The Decentralized Finance (DeFi) movement has been at the forefront of innovation in the blockchain space. One of the new concepts that has emerged is yield farming. It’s a new way to earn rewards with cryptocurrency holdings using permissionless liquidity protocols. It allows anyone to earn passive income using the decentralized ecosystem of “money legos” built on ETHereum.
As a result, yield farming may change how investors HODL in the future – why keep your assets idle when you can put them to work? But, how to yield farm crypto? Where should you start if you’re thinking of becoming a yield farmer? We’ll explain them all in this article.
What is Yield Farming?
Yield farming, also referred to as liquidity mining, is a way to generate rewards with cryptocurrency holdings. In simple terms, it means locking up cryptocurrencies and getting rewards.
Yield farming is typically done using ERC-20 tokens on ETHereum, and the rewards are usually also a type of ERC-20 token since most of this activity is happening in the Ethereum ecosystem. However, this may change in the future given that cross-chain bridges and other similar advancements may allow DeFi applications to become blockchain-agnostic in the future.
Yield farmers will typically move their funds around quite a lot between different protocols in search of high yields. As a result, DeFi platforms may also provide other economic incentives to attract more capital to their platform. Just like on centralized exchanges, liquidity tends to attract more liquidity.
How Did Yield Farming Boom?
A sudden strong interest in yield farming may be attributed to the launch of the COMP token – the governance token of the Compound Finance ecosystem. Governance tokens grant governance rights to token holders. But how do you distribute these tokens if you want to make the network as decentralized as possible?
A common way to kickstart a decentralized blockchain is distributing these governance tokens algorithmically, with liquidity incentives. This attracts liquidity providers to “farm” the new token by providing liquidity to the protocol.
While it didn’t invent yield farming, the COMP launch gave this type of token distribution model a boost in popularity. Since then, other DeFi projects have come up with innovative schemes to attract liquidity to their ecosystems.
What is Total Value Locked (TVL)?
So, what’s a good way to measure the overall health of the DeFi yield farming scene? Total Value Locked (TVL). It measures how much crypto is locked in DeFi lending and other types of money marketplaces.
In some sense, TVL is the aggregate liquidity in liquidity pools. It’s a useful index to measure the health of the DeFi and yield farming market as a whole. It’s also an effective metric to compare the “market share” of different DeFi protocols.
A good place to track TVL is Defi Pulse. You can check which platforms have the highest amount of ETH or other cryptoassets locked in DeFi. This can give you a general idea about the current state of yield farming.
Naturally, the more value is locked, the more yield farming may be going on. It’s worth noting that you can measure TVL in ETH, USD, or even BTC. Each will give you a different outlook for the state of the DeFi money markets.
How Does Yield Farming Work?
Yield farming is closely related to a model called automated market maker (AMM). It typically involves liquidity providers (LPs) and liquidity pools such that liquidity providers deposit funds into a liquidity pool. This pool then powers a marketplace where users can lend, borrow, or exchange tokens. The usage of these platforms incurs fees, which are then paid out to liquidity providers according to their share of the liquidity pool.
On top of fees, another incentive to add funds to a liquidity pool could be the distribution of a new token. It may be accumulated by providing liquidity to a specific pool though, the rules of distribution will all depend on the unique implementation of the protocol. The bottom line is that liquidity providers get a return based on the amount of liquidity they are providing to the pool.
The funds deposited are commonly stablecoins pegged to the USD – though this isn’t a general requirement. Some of the most common stablecoins used in DeFi are DAI, USDT, USDC, BUSD, and others. Some protocols will mint tokens that represent your deposited coins in the system. For example, if you deposit DAI into Compound, you’ll get cDAI, or Compound DAI. If you deposit ETH to Compound, you’ll get cETH.
As you can imagine, there can be many layers of complexity to this. You could deposit your cDAI to another protocol that mints a third token to represent your cDAI that represents your DAI. And so on, and so on. These chains can become really complex and hard to follow.
How Are Yield Farming Returns Calculated?
Typically, the estimated yield farming returns are calculated annualized. This estimates the returns that you could expect over the course of a year.
Some commonly used metrics are Annual Percentage Rate (APR) and Annual Percentage Yield (APY). The difference between them is that APR doesn’t take into account the effect of compounding, while APY does. Compounding, in this case, means directly reinvesting profits to generate more returns. However, be aware that APR and APY may be used interchangeably.
It’s also worth keeping in mind that these are only estimations and projections. Even short-term rewards are quite difficult to estimate accurately as yield farming is a highly competitive and fast-paced market, and the rewards can fluctuate rapidly. If a yield farming strategy works for a while, many farmers will jump on the opportunity, and it may stop yielding high returns.
As APR and APY come from the legacy markets, DeFi may need to find its own metrics for calculating returns. Due to the fast pace of DeFi, weekly or even daily estimated returns may make more sense.
How to Yield Farm Crypto
How can you earn these yield farming rewards? Well, there isn’t a set way to do yield farming. In fact, yield farming strategies may change by the hour. Each platform and strategy will have its own rules and risks. If you want to get started with yield farming, you must get familiar with how decentralized liquidity protocols work.
We already know the basic idea. You deposit funds into a smart contract and earn rewards in return. But the implementations can vary greatly. As such, it’s generally not a great idea to blindly deposit your hard-earned funds and hope for high returns. As a basic rule of risk management, you need to be able to remain in control of your investment.
So, what are the most popular yield farming platforms used? This isn’t an extensive list, just a collection of protocols that are core to yield farming strategies.
Compound Finance
Compound is an algorithmic money market that allows users to lend and borrow assets. Anyone with an ETHereum wallet can supply assets to Compound’s liquidity pool and earn rewards that immediately begin compounding. The rates are adjusted algorithmically based on supply and demand.
Compound is one of the core protocols of the yield farming ecosystem.
Uniswap
Uniswap is a decentralized exchange (DEX) protocol that allows for trustless token swaps. Liquidity providers deposit an equivalent value of two tokens to create a market. Traders can then trade against that liquidity pool. In return for supplying liquidity, liquidity providers earn fees from trades that happen in their pool.
Uniswap has been one of the most popular platforms for trustless token swaps due to its frictionless nature. This can come in handy for yield farming strategies.
Curve Finance
Curve Finance is a decentralized exchange protocol specifically designed for efficient stablecoin swaps. Unlike other similar protocols like Uniswap, Curve allows users to make high-value stablecoin swaps with relatively low slippage.
As you’d imagine, due to the abundance of stablecoins in the yield farming scene, Curve pools are a key part of the infrastructure.
Yearn.finance
Yearn.finance is a decentralized ecosystem of aggregators for lending services such as Aave, Compound, and others. It aims to optimize token lending by algorithmically finding the most profitable lending services. Funds are converted to yTokens upon depositing that periodically rebalance to maximize profit.
Yearn.finance is useful for farmers who want a protocol that automatically chooses the best strategies for them.
Yield Farming Risks
Yield farming isn’t simple. The most profitable yield farming strategies are highly complex and only recommended for advanced users. If you don’t understand what you’re doing, you’ll likely lose money. In addition, yield farming is generally more suited to those that have a lot of capital to deploy (i.e., whales).
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. DeFi protocols are permissionless and can seamlessly integrate with each other, meaning 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.
However, 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.
Closing Thoughts
We’ve taken a look at the latest craze in the cryptocurrency space – yield farming – and how to yield farm crypto. What else can this decentralized financial revolution bring? It’s impossible to see what new applications may spring up in the future built on these current components.
Nevertheless, trustless liquidity protocols and other DeFi products are certainly at the cutting edge of finance, cryptoeconomics, and computer science. And undoubtedly, DeFi money markets can help create a more open and accessible financial system available for anyone with an Internet connection.
