What yield farming is
In 2020, a boom of decentralized finances (DeFi) appeared, which introduced new ways of receiving income from investments and cryptocurrency known as yield farming or simply farming. Moreover, cryptocurrency holders can increase their income by means of yield farming or decrease losses in the event of crypto assets’ rate drop.
At first glance, the idea seems simple, but if we dig deeper, we can see that in order to receive significant income, farmersapply complex strategies allowing them to maximize profits. In this article, we are going to tell you what yield farming is, how farming works, what types of it there are, as well as tell you about advantages and risks related to yield farming.
In simple terms, Yield Farming is a combination of methods of receiving income from cryptocurrencies in DeFi protocols. It is also called the mining of liquidity. In fact, you provide other users with your digital assets with the help of smart contracts and receive a fee for that. Farming has opened holders a new way of using cryptocurrencies to receive extra income: cryptocurrencies work instead of being simply laid a dead weight in a wallet.
The name ‘yield farming’ is symbolic since income from investments in DeFi can be compared to harvesting: the more effort a farmer puts, the more harvest he will receive. And weather conditions may also affect the ‘yield’ – the volatility of the crypto market. For example, ‘crypto winter’ may not only decrease the harvest but even ‘destroy’ it – these are risks of yield farming that we will discuss in a subsequent part of the article.
Yield farming appeared with the launch of liquidity protocols, such as Uniswap or Synthetix. Users use them to get income (mining of liquidity, for instance). The Ethereum system, the first protocol to use smart contracts, became the basis for the creation of the DeFi ecosystem. It allowed the creation of various decentralized apps (DApps) over the blockchain network.
Later some other platforms emerged that even outperformed the Ethereum network by efficiency. Due to the issues with scalability as well as the growth of the number of users and apps, the network had faced a higher load that led to expensive and slow transactions. One of the more productive networks became the Binance Smart Chain – the second by number of users and transactions after the Ethereum platform.
At first, you will need to have any pair of cryptocurrencies available on a chosen liquidity protocol, for example, Uniswap, 1inch, or PancakeSwap. If there is no necessary pair, the missing asset may be purchased on these very platforms. These protocols are decentralized – that is are not managed by a centralized node.
Note: despite the fact that all operations go through a smart contract, that is just a program performing instructions set to it. But transactions and blocks are added by miners (or validators of a network). The smart contract does not manage it: it only ensures that liabilities between the parties of the deal are fulfilled.
Once you have received the required cryptocurrencies, you need to lock them in a protocol so that other users can use them. They are going to pay you a fee for that. In other words, you need to add assets to the pool of liquidity and ensure liquidity for an exchange. Such users are called providers or suppliers of liquidity.
To better understand the mechanics of yield farming, let us look into what the pool of liquidity is.
A pool of liquidity or Liquidity Pool is a smart contract that stores all funds of liquidity suppliers. Holders can withdraw their assets from a smart contract at any time and without any limitations. But it all is not as simple as it seems: the thing is liquidity suppliers are constantly facing the risks of impermanent loss.
In simple terms, the impermanent loss is a temporary loss that suppliers of liquidity bear due to the volatility of cryptocurrencies. In other words, impermanent loss arises when traders make large purchases of one or sales of another cryptocurrency in a pair. In case the liquidity supplier withdraws funds in this period, the losses will become permanent. The mechanics may differ at various platforms. For example, at Uniswap, users can add assets to the pool directly. But in other protocols, the mechanics may be different: e.g. at PancakeSwap, holders will firstly need to receive LP tokens that are appropriate to the pool, and only then it will be possible to add them to the pool for farming.
One more way of liquidity mining is crypto loans (lending) with collateral security in cryptocurrency. Such an approach helps investors to hedge risks and apply complex strategies of yield farming. However, lending bears high risks: because the pledge may be liquidated during a heavy drop in the rate of collateral security.
That is why DeFi protocols require high security that may vary from 200% to 750%. It means that to get $100, you will need to block from $200 to $750 in the cryptocurrency equivalent in a smart contract.
Farmers receive remuneration for adding assets to the liquidity pool generated by a smart contract from the fees paid by traders or via another method. As a rule, a DeFi platform gives remuneration in native tokens, that is those, released by this platform.
For example, Uniswap crypto exchange pays out farmers UNI, 1inch – 1INCH tokens, while PancakeSwap – CAKE. But that is not necessarily so: platforms may pay out remuneration in other tokens, but each of these tokens must belong to the principal network, on top of which the infrastructure is created. The Ethereum-based platform can generate income only in tokens of ERC-20 standard, while Binance Smart Chain – only of BEP-20 standard.
Note: in the future, this approach may alter. Blockchain developers are actively working on cross-chain solutions that allow creating bridges between various blockchains or, in other words, make them interoperable. It means that platforms will become independent of a specific blockchain and will be able to function even on several blockchains simultaneously. Owing to this feature, it will be possible, for example, to generate income from ERC-20 tokens receiving BEP-20 as a reward and vice versa.
The current situation makes various DeFi platforms inflexible and ‘limited’ within one ecosystem, which contributes to the industry fragmentation. Now holders cannot transfer assets from one blockchain to another without a centralized intermediary. But soon such solutions will be developed. For instance, the Polygon platform is building a layer-2 ecosystem that will allow not only to scale the Ethereum network but also connect it to other ecosystems.
One of the most significant indicators of DeFi platforms is the TVL coefficient, which stands for Total Value Locked or the total amount of locked assets. This term appeared together with DeFi and, in fact, means the liquidity familiar to traditional traders. TVL represents the total amount of assets that were added to liquidity pools by suppliers and is usually expressed in the currency equivalent.
The TVL coefficient is common to all types of DeFi platforms: AMM, DEXes, lending ones, and Assets. It is among key indicators measuring the current dynamics of DeFi market. Using this index, you can compare the sizes of DeFi platforms to assess their popularity and other features. Large DeFi protocols with significant TVL are considered to be the most reliable and proven by many users. However, it also indicates that the profitability of pools of liquidity is not likely to be high: most often, they do not exceed 100% per annum.
On the other hand, less liquid platforms provide high yield that sometimes exceeds 1000%. But it means that protocols have appeared in the market lately and have not been tried; that is why they may be associated with higher risk.
Note: actually, high TVL not always ensures lower profitability, while low TVL does not always mean higher yield. The profitability of farming also depends on traders’ activity: the higher it is, the higher income of liquidity suppliers will be.
The Total Value Locked indicator can be tracked on such websites as DeFi Pulse and DappRadar. The latter can monitor DeFi platforms not only on Ethereum but in other networks as well. For example, Binance Smart Chain or Tron.
Platforms automatically calculate the indicators of annual yield based on algorithms laid down in a protocol. To calculate yield, two indicators are used: the annual percentage yield (APY) and the annual percentage rate (APR).
APR and APY regularly change each other depending on traders’ activity on an exchange as well as the number of locked assets (TVL). The difference between these indicators is only that APY considers an effect of addition, that is compound interest – reinvesting of income for receiving even higher income. The above coefficients may be interchangeable.
The issue is that it is quite difficult to predict APR and APY in the long run since these metrics can be changed for several or even tens of percent within a day. It happens due to high competition: when there is a chance to get high APR, investors are more eager to add assets to the pool to receive the highest income possible.
Meanwhile, other pools are being released, the yield of which, on the contrary, is only rising. To predict the short-term change of indicators, you can use the TVL coefficient as an indicator and monitor the trends at various DeFi platforms.
Today the number of DeFi protocols is in the hundreds, and new ones are appearing almost every day: you cannot even track them all. But that is not even required since there are famous decentralized platforms, the use of which is fully enough to start earning via yield farming.
There is no single system for receiving income: it depends on a specific platform and experience of the investor. Besides that, they are regularly changed. You need to figure out how that or another protocol works before you begin liquidity mining. Let us enumerate well-known DeFi protocols for yield farming.
The largest decentralized platform in the whole DeFi ecosystem at the time of writing this article. Aave is a lending platform on Ethereum, that is, allowing to receive and provide loans in cryptocurrencies. Most recently, Aave became a multi-chain protocol and is now working on Binance Smart Chain as well.
The second by capitalization (TVL) DeFi protocol that became multi-chain following Aave. Curve Finance became the first decentralized exchange (DEX) to work on two blockchains simultaneously: Ethereum and Binance Smart Chain. The exchange is also notable for allowing large traders (whales) to make deals on large amounts of stablecoins virtually without slippage.<
The second largest lending platform. Compound not only accrues percent in tokens that were provided on credit but also rewards lenders with its COMP tokens. The income is generated easily: you need to add assets to a lending pool. After that, rewards will start to be accrued instantly.
That is one of the first and largest decentralized platforms in the DeFi industry. These were Maker Dao developers to have created DAI stablecoin pegged to the rate of the dollar.
To generate DAI, a user needs to lock ETH or some other tokens, after which received stablecoins can be used for various strategies of yield farming.
Biggest automatic market maker as for now.
Uniswap supports simplified mechanics of adding crypto assets to the liquidity pools. At this very platform, you can quickly exchange ETH and ERC-20 tokens. Liquidity suppliers received rewards from fees paid by traders at the Uniswap platform.
The platform quickly became one of the most popular due to its simplicity of use and an intuitive interface.
In 2020, this DeFi protocol gained its popularity so rapidly that the rate of YFI native token skyrocketed by 30 000% in less than a month, which made it one of the most fast-growing assets of the whole cryptocurrency history. In comparison, it took Bitcoin more than five years to reach the same heights.
Yearn Finance offers combined financial services: liquidity pools, lending, and crypto deposits (vaults) similar to bank deposits. It possesses a simple interface, which is perfect for newbies. However, its mechanics is not that evident.
This one is among the most unique DeFi protocols. Synthetix allows ETH and token holders to release almost any synthetical (tokenized) assets pegged by a basic cryptocurrency. In other words, you may lock Ethereum coins and receive tokenized securities of Google or Apple, oil and even gold instead.
Important condition: a synthetical asset should have a price that can be measured. Even today, the list of available synthetical assets is pretty long, and it will only be expanding in the future.
It is the largest AMM platform in the Binance Smart Chain ecosystem. PancakeSwap users can take part in farming and receive income in native tokens CAKE. Besides yield farming, there are also non-fungible tokens (NFTs) and lotteries available on PancakeSwap.
The main advantage of yield farming is its accessibility. You do not need to open an account with the bank to receive access to financial services or to get income from farming. Your age, geography, or social status do not matter. Minimal requirements help to get access to DeFi platforms at any time. All you need for farming is a personal wallet and crypto-assets. In addition to that, mediators to whom you need to pay a fee for their services are absent here. All operations are executed directly between users via a smart contract.
But that is, unfortunately, what disadvantages of yield farming are about: the lack of experience and at least basic knowledge of how DeFi industry and cryptosecurity work lead to increased risks. Firstly, it is vital to understand how to secure yourself when using decentralized protocols.
Farming may benefit both investors and developers of a project. For example, thus they can attract a lot of holders to the platform by distributing their tokens among them instead of holding ICO or IEO token sales, which require sufficient expenses. It also solves the problem of listing tokens at exchanges that may go on for several months.
One of the main disadvantages of yield farming is its high difficulty, which makes it a tough task for newbies to understand how farming mechanics works. To extract high profitability, one needs to be familiar with how various platforms work, develop strategies, and quickly switch between several pools of liquidity and DeFi protocols. For this reason, liquidity mining is more appropriate for professionals.
The first risk is related to impermanent losses described by us above. The cost of a share in the pool may increase due to a drop in the cryptocurrency price. However, it is unlikely it can be called a lack for holders since, most likely, they would continue holding their assets. Instead, liquidity mining, in this case, helps them to reduce losses and, as a result, reduce risks when investing in cryptocurrencies.
Another risk is connected with the rising popularity of DeFi that attracts not only crypto enthusiasts and investors but fraudsters as well. Due to a high number of regularly appearing platforms, it is sometimes difficult to find out which one is aimed at long-term perspective and which of them is striving to ‘take advantage’ of inexperienced holders.
Many new platforms offer high income to attract as many investors as possible. The problem is that even without any evil intent, developers may launch a ‘raw’ protocol in which hackers may find vulnerabilities and withdraw users’ assets eventually. There were similar cases with famous platforms, such as SushiSwap and Yam Finance.
To do that, holders add a pair with a stablecoin, for example, Tether (USDT), DAI, Usd Coin (USDC), or Binance USD (BUSD). Thus, liquidity suppliers hedge risks, that is open opposite positions. While Ethereum gets cheaper, the rate of stablecoins in relation to it will be rising.
To minimize the risks, users may add pairs of stablecoins, for instance, USDT-BUSD, USDT-DAI, UST-USDC, and so on. In this case, investors will be protected from the volatility of cryptocurrencies, but the yield will be lower: as a rule, it seldom exceeds 20% per annum. Especially, during periods of correction in the crypto market when most investors withdraw their assets into stablecoins.
You have got acquainted with the main concepts of Yield Farming and the general principle of DeFi protocols’ work and can already make your first steps towards yield farming. Do not forget about risks and study strategies to invest in liquidity pools effectively. The better you learn farming strategies, the more benefit it may bring you in the future.
Experience will help you to outperform other investors and receive the highest APR from your investments!