Everything About DeFi Yield Farming

What is DeFi yield farming, and how can you take part? In this post, we'll look at how yield farming (farming) works as a way to earn extra income in decentralized finance, and how you can actually participate to earn additional returns.

TL;DR

• DeFi yield farming is a way of using your crypto assets as a pickaxe to earn other coins or tokens as interest.
• Yield farming uses smart contracts to lend funds to other participants and earn interest, with no intermediary involved.
• Yield farmers can move their assets across multiple DeFi platforms to earn interest strategically.

What Is DeFi Yield Farming?

DeFi yield farming means lending or staking crypto assets to earn additional tokens as a reward. Yield farming is also called liquidity mining, and it has become popular because it can offer higher returns than typical savings products.

For example, let's say you hold Ether (ETH) or a stablecoin like Dai (DAI). Instead of just keeping it in your wallet, you can lend or deposit it on various DeFi platforms and earn interest. DeFi platforms include decentralized exchanges (DEXs), lending and borrowing platforms, yield aggregators, liquidity protocols, and options and derivatives protocols.

You then become a liquidity provider (LP) supplying liquidity, and you can receive the platform's native token, its governance token, or a share of the platform's revenue.

Yield farmers can join a liquidity pool, earn returns, and then move to another liquidity pool to collect yet another reward. Yield farming rewards can vary depending on several factors, such as the type and amount of assets lent, the length of participation, and the platform's yield.

How Do You Do Yield Farming?

Yield farming is based on a concept called the automated market maker (AMM). It makes use of liquidity providers (LPs) and liquidity pools. When participants deposit funds (liquidity) into a pool, a decentralized finance protocol can run that lends those funds to other users.

Just as loans accrue interest in traditional financial markets, borrowing from these liquidity pools also incurs fees. These fees are distributed to liquidity pool participants according to their share.

Besides fees, you can also add funds to a liquidity pool and receive new tokens. For example, when a new DeFi protocol launches, the project team may distribute tokens to those who provide liquidity to certain pools.

Some protocols also issue collateral tokens that represent the coins deposited in the system. For example, if you deposit Dai into Compound, you receive cDAI, or Compound Dai. If you deposit Ether into Compound, you receive cETH.

These tokens can be used for further yield farming. For example, an investor could deposit cDAI into another protocol, and that protocol could issue a third token, creating a wrapped token backed by cDAI as collateral.

As you can see, yield farming strategies can be complex and varied, so you need to understand the underlying mechanics of each protocol before participating. Basically, to start yield farming you (1) set up a wallet such as MetaMask, (2) connect it to the DeFi platform of your choice, (3) deposit the required assets, and (4) follow the platform's instructions.

How Are Yield Farming Returns Calculated?

Expected yield farming returns are usually calculated on an annual basis. This is an estimate of the return an investor can expect over one year.

Commonly used metrics are annual APR and APY. The difference between them is that APR reflects simple interest, while APY reflects compound interest. Compounding in this case means reinvesting your returns into the protocol to generate even more returns. However, APR and APY are often not clearly distinguished and are sometimes used interchangeably.

It's also important to remember that these are only estimates and projections. Yield farming is highly competitive and fast-moving, and rewards can change rapidly, so it's hard to accurately estimate even an hour's or a day's worth of rewards. If word gets out that a farm offers great returns, many farmers may pile in and the yield can shrink in no time.

In addition, when you hold assets in a pool, there is the possibility of impermanent loss. As a result, the returns you earn from yield farming could end up smaller than the value lost to impermanent loss, leaving you with a net loss.

3 Types of Yield Farming

1. Liquidity Provision

Liquidity provision means depositing equal amounts of two assets into a liquidity protocol. For example, you could deposit DAI and ETH. Then, whenever someone trades between the two assets, you earn a share of the trading fees generated on the platform.

2. Staking

Staking means depositing a certain amount of coins on a blockchain to support the security and operation of the blockchain network.

When you stake tokens, you receive additional coins as an incentive reward. Rewards can come from transaction fees, inflation mechanisms, or additional rewards determined by the protocol.

For example, the Ethereum network runs on a proof-of-stake consensus mechanism and uses a staking system to secure the network.

3. Lending

You can lend your assets to others through DeFi platforms. In doing so, the lender can earn interest.

Risks and Precautions of Yield Farming

1. Smart Contract Vulnerability Risk

Yield farming relies on smart contracts, and smart contracts can contain inherent potential vulnerabilities. Bugs or security flaws in smart contracts can also lead to financial losses, such as losing both your deposited funds and the rewards you've earned. That's why it's important to take care to evaluate the security of the protocol you choose and check its audit reports.

2. Protocol Risk

Each yield farming protocol carries its own unique risks. These include flaws in protocol design, errors in smart contract upgrades, changes to the protocol's economic model, or rug pulls.

3. Market Volatility

The crypto market is well known for its high volatility. This volatility can affect the value of the tokens you hold or the rewards you earn through yield farming. Sharp price swings can lower the prices of your deposited assets and reward coins, reducing your overall profitability. In addition, if the price of the deposited tokens fluctuates significantly during the farming period, liquidity providers face the risk of impermanent loss, incurring a loss when they withdraw their assets from the pool.

4. Liquidity Risk

Yield farming usually involves depositing your funds for a certain period. If liquidity then runs short, you may not be able to access or withdraw your funds immediately when you need them. As a result, you might not get your deposited assets back properly, or the project could fail and the token price could plunge.

Popular Yield Farming Platforms and Protocols

Now let's take a look at some popular yield farming platforms and protocols used in the yield farming ecosystem.

The DeFi platforms below are known to be relatively safe, but you should still use careful judgment and do your own additional research before participating.

1. Compound Finance

Compound is an algorithmic money market where users can lend and borrow assets. Anyone with an Ethereum wallet such as MetaMask can deposit assets into Compound's liquidity pools and start earning rewards immediately. Interest rates are adjusted algorithmically based on supply and demand.

2. MakerDAO

MakerDAO is a decentralized finance platform that issues Dai (DAI), a stablecoin algorithmically pegged to the value of the US dollar. Anyone can open a Maker Vault and lock up assets such as Ethereum, Bitcoin, Tether, Bitcoin Cash, and Litecoin as collateral. You can then generate Dai from the Maker Vault as debt against that collateral. This debt accrues interest over time based on the rate set by holders of Maker's MKR token.

3. Aave

Aave is a decentralized protocol for lending and borrowing. Interest rates are adjusted algorithmically according to current market conditions. Lenders receive Aave tokens (AAVE) in return. These Aave tokens start earning interest immediately. The Aave platform also offers other advanced features such as Flash Loans.

4. Uniswap

Uniswap is a decentralized exchange (DEX) protocol that lets you swap tokens trustlessly. Liquidity providers can deposit two tokens at the same time to create a pool. Then, when traders trade in that liquidity pool, the providers receive the trading fees generated by the pool in return for supplying liquidity.

5. Curve Finance

Curve Finance is a decentralized exchange protocol designed specifically for efficient stablecoin swaps. Curve users can swap large amounts of stablecoins with relatively low slippage.

6. Synthetix

Synthetix is a protocol for synthetic assets. You can provide Synthetix Network Token (SNX) or Ethereum as collateral and then mint synthetic assets against it. Synthetic assets can be thought of as tokenized derivatives that use blockchain technology to replicate the value of an underlying asset.

In this way, synthetic asset protocols provide a way to hold and trade assets without actually owning them. Almost any financial asset, including stocks, altcoins, and options contracts, can be added to the Synthetix platform.

Wrapping Up

Yield farming plays an important role in the evolving decentralized finance (DeFi) ecosystem and is transforming the world of new financial services. Farmers who take part in yield farming supply liquidity and can receive crypto coins as a reward for their participation.

Yield farming is appealing in that anyone who holds crypto and has an internet connection can join DeFi platforms and earn extra income, but as with any investment, understanding the risks is essential.