Farming Platforms
There are several popular platforms standing head and shoulder above the others in the yield farming space in terms of user base, ingenuity, and returns. Here are they:
ETH/Stables Pool on Uniswap
UniSwap is one of the leading DEXs and automated Market Maker, where ERC-20 tokens are permitted to trade. Liquidity providers deposit a pair of assets 50-50 and earn a share of the fees and UNI tokens. There are two main versions of Uniswap: V2 with ~$5 billion TVL, and V3, which has brought concentrated liquidity and boasts over 200 integrations with ~$2 billion TVL.
Image credit: Coinmarketcap
Curve Finance & Stablecoin Pools
Curve Finance is focused on low-slippage, low-fee trading of stablecoins with a highly optimized AMM. It is in the top 3 DEXs in terms of TVL, with $9.7 billion in liquidity. Curve offers base APYs up to 10%, APYs boosted beyond 40% through additional rewards. Since stablecoins tend to keep their peg, pools on Curve are considered to be less volatile than other DeFi investments.
Image credit: Pexx
AAVE Lending Protocol
AAVE is an open-source and non-custodial protocol, licensed under the GNU Affero General Public License, allowing users to earn interest on deposits and borrow assets. It backs a variety of money markets and generates yields paid out in the AAVE token. Currently, AAVE, with the TVL of $21 Billion is among the top DeFi protocols for lenders.
Image credit: Rootstrap
Yield Farming vs Staking
Both of these are the ways to reap returns on your cryptocurrency stash. Yield farming and staking enable you to earn passive income in crypto, but they vary in difficulty and use case:
Aspect
Yield Farming
Staking
Mechanism
Users lend their liquidity to the DeFi services and earn money from trading fees, interest on loans, and incentives for the smallest governance token.
Users freeze their cryptocurrency to secure transaction processing on a Proof-of-Stake (PoS) blockchain.
Rewards
Returns can vary between 5% and over 100% APY, depending on platform and strategy.
Generally the platorm pays 5% to 14% annual percentage yield (APY) in further tokens.
Active vs. Passive
Needs active management to get the gains and adjust to DeFi tactics.
A less active strategy – you don't need to do much after staking your asset.
Risk Level
Greater risk of impermanent loss, price oscillations of the token, and smart contract bugs.
Less risk than DeFi yield farming but still exposed to crypto volatility and project risks.
Liquidity farming is a lot more complex and hands-on approach and can offer higher rewards for those who know how to actively manage their investments. Staking is an easier and less dangerous option for more passive users.
Risks & Considerations
Crypto-yield farming can produce a lot of passive income – sometimes even better than traditional finance. But, the opportunity is followed with high-risk high reward while opening yourselves up to impermanent loss and smart contract exploits.
Impermanent Loss & Volatility
Impermanent loss is the result of the price shift of the deposited token in a liquidity pool compared to its initial deposit. This divergence decreases the value of the liquidity provider’s position—either temporarily if prices revert to prices that correlate with the holding value or permanently if the position is redeemed before such a price arises.
Impermanent loss becomes more acute, and much more common in the wild world of crypto, during high market volatility. The sudden price swings widen the spread between pool value and market price, leading to larger losses.
More about impermanent loss read here
Smart Contract Security & Rug Pulls
DeFi is built on smart contracts, but those aren’t foolproof, and attackers can exploit bugs or security vulnerabilities, which could lead to the loss of funds and the manipulation of reward mechanisms.
Sometimes, scammers create a project and let people deposit funds into it before taking away the liquidity pool — a phenomenon known as a “rug pull”. This further emphasizes the need for proper research and careful decision-making when it comes to investing in yield farming platforms.
Tools & Calculators
To estimate potential profits, many people use specialized tools and yield calculators: They help simulate APY, platform fees, reward distributions, etc., based on current market conditions.
Yield Calculators & Dashboard Tools
Yield farming calculators and dshboard tools are instruments intended to estimate the possible return on investment. They help investors in measuring the income that an investment brings relative to its cost. These tools are crucial for monitoring and fine-tuning all aspects of business and investment processes to achieve the maximum return on resources.
Risk Profilers & APY Estimators
Risk Profilers and APY Estimators are a type of analytical tools for yield farming in crypto that can be used to gain better clarity of where to allocate your crypto assets. Risk profiler prevents from dangerous or unprofitable farms and APY estimator compares earnings chances. Together, they answer the question: “Is this yield worth it all?”
Tax & Regulatory Aspects
DeFi strategy of yield farming, where individuals provide liquidity with their assets in a trade for earning yields, comes with substantial tax repercussions in the form of Income tax and Capital gains tax. Most treat these as regular income and impose tax at receipt. Capital gains tax can get triggered when you sell the tokens you earned through crypto farming or cashing your liquidity pool back out. Keeping good records of transactions and engaging a tax professional about your tax reporting is essential.
Future of Yield Farming
Defi’s crypto farming presents huge opportunities for artificial intelligence and new protocols at the forefront of the next wave of innovation. Yield farming, with the DeFi environment expanding, will probably leverage sophisticated technologies, and integrate with emerging regulatory contexts. AI’s advantages can increase the efficiency of data analysis and strategy iterative process, while new protocols may lead to more optimal and diverse earning models for participants.
Conclusion
The degree of yield farming value depends on the protocol and size of capital that’s been deployed. At the heart of yield farming in crypto is the ability to earn significant passive returns by earning rewards or interest by providing liquidity. But it has its risks too: market volatility and weaknesses in smart contracts. So it’s suitble for experienced investors who can take the heat and suffer losses far easier than a first-time investor.
FAQ
Is Yield Farming Risky?
Yes, yield farming is risky. There’s price volatility risk, as well as impermanent loss and smart contract vulnerabilities, all of which can result in total money loss. Although using trusted platforms and researching thoroughly can mitigate some of the risks, it is essential to remember that no yield farming strategy is not risk-free.
Is Yield Farming Still Profitable?
Yield farming can be lucrative, particularly for those who are selective with their protocols and risk management. The market may have become matured in recent years, there are plenty of opportunities to earn returns and yield farming is among the main ones.
Is Yield Farming Better Than Staking?
Both yield farming and staking have their benefits. Staking is more stable and predictable and usually involves lower risk, which apeals to conservative investors. Yield farming, however, offers higher earning potential while increasing complexity and risk. Your decision should match your risk tolerance and investment approach.
How Much Does Yield Farming Cost?
The cost of yield farming depends on the specific platform and blockchain utilized. General expenses include transaction fees (also known as Ethereum gas fees), token swap fees, and loss from price variation in assets. Furthermore, some protocols have governance tokens and liquidity rewards available which could make that cost zero or add to the yield based on conditions in the market.
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