Decentralised finance (DeFi) aims at removing intermediaries in financial transactions. This emerging financial technology has opened multiple avenues of income for potential investors. One such investment strategy in DeFi is yield farming. You can consider yield farming if you are a crypto investor seeking to increase investment returns.
What is yield farming?
Also known as liquidity mining, yield farming refers to using decentralised finance protocols to produce additional earnings on your cryptocurrency holdings. In simpler terms, it involves locking up cryptos and receiving rewards.
Users borrow or lend cryptocurrency on a DeFi platform, and in return for their services, they earn crypto.
Yield farmers looking forward to increasing their yield output can implement more complicated tactics. For instance, yield farmers can shift their cryptocurrencies constantly between multiple loan platforms to optimise their gains.
How did yield farming become popular?
The launch of the Compound Finance ecosystem’s governance token, COMP token, can be held responsible for the yield farming boom. Governance tokens enable holders to participate in a DeFi protocol’s governance.
A common approach to starting a decentralised blockchain is algorithmically distributing these governance tokens with liquidity incentives. This proves to be attractive for liquidity providers to farm the new token by offering liquidity to the protocol.
The launch of the COMP token did not invent yield farming. But it boosted the popularity of this kind of token distribution model. Since then, other decentralised finance projects with innovative schemes have emerged to attract liquidity to their ecosystems.
Yield farming: Working
Yield farming works by first letting an investor stake their coins by using a decentralised app (dApp) to deposit them into a lending protocol. After that, other investors can borrow the coins via a dApp for speculation. Here, they try to gain from the sharp swings in the coin’s market price, which they expect.
Users offering their cryptos to function in the decentralised finance platform are called liquidity providers (LPs) who provide tokens or coins to a liquidity pool. This pool is a dApp based on a smart contract containing all the funds.
After the liquidity providers lock the tokens into a liquidity fund, they earn interest or a fee from the underlying DeFi platform on which the liquidity pool is.
This liquidity pool powers the marketplace where an individual can borrow or lend tokens. The use of this marketplace requires a certain fee from users. These fees are used to pay the liquidity providers for staking their tokens in the pool.
Notably, substantial yield farming occurs on the Ethereum platform; therefore, the rewards are a kind of ERC-20 token.
Lenders can make use of the tokens as they want to. However, it’s worth noting that most lenders are speculators seeking arbitrage opportunities by cashing in on a token’s fluctuations in the market.
Calculation of yield farming returns
The estimated yield farming returns are typically calculated annually. This forecasts the returns, which you can anticipate over a year.
Annual Percentage Yield (APY) and Annual Percentage Rate (APR) are some commonly used metrics.
The difference between these two is that the latter does not consider the effect of compounding, while the former does. Here, compounding implies directly reinvesting profits to produce more returns. It is worth noting here that these are projections and estimations.
As APY and APR come from legacy markets, decentralised finance may require finding its metrics to calculate returns. Due to DeFi’s fast pace, daily or weekly estimated returns may be more meaningful.
Popular yield farming protocols
- Curve Finance
This liquidity pool on Ethereum uses a market-making algorithm to allow users to exchange stablecoins. Pools that use stablecoins can be safer as their value is pegged to another exchange medium.
- Uniswap
In this decentralised exchange, liquidity providers need to stake both sides of the pool in a ratio of 50/50. In exchange, they earn a part of the transaction fees in addition to UNI governance tokens.
- Instadapp
Engineered for developers, Instadapp enables users to develop and manage their DeFi portfolio.
- Aave
This open-source liquidity protocol allows users to borrow and lend cryptocurrency. As a depositor, you will receive interest on deposits in the form of AAVE tokens. The market borrowing demand forms the basis of interest-earning. Also, you can act as a borrower and depositor by using the deposited coins as collateral.
- Compound
Compound is an open-source protocol built for developers, using an autonomous, algorithmic interest rate protocol to ascertain the rate that depositors earn on staked coins. Also, you, as a depositor, can earn COMP tokens.
Risks of yield farming
- Smart contract risk
Smart contracts utilised in yield farming can be susceptible to hacking or may have bugs. This puts your crypto at risk. Improved code vetting and third-party audits will help enhance the security of these contracts.
- Rug pulls
These refer to an exit scam in which a crypto developer collects investor funds for a project and then abandons the project without returning the funds.
- Volatility
When tokens are locked up, their value may rise or drop. This proves to be a significant risk to yield farmers, particularly when cryptocurrency markets experience a bear run.
- Impermanent loss
When there is high volatility, liquidity providers can face impermanent loss. This occurs when there is a change in the price of a token in a liquidity pool which subsequently changes the ratio of tokens in the pool to stabilise its total value.
Closing thoughts
Yield farming is the most significant growth driver of the decentralised finance sector, helping it grow to a market cap of $10 billion from $500 million in 2020.
This may appear lucrative for several individuals. But, at the same time, it is vital to keep in mind that there is a significant risk involved as well. Hacks, losses and scams because of volatility are not something uncommon in the decentralised finance yield farming space.
Also, it is pretty difficult to make accurate estimations of short-term rewards. This is because yield farming is an extremely fast-paced and competitive market, and there can be rapid fluctuations in rewards. If the strategy for yield farming works for a while, several farmers will grab the opportunity, which can further stop yielding high returns.
