While exploring the decentralized finance ecosystem, you’ll likely come across the term ‘yield farming’.
What is Yield Farming?
Yield farming is the process of leveraging various decentralized finance (DeFi) protocols to maximize returns on crypto assets.
Yield farmers lend, borrow, and swap crypto assets on various DeFi protocols to aim for the highest rate of return. The participants take advantage of fluctuating interest rates and various incentives offered by the protocols.
Yield farming is a high-risk, high-reward way to earn interest on crypto assets. Effective yield farming strategies can become highly complex, but if done correctly can generate incredible returns.
How Does Yield Farming Work?
First, it’s important to understand what a ‘yield’ is.
A yield refers to the interest earned on an investment over time. These interest rates are often expressed in terms of an Annual Percentage Yield, or APY.
Consider the way you earn interest by depositing fiat currencies into a bank account. After you deposit your money, the bank turns around and lends out that cash to borrowers. Then, they collect interest as the borrower repays the loan. As an incentive for giving the bank the money to lend, they give a small portion (often less than 1%) of the interest they earned.
In DeFi, earning yields works in a similar way. By lending your crypto assets to a decentralized exchange (DEX), many exchanges will pay you out a portion of the fees collected on transactions. Unlike traditional banks, however, these decentralized exchanges cut out the middleman and offer much higher interest rates to lenders.
In addition, since these DeFi protocols are open and permissionless, users are free to withdraw or move their assets to another platform at any time. This means that if a user identifies a better opportunity, they can quickly migrate their assets to take advantage of it.
Yield farmers often create complex strategies to leverage DeFi protocols to maximize their profits. They will typically move their assets around to various protocols to earn a higher interest rate or receive better incentives, such as LP tokens. Sometimes, they will create multi-step strategies involving various aspects of DeFi.
A simple example of yield farming is a yield farmer moving their assets between liquidity pools on Compound based on where they can earn the highest APY.
However, yield farming strategies are typically far more complex and sometimes involve leveraging multiple protocols at once.
Types of Yield Farming:
Yield farming strategies often take advantage of various aspects of the decentralized finance ecosystem, including:
Using smart contracts, individuals can lend their crypto assets to borrowers in a trustless manner while earning interest paid on the loan.
In DeFi, you can provide assets as collateral and borrow another asset. Some yield farmers choose to take a loan, then use those borrowed assets to earn yield elsewhere.
This allows the yield farmer to hold their original assets in the event they increase in value, while simultaneously using the borrowed assets to generate a return.
Decentralized exchanges rely on assets provided by liquidity providers (LP) to enable traders to buy and sell on the exchange. By depositing equal amounts of two tokens (a ‘trading pair’) to a DEX, some exchanges will give a fraction of the transaction fees back to the liquidity provider.
Some blockchains use a Proof-of-Stake mechanism to secure the network. In Proof-of-Stake networks, validators guarantee the legitimacy of transactions by pledging their tokens. If transactions are found to be illegitimate, the validator risks losing their tokens.
By staking their tokens, users earn interest while their assets are being utilized by the network.
Risks of Yield Farming
In decentralized finance, your funds aren’t insured by a third party like they would be if they were deposited in a traditional bank account.
Rug pulls / exploits
DeFi is still in its early stages and sometimes lacks regulatory oversight. This can incentivize bad actors to create illegitimate tokens or protocols in an attempt to run off with some cryptocurrency.
Exploits are another concern in the DeFi space. According to a report published by DeFi security platform Immunefi, hacks, scams, and other exploits resulted in a loss of over $10.2 billion in 2021 alone.
Liquidity providers face the risk of experiencing impermanent loss. Impermanent loss occurs when the price of a token in a liquidity pool changes dramatically, causing the ratio of tokens in the pool to rebalance.
Impermanent losses aren’t to be confused with permanent losses. Impermanent losses can potentially break even or be recovered if the assets aren’t withdrawn from the pool.