Yield farming is one of the hottest trends in decentralized finance (DeFi). There is also a high chance you may have already heard about the lucrative returns that some yield farmers have made. But, how exactly do you pick up yield farming, and where do you begin?
Here, we will be covering:
What is yield farming?
How does yield farming work?
What are some of the examples?
What are the risks of yield farming?
Yield farming is a process where you stake or lend your crypto assets to generate high rewards in the form of additional cryptocurrencies.
In general, yield farming rewards are given to users who engage in beneficial actions to the protocol. This includes:
Pooling liquidity into a contract to provide markets
Adding liquidity to be a more significant market maker or get a discount
Locking up specific assets
The yield generated can be in the form of a percentage of the transaction fees generated by the underlying DeFi platforms, interest from lenders, or governance tokens.
How Does Yield Farming Work?
Here’s a diagram of how liquidity pools work.
As a liquidity provider, you first deposit your crypto assets into liquidity pools. Liquidity pools are pools of tokens locked into a smart contract that facilitates asset trading while allowing investors to earn a return on their holdings. These pools allow traders to execute their trades in a permissionless manner on Automated Market Maker (AMM) platforms.
Traders need to pay trading fees for using the liquidity pool; the fees are then divided between all liquidity providers based on the respective liquidity amount in the pool. Participants can also earn the platform’s governance token as an additional incentive in certain pools.
When the token amount in a liquidity pool constantly changes, you’ll be suffering impermanent loss. If the price of Token X falls, there’s a possibility that the situation may be reversed, as more Token X is sold back to the pool for Token Y.
Impermanent loss can be tricky to calculate, especially for dual-asset and multi-asset pools. To simulate impermanent loss on dual-asset pools, you can calculate it on CoinGecko’s Impermanent Loss Calculator.
The Difference between APY and APR
Annual Percentage Yield (APY) - interest rate earned with compounding interest within the year.
Annual Percentage Rate (APR) - interest rate earned without compounding interest within the year.
Here’s an APY calculator on CoinGecko for ease and comparison.
Since APY takes compounding effects into account, it can be slightly misleading to new users as the APY figures do not accurately reflect your actual yield. You could achieve the advertised yield if you were to compound it manually. Note that this would not be as feasible for users with lower capital since transaction costs could eat into your returns.
When there are high APYs or APRs offered, this usually means that there is low liquidity in the pool. It can signify two things - either people have no confidence in the pool or that the distribution of the native token is very high, which will dilute the token supply significantly.
Another type of yield farming for degens is leverage farming.
A simple example is as follows:
Michael puts 100 USDC on Compound as collateral (earning interest + COMP tokens)
Michael borrows 70 DAI against his 100 USDC collateral (paying interest on the DAI borrowed but subsidized by COMP token rewards)
Michael trades 70 DAI for 70 USDC on a decentralized exchange and repeats Step 1. Alternatively, Michael can put the 70 DAI from Compound into another DeFi protocol, for example, Balancer, for additional yield farming rewards.
The yield in yield farming is generated through various means:
A team incentivizing actions by distributing their native tokens (Buyers speculate on the value of the native token, thus providing value to the token)
A protocol that pays out the fees collects by providing a service (for example, swaps on decentralized exchanges)
A protocol that distributes fees obtained from other protocols (for example, Yearn Finance provides users with highest APY on the deposited cryptocurrencies by using their proprietary strategy)
How To Yield Farm
Here’s a simple illustration of how to yield farm on Sushiswap on the Ethereum network.
Step 1: Go to app.sushi.com
Connect your wallet (MetaMask in this example).
Step 2: Please be sure that your funds are already in your wallet
In this case, we will have Wrapped Ether (WETH) and Alchemix (ALCX).
Step 3: Go to ‘Pool’ on the top header and select the pool that you would like to add liquidity to
You will then receive Liquidity Pool tokens that represent your share of the liquidity pool.
Step 4: Press on the ‘Farm’ on the top header
Click on the liquidity pool that you’ve chosen, key in your amount of LP tokens to deposit, and press Stake.
Congrats! You’re now farming SUSHI and ALCX from the WETH-ALCX pool.
This is just one of the many platforms to begin your yield-farming journey. Each blockchain has its unique protocols for yield farming with varying rates of return. You may refer to our previous yield farming guides on Solana, Polygon, and BSC for more information.
Risks of Yield Farming
Despite the apparent potential upside, yield farming has its risks that users need to be aware of.
Smart contract bugs and hacks: Smart contracts can be vulnerable due to coding bugs. Hacks are a constant threat in decentralized finance.
Admin key risk: Developers of DeFi protocols may still control admin keys. If the admin keys are not sufficiently distributed, it may represent a high risk of developers running away with funds in the liquidity pools. Therefore, there is always a risk of a centralized takeover of the protocol.
Systemic Risks: With the yield farming craze, activity in decentralized applications has been artificially increased by yield farmers looking to maximize the rewards they can gain. This is usually accomplished by depositing, trading, and borrowing tokens in a complex and recursive manner.
Impermanent Loss: As mentioned above, this threat will persist for liquidity providers unless you’re in a single staking pool or stable pool.
Rug pulls: There is an increased risk of being rug pulled with a high APY for yield. It frequently happens on decentralized exchanges where the original liquidity provider would drain the liquidity pool right after people have minted the tokens, leaving the holders with a worthless coin. You are advised to do a background check on the project before yield farming on any liquidity pools.
Liquidation Risks: If you are borrowing on a lending protocol, you risk having your position liquidated when the cryptocurrency you use as collateral loses its value. You will need to monitor your collateral position closely so that your borrowing positions are not undercollateralized.
You are advised to do your research before participating in yield farming. Here is a list of questions that you may ask yourself before participating in any liquidity pools:
Is there a better place for your asset?
How established is the protocol?
Is there a single admin key?
How is the yield generated?
Is the protocol audited?
Is there a lot of liquidity? (Can you sell your yield at a specific price into another asset without slippage?)
Will the yield farming activity result in a high impermanent loss?
How trustable is the blockchain on which this is running?
Information is important. High yields can be attractive and tempting, yet it comes with high risks. Keep an eye out on the token prices constantly if you’re a part of this yield farming community to stop losses in time.
Stacy is a market research intern at CoinGecko. She's very much into cryptocurrency. Big on BTC, ETH, SOL, NFTs, and Japanese food. Follow the author on Twitter @trufflefriesx