What Is Yield Farming in DeFi?
Feb 25, 20226 min read
To simplify, yield farming is a process to multiply crypto with your crypto. You lend your assets to others via computer programs called smart contracts. In return for your help, you get fees in crypto.
Yield farmers have to use some sophisticated strategies if they really want to gain some profit. They transfer their crypto assets between different lending marketplaces to increase their income. They could be pretty reserved about the most successful yield farming strategies. As once more people know about a strategy, the less effective is it. Nothing personal, it’s strictly business.
What Is a Yield Farming?
Yield farming sometimes called liquidity mining, it’s a way to gain rewards with cryptocurrency assets. A liquidity provider’s (LP) holdings are locked up cryptocurrencies and they getting rewards for that.
What is a liquidity pool? It’s a smart contract containing provided assets. For providing liquidity to the pool, LPs are rewarded. That award usually comes from fees generated by the underlying DeFi platform, or some other source.
Some liquidity pools give rewards in different tokens. Those tokens could be deposited to other liquidity pools to earn another portion of rewards there, and then again and again. It’s quite evident that the system is pretty complex, so a trader should be into the topic to gain a worthy reward. But the basic idea is that an LP gives funds into a liquidity pool and gets rewards for that.
Yield farming is done using Ethereum ERC-20 tokens, so the rewards are usually also a type of ERC-20 token.
Liquidity providers deposit funds into a liquidity pool. This pool empowers a marketplace where users lend, borrow, and exchange assets. The usage of these platforms involves fees, which are then paid to liquidity providers regarding their share of the liquidity pool.
The funds deposited are commonly stablecoins pegged to the U.S. dollar – though it’s not an obligatory requirement. The most common stablecoins used in DeFi are DAI, USDT, BUSD, and some others.
Is yield farming profitable?
According to CoinGecko, returns can vary from 1% to 1,000% APY, early-yield farmers, those who become involved in the early stage of the project, can gain a significant profit.
The approximate return in the yield farming process is calculated in terms of annual percentage yield (APY). It is the rate of return that LP provides over a year. Compound interest is also calculated within the APY.
10 yield farming platforms
- Aave is an open source non-custodial decentralized lending and borrowing protocol to create money markets, where users can borrow assets and earn compound interest for lending in the form of the AAVE (previously LEND) token. Aave has the highest TVL locked among all DeFi protocols, sitting at over $21 billion as of August 2021. Users can earn up to 15% APR for lending on AAVE.
- Compound is a money market for lending and borrowing assets, where algorithmically adjusted compound interest rate as well the governance token COMP can be earned. It is audited and reviewed to ensure the highest level of security standard. Total supply is over $16 billion as of August 2021 and APY range from 0.21% to 3%.
- Curve Finance is a DEX that lets users and other decentralized protocols exchange stablecoins with low fees and low slippage using its unique market-making algorithm. It is the largest DEX in terms of TVL, with over $9.7 billion locked. Base APY can go as high as 10%, while rewards APY can go over 40%. Stablecoin pools are generally safer as they do not lose their peg value.
- Uniswap is a hugely popular DEX and AMM that enables users to swap almost any ERC20 token pair without intermediaries. Liquidity providers must stake both sides of the liquidity pool in a 50/50 ratio, and in return earn a proportion of transaction fees as well as the UNI governance token. There are two live versions – Uniswap V2 and V3. The latest version, Uniswap V3, is a growing protocol ecosystem with over 200 integrations. TVL is $5 billion for V2 and over $2 billion for V3 as of August 2021.
- Instadapp is the world's most advanced platform to leverage the potential of DeFi. Users can manage and build their DeFi portfolio and developers can build DeFi infrastructure using their platform. As of August 2021, over $9.4 billion is locked on Instadapp.
- SushiSwap is a fork of Uniswap, which caused a huge wave in the community during their liquidity migration process. It is now a DeFi ecosystem, with multi-chain AMM, lending and leverage markets, onchain mini Dapps and launchpad. TVL on the platform is $3.55 billion as of August 2021.
- PancakeSwap is a DEX built on the Binance Smart Chain (BSC) network for swapping BEP20 tokens. PancakeSwap uses an automated market maker (AMM) model where users trade against a liquidity pool. It has the highest TVL among BSC protocols, with over $4.9 billion locked as of August 2021. It focuses heavily on gamification features, with lottery, team battles and NFT collectibles. APYs can go as high as over 400%.
- Venus Protocol is an algorithmic-based money market system that aims to bring lending and credit-based system on the Binance Smart Chain. Users supply collateral to the network and earn APY for lending, while borrowers pay an interest. Venus differs by its ability to use the collateral supplied to the market not only to borrow other assets but also to mint synthetic stablecoins with over-collateralized positions that protect the protocol. These synthetic stablecoins are backed by a basket of cryptocurrencies. TVL is over $3.3 billion as of August 2021.
- Balancer is an automated portfolio manager and trading platform. Its liquidity protocol distinguishes itself through flexible staking. It doesn’t require lenders to add liquidity equally to both pools. Instead, liquidity providers can create customized liquidity pools with varying token ratios. Over $1.8 billion is locked as of August 2021.
- Yearn.finance is an automated decentralized aggregation protocol that allows yield farmers to use various lending protocols like Aave and Compound for the highest yield. Yearn.finance algorithmically seeks the most profitable yield farming services and uses rebasing to maximize their profit. Yearn.finance made waves in 2020 when its governance token YFI climbed to over $40,000 in value at one stage. Users can earn up to 80% APY in Yearn, and $3.4 billion is locked in the protocol.
Risks of yield farming
Yield farming isn’t for newcomers. The most beneficial yield farming strategies are highly complecated and work only for crypto gurus. Plus, yield farming is mostly for those who have a lot of capital to invest (so-called crypto whales).
Yield farming isn’t as easy as it seems, and if you don’t understand what you’re doing, you’ll likely lose money. We’ve just discussed how your collateral can be liquidated. But what other risks do you need to be aware of?
One obvious risk of yield farming is smart contracts. Due to the nature of DeFi, many protocols are built and developed by small teams with limited budgets. This can increase the risk of smart contract bugs.
Even in the case of bigger protocols that are audited by reputable auditing firms, vulnerabilities and bugs are discovered all the time. Due to the immutable nature of blockchain, this can lead to loss of user funds. You need to take this into account when locking your funds in a smart contract.
In addition, one of the biggest advantages of DeFi is also one of its greatest risks. It’s the idea of composability. Let’s see how it impacts yield farming.
As we’ve discussed before, DeFi protocols are permissionless and can seamlessly integrate with each other. This means that the entire DeFi ecosystem is heavily reliant on each of its building blocks. This is what we refer to when we say that these applications are composable – they can easily work together.
Why is this a risk? Well, if just one of the building blocks doesn’t work as intended, the whole ecosystem may suffer. This is what poses one of the greatest risks to yield farmers and liquidity pools. You not only have to trust the protocol you deposit your funds to but all the others it may be reliant upon.
Yield farming definitely could gain profit for you, you can grow your crypto by applying difficult yield strategies, but you have to work a lot — read, learn, compare yield farming protocols and try various ways to succeed in that field.