Yield Farming is one of the hottest topics in crypto and decentralized finance. Chances are you may have heard about yield farming and some of the lucrative returns that yield farmers are making. So what is yield farming? How does yield farming work? How did yield farming start and what are some examples of yield farming? In this guide, we will be covering everything related to yield farming as well as some of the risks of the practice.
- Yield farming is the practice of maximizing your return on capital by using different DeFi protocols
- Some of the most popular DeFi protocols include Compound, Curve, Synthetix, Uniswap, and Balancer
- Different elements of yield farming include liquidity mining, leverage, and risk tolerance
What is Yield Farming?
Yield farming is the practice of maximizing rates of return on your capital by utilizing different DeFi protocols. Yield “farmers” will try to find and make use of the highest yields by switching between different yield farming strategies. The most popular as well as profitable strategies make use of different DeFi protocols such as:
If the yield farming strategy stops working or if there is a better strategy through a different DeFi protocol, yield farmers will move their capital around to the most favorable yield. For example, yield farmers may move their capital between different protocols or swap out some of their tokens and coins for ones that are paying out a higher yield. This practice is referred to as “crop rotation”.
Comparing this to traditional finance you can imagine people trying to find savings accounts or bonds with the highest APY. APY stands for Annualized Percentage Yield and it’s a common way of comparing rates of return on your investments across different financial products. Yield farming, it’s a way of expressing returns of different yield farming strategies.
Standard APY returns for traditional savings account range between .10% to .50% on the high end. With the current rate of inflation, your money is simply losing value sitting in a savings account. When it comes to yield farming, the returns are much more lucrative. Some strategies can bring in as much as 100% APY. How are these types of returns possible? Where is the catch and what are the risks involved?
Elements of Yield Farming Returns
There are three main mechanisms that make yield farming returns so lucrative. They include:
- Liquidity mining
- Risk tolerance
Let’s take a look at each one in detail to get a better understanding of how they work and the common risks associated with them.
Liquidity mining is a process for distributing tokens to the users of a specific protocol. One of the very first DeFi projects that introduced liquidity mining was Synthetix. It started rewarding users who helped add liquidity to their SETH/ETH liquidity pools on Uniswap. Users were rewarded with SNX tokens.
The process of liquidity mining creates additional incentives for farmers as the token rewards are added on top of the yield that is already generated by using a certain DeFi protocol. Depending on the protocol the incentives may be strong enough that farmers may be willing to lose their initial capital just to get additional rewards through the tokens. This makes the overall strategy extremely profitable.
Liquidity Mining Example
A good example of this is the liquidity mining of comp tokens which was introduced by Compound. They were initially giving out higher rewards to users who were borrowing assets with the highest APY.
This gave yield farmers an incentive to start borrowing these assets as the value of minted comp tokens was compensating them for the high borrow rates they had to pay. The popularity of comp liquidity mining got very popular and was a major catalyst to help yield farming grow.
In addition to liquidity mining, leverage is another major reason that yield farming returns can be so lucrative. Leverage is a strategy of using borrowed funds to increase the potential returns of an investment. In yield farming, farmers can deposit their coins and tokens as collateral to different lending protocols and borrow other coins.
Farmers can then use the borrowed coins as further collateral to borrow more coins. By repeating this process, farmers can leverage their initial capital multiple times and generate much higher returns.
The last component to high returns in farming is risk tolerance. Risk is directly related to the amount of leverage used. All the loans that farmers take are over-collateralized and the given collateral carries liquidation risk if the collateralization ratio drops below a certain threshold.
In addition to the liquidation risk, there is smart contract risk. Smart contract risks carry the risk of bugs, platform changes, admin keys, and systemic risks.
There are also DeFi protocol-specific risks. These risks can include trading attacks that aim to drain liquidity pools and crash the price of certain tokens and coins. Assuming all of these risks, you can see why yield farming returns can be so lucrative. Now that you have a basic understanding of yield farming, let’s take a look at some of the different strategies.
Yield Farming Strategies
These strategies are a series of steps that focus on generating a high yield from allocating capital. These steps usually involve some of the following:
- Lending and Borrowing
- Supplying capital to liquidity pools
- Staking LP tokens
Let’s take a look at each strategy and the necessary steps involved to generate a high yield.
Lending and Borrowing
A very simple way of generating APY on your capital is by supplying stable coins such as DAI, USDC, or USDT to one of the lending platforms. Adding liquidity mining along with leverage to supplying stable coins can further amplify your returns. This is a highly coordinated process that takes some experience.
For example, farmers can get rewarded with extra comp tokens for lending and borrowing on Compound. They also can borrow funds with their collateral to purchase even more coins. However, this can carry liquidation risk.
Supplying Capital to Liquidity Pools
Famers can supply tokens to liquidity pools and protocols like Uniswap, Balancer, Curve and get rewarded with fees charged for swapping different tokens. And again, if you use liquidity mining along with leverage, you can earn a very lucrative APY.
For example, by supplying coins and tokens to specific liquidity pools farmers are rewarded with additional tokens. The amounts will vary based on the liquidity pool demands and their token rewards.
Staking LP Tokens
Different protocols incentives users even more by allowing them to stake their LP tokens (liquidity provider) that represent their participation in a liquidity pool. Staking LP tokens can be a complicated process, but the APY can be massive.
For example, the protocols Synthetix, Run, and Curve created a partnership. In their partnership, users can provide WBTC, SBTC, and RENBTC to the Curve BTC liquidity pool. In exchange for providing liquidity to the pool, users Curve LP tokens as a reward.
You can then trade these tokens for a stable coin or stake them and earn further tokens. This downstream process allows you to quickly stack up more and more tokens which can be deployed over and over again.
The Risks Associated with Yield Farming Strategies
If you want to start yield farming, it’s important to keep in mind that these strategies will evolve. Some strategies will become obsolete as new tokens, liquidity pools, and protocols get enter the crypto market. The crypto market moves extremely quickly with massive levels of volatility which by nature is a massive risk.
In addition to this, constant technology changes are occurring within protocols and incentives which may render your strategy less profitable. If you want to stay profitable long term you will have to pay close attention to changes in the market and how incentives, strategies, and DeFi protocols change.
In the scope of our global financial system, yield farming is very new and very far from being an efficient market. Due to this, there is plenty of opportunities to find high-yielding strategies. It’s also worth mentioning that yield farming carries significant risk for beginners and can have a steep learning curve.
Although it carries risks, it presents an opportunity to further help increase DeFi user adoption and improve liquidity in the crypto market.