What Is Yield Farming?

Since the days of its early beginnings in 2018, the world of DeFi in the crypto industry has continued to grow in immense proportions and attract a lot of interest from investors. This growth can be attributed to the benefits and opportunities that DeFi offers over traditional finance products. One of these many opportunities is yield farming, which is a key focus area of the ever growing DeFi sector.

As a crypto trader, you are always looking for ways to maximize your profits. This is where yield farming comes in. So what is yield farming? Simply put, yield farming is the process of lending out your assets in order to generate a profit. This may sound complicated, but it's actually a fairly straightforward process. In this post, we'll break down what yield farming is, some of the best crypto yield farms, and how you can start using it to earn more crypto.

How does yield farming work?

Yield farming is a popular DeFi strategy for making passive income on your crypto assets. Yield farming didn't become popular until 2020, and before then, many investors who bought and held cryptocurrencies only did so with the hopes of selling at a higher price. But why just buy and hold when you can put your assets to work and get additional crypto as rewards?

The vast majority of yield farming activities take place on the Ethereum platform and farmers are rewarded with ERC-20 tokens, but there are other blockchain that support yield farming. It generally involves you lending your assets to a project by locking them in a liquidity pool created by a decentralized finance (DeFi) protocol. These liquidity pools work based on smart contracts that run automatically and they do not involve centralized intermediaries. Through yield farming, crypto hodlers can build passive income generation on their locked assets in the form of transaction fees, interest, or whatever means employed by the DeFi protocol.

Is yield farming the same as staking?

Yield farming and staking are two very different processes, although they both require you to lock up your otherwise idle assets to generate passive income. For one, yield farming involves more risk than staking. It involves locking in assets in DeFi protocols to earn interest and rewards. Staking, on the other hand, serves a special purpose. It is used to support blockchains that rely on the Proof-of-Stake (PoS) consensus algorithm.

In Proof-of-Stake, validators (equivalent to miners in Proof-of-Work), lock in a certain amount of crypto assets to indicate their interest in validating transactions on the blockchain. If selected as validators, they are rewarded with newly minted coins in exchange for their efforts.

Staking also requires you to lock in more assets than yield farming. The bigger the number of assets locked in, the greater the possibility of being selected as a validator. However, you can stake with lesser holdings through other options like crypto exchanges and staking pools.

Yield Farming Metrics

Yield farming metrics are important because they provide a snapshot of how well a particular DeFi contract is performing. By tracking things like investment volume and estimated returns, you can get a good sense of how safe and profitable a given contract is. Although, it’s important to note that these metrics only provide estimations. There are three yield farming metrics that you need to keep an eye on:

Total Value Locked (TVL)

This figure tracks how much value has been locked in DeFi contracts for the purpose of yield farming. It is calculated by multiplying the number of assets staked or deposited by the price of the assets.

The TVL is a useful indication of the overall health of the DeFi and yield farming market. It’s also a good metric for understanding leading DeFi protocols and estimating the market share of different blockchains. You can find the TVL for a specific project by visiting its website, but you can get a better overview on websites like DeFi Llama and DeFi Pulse (Ethereum-based protocols only).

Annual Percentage Yield (APY)

When it comes to yield farming in DeFi, the Annual Percentage Yield (APY) is one of the most important metrics to keep an eye on. The APY measures the total interest earned on your crypto investment over a one-year period. It is a particularly good metric and indicator of how profitable a particular yield farming strategy is because it takes into account the effect of compounding interest. That is, total interest on both your initial crypto investment and the interest you reinvested.

Annual Percentage Rate (APR)

The APR also calculates the interest you earn when you put up crypto tokens in a yield farm. However, unlike the APY which considers the effect of compounding interest, the APR only considers the annual interest rate.

Types of yield farming

There are a few different roles that investors can take on and it's important to understand the different types of yield farming.

Liquidity provider

Liquidity providers are the backbone of the automated market makers of decentralized exchanges (DEXes) and are crucial to the health of these marketplaces. They use their otherwise idle crypto assets to provide liquidity to decentralized exchanges. In return, they get a cut of the fees that are charged for trades or issued tokens from the platform.

To act as liquidity providers, investors have to deposit a crypto trading pair into a smart contract known as the liquidity pool. For example, ETH and USDT. This ensures that there are always enough assets to fill buy/sell orders and that users can always trade ETH/USDT on the platform.

Lending

Lending is another popular option as there's a high potential for returns and it's a relatively low-risk way to earn income from your crypto holdings. Here, investors put in funds in a trustless smart contract liquidity pool which offers them up to borrowers. By doing so, they act as a liquidity provider for the project or entity that borrows the funds. When the borrower pays back with interest, the investors get a cut of the interest based on their share of funds in the liquidity pool.

Borrowing

This is a less popular method of yield farming as it is more complex than lending. Here, investors can deposit one token as collateral, receive a loan of another, and then put it up for lending again. What this means is they are essentially lending out their original deposit and borrowed funds to receive double the rewards for lending. However, this is much riskier for retail investors as a decrease in value can trigger liquidation.

Staking

In staking pools, members pool their funds together to stake more tokens, and then the pool shares the rewards proportionally based on how much each person contributed.

This type of yield farming is attractive to new crypto traders because it doesn't require a lot of capital to get started, and it's a great way to learn about other types of yield farming. Also, you can stake token-based rewards from liquidity pools.

Calculating yield farming returns

This is actually a pretty simple process, as the returns are calculated by the important metrics that we've already discussed. Typically, rewards are calculated annually with the Annual Percentage Yield (APY) and the Annual Percentage Rate (APR), but daily or weekly estimated returns are more appropriate as the returns are rapidly changing. The greater the number of investors who contribute to a liquidity pool, the smaller the return for each participant.

The APY calculates yearly rewards with the effect of compounding interest while the APR calculates yearly rewards without taking into consideration compound interest. Hence, the more investors compound their interest, the greater the difference between APR and APY. This makes the APY a more accurate representation of the return at the end of each year.

A much easier way to get your total return after farming is to simply calculate the percentage of the number of tokens you earn from the number of tokens you put in.

Yield farming protocols

So you're looking to get into yield farming? That's great. But where do you farm your crypto assets for reward? There are a number of different DeFi yield farming protocols and not all of them are created equal. Each protocol has its own strengths and weaknesses, so you need to find the one that matches your trading style and investment goals. Many of these platforms offer various incentives to attract both liquidity providers and borrowers. So which one is the best? Let's take a brief look at some of the most popular platforms to help you decide which is best for you.

Maker DAO

There are a few different DeFi yield farming protocols out there, but MakerDAO is one of the best. It has a proven track record of stability and security and has been around since 2014.

The MakerDAO crypto protocol allows people to borrow crypto by locking up their ETH (Ether) as collateral in an Ethereum wallet (e.g. Metamask) to mint a stablecoin called DAI. DAI is always pegged to the US Dollar, so this way, individuals can borrow crypto and have a stable amount to pay back without worrying about market volatility.

The lowest collateralization rate for Ether is set at 150%. Depositing $150 worth of Ether makes you eligible to borrow up to 100 Dai. Once the DAI loan is paid back with interest, it is burned off and the collateral can be withdrawn. MakerDAO currently has the highest Total Value Locked with a TVL of $8.6 billion.  

Uniswap

Uniswap is one of the first decentralized exchange protocol that allows users to trade ERC-20 token pairs without the need for a third party. It works by matching buyers and sellers of tokens, and then automatically swaps the tokens between them. This process is made possible by Uniswap's smart contracts which allow liquidity providers to deposit the trading pair in liquidity pools. The liquidity provider contract shares a 0.3% transaction fee between the providers according to their share of the pool.

Curve Finance

Curve Finance is a decentralized exchange that lets users exchange large amounts of stablecoins without worrying much about slippage and fees. Hence, Curve Finance is like a UniSwap for stablecoins. By focusing on stablecoins like USDC and USDT, Curve allows investors to avoid volatile crypto assets while earning interest rates from lending and yield farming their stablecoins. Users with contributions in the liquidity pools receive Curve LP tokens.

Curve also has its own governance token called CRV. These tokens can be staked and converted to veCRV to increase the APY of your deposit. The veCRV (vote-escrowed CRV) tokens simply refer to the CRV tokens locked into the Curve protocol. The more veCRV you lock, the more you can boost your CRV rewards. Curve Finance currently has a yearly return as high as 36%

Convex Finance

Convex Finance is a platform that allows Curve liquidity providers and CRV token owners to generate additional interest. Curve liquidity providers can deposit their Curve LP tokens in the Convex protocol to get more rewards without locking them in Curve.

Instead of staking through Curve to get veCRV tokens, you can also stake CRV tokens on the Convex platform to earn CVX tokens. However, this process is irreversible because the CRVtokens provided are staked in Curve for veCRV.  This allows them to get the same benefits as veCRV tokens and a share of all rewards generated by Convex's protocol.

PancakeSwap

PancakeSwap is one of the few decentralized exchanges built on the Binance Smart Chain (BSC). It works on the automated market maker (AMM) model where investors can add funds to the liquidity pool in exchange for a token. Users can also lend from the pool and pay a fee. This fee is then distributed among the liquidity providers according to their share of the pool.

PancakeSwap also has a token called CAKE which you get after locking your LP tokens

CAKE then allows you to stake, partake in lotteries, and win NFTs on PancakeSwap. The current APY for staking CAKE can go as high as 84.11%.

Lido

Lido is a decentralized autonomous organization that provides liquid staking solutions. Initially developed for Ethereum 2.0, Lido has since moved to other blockchains like Solana, Polygon, and Polkadot. The platform allows users to stake their tokens which will be used to verify transactions in these blockchains. In return for staking, they get liquid tokens that can be used across other DeFi lending platforms. For example, staking 32 ETH on Lido mints 32 stETH in return. Apart from getting rewards from their stake, users can also use stETH as collaterals on other yield farming protocols. Once the ETH is redeemed, the stETH is burned. Lido currently has an APR of 3.9% to 21.2% for staking on the supported networks.

Aave

Aave is an open-source decentralized platform for lending and borrowing through smart contracts. Running on the Ethereum blockchain, the Aave protocol gives users the ability to borrow crypto token loans as well as earn interest by depositing ETH-based assets in liquidity pools. In addition to this, it offers a feature for developers known as flash loans. Flash loans are essentially unsecured loans that must be repaid to the protocol together with interest in the space of just one block transaction.

Aave also has its own token called AAVE which can be staked to earn rewards. Lending on AAVE can also return an APR of up to 15%.

Compound

Compound is another decentralized protocol running on Ethereum that allows users to lend and borrow digital assets. Compound allows you to start yield farming and earn interest on Ether or any other ERC-20 tokens by depositing them in a pool running on a smart contract. You can also borrow against your locked crypto and pay interest. Compound currently has a supply APY of around 0.7% to 1.79%.

Potential risks of crypto yield farming

Although yield farming allows investors to generate passive income from their unused assets, there are several risks associated with this investment strategy. The following are a few of them that you need to watch out for:

Rug pulls

Rug pulls are one of the most used scam methods in the crypto industry. Although there are many strong and established yield farming protocols, rug pulls are bound to happen once in a while. Since yield farming requires investors to contribute money in a liquidity pool, a smart contract mishap can cause malicious people to drain all the assets in the pool. An example of this is in a project called Arbix Finance where a hacker drained $10 million deposited by users in unverified liquidity pools.

Regulatory risk

The crypto industry is known for being obscured by a lack of clear regulations. As with any investment, there is always the possibility of regulatory changes that could have a negative impact on your returns. These liquidity pools also lack government insurance protecting the funds and an assault can be disastrous for investors.

Volatility risk

With the exception of stablecoins, cryptocurrencies are notorious for their extreme price swings. When there is a significant drop in prices, the prices of assets may change quickly. This results in an impermanent loss, and it may also cause the profits from yield farming to fluctuate significantly. This can be risky for new traders who may not be able to afford to lose any of their initial investments. The interest rate also changes from time to time and investors can never be really sure of how much they will make over the course of a year.

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