Yield farming involves lending crypto in exchange for high returns, also called yield, typically paid out in crypto. It requires a liquidity pool (smart contract) and a liquidity provider (an investor).
Yield farming has been one of the biggest factors driving the growth of decentralized finance (DeFi), blockchain-based platforms providing financial services, such as borrowing and lending, without a centralized authority like a traditional bank or lender.
What is Yield Farming?
Yield farming crypto protocols reward liquidity providers (LPs) for locking up their crypto in a liquidity pool governed by smart contracts. In this way, the LPs are effectively lending their crypto. The rewards generally come in one of three forms:
• A percentage of transaction fees
• Interest from lenders
• A governance token
Regardless of the method of payout, returns are expressed as an annual percentage yield (APY). The more funds added to the pool by investors, the lower the value of the issued returns will fall.
In the early days of yield farming, most investors staked stablecoins like USDC, DAI, or USDT. But today, the most well-known DeFi protocols run atop the Ethereum network and provide governance tokens as an incentive for “liquidity mining.” In exchange for providing liquidity to decentralized exchanges (DEXs), tokens are farmed in liquidity pools.
💡 Recommended: What Is a Liquidity Pool, Exactly?
With liquidity mining, yield farming participants earn token rewards as an additional form of compensation. This type of incentive gained traction when the Compound network began issuing COMP, its rapidly appreciating governance token, to users of its platform.
The majority of yield farming protocols today reward liquidity providers in the form of governance tokens. Most of these tokens can be traded on centralized and decentralized exchanges alike.
How Does Yield Farming Work?
Yield farming uses an order-matching system known as the automated market maker (AMM) model.
The AMM model, which powers most decentralized exchanges, does away with the traditional order book, which would contain all “bid” and “ask” (buy and sell) orders on an exchange. Rather than stating the current market price of an asset, an AMM conjures liquidity pools through smart contracts. The pools then execute trades according to preset algorithms.
This DeFi yield farming method relies on liquidity providers to deposit funds into liquidity pools. These pools provide funding for DeFi users to borrow, lend, and swap tokens. Users pay trading fees, which are shared with liquidity pools based on how much liquidity they provide to the pool.
How to Calculate Returns in APY
Estimated DeFi yield farming returns are calculated on an annual basis. The key word here is “estimated,” because interest rates can change dramatically over the course of the year, or even the course of one week.
There’s no particular method to calculate exactly how much APY a protocol will earn. Word tends to spread quickly about a yield farming strategy that earns high returns. The masses then rush in, pushing down yields.
There’s another variable factor: the token in which rewards are denominated. If investors are paid in the form of a DeFi token of some kind, and that token drops in value relative to other currencies, even high percentage gains could be reduced or wiped out.
Yield Farming vs Staking
Staking is different from yield farming. Proof-of-stake (PoS) tokens allow users to become transaction “validators” who confirm transactions on the network by locking up tokens for a set period of time. In exchange, users earn interest on their tokens.
While both staking and yield farming involve depositing tokens and earning a kind of crypto dividend (which is why the terms “staking” and “locking up tokens” are sometimes used interchangeably), what’s going on behind the scenes is much different in each case.
Staking crypto involves validating network transactions and earning a portion of newly minted block rewards. This action happens directly on the blockchain of the network of the token being staked. Staking serves the same function on PoS networks as mining does on proof-of-work networks — that of achieving consensus. Through staking, all nodes in a network agree on which transactions are valid.
Yield farming is participating in a decentralized financial product, earning interest on crypto that has been loaned out to someone else. These transactions are facilitated by smart contracts, most commonly on the Ethereum network.
What Are the Risks of Yield Farming?
This application of DeFi is as risky as it is volatile. At best, LPs might find themselves earning far less interest than expected, since rates can swing upwards or downwards quickly. At worst, they can lose everything they invested — in some cases thanks to hackers, and in other cases to what’s known as a “rug pull” scheme.
How Can Yield Farming be Hacked?
Software-related vulnerabilities can lead to hacking. For example, in 2020 Harvest Finance was hacked when flaws in the smart contracts used to govern the protocols were exploited by attackers. It resulted in more than $420 million of investor funds being lost. Those funds can never be recovered and there is no regulatory authority that investors can appeal to.
What is a “Rug Pull” Scheme?
A rug pull involves a group of people creating a seemingly promising new platform that is in fact a scheme to steal user funds. Once enough unsuspecting liquidity providers have bought into the scam by depositing tokens, the protocol goes offline — and the creators make off with all the invested funds. Investors lose everything and have no recourse. Simply search for the term “defi rug pull” and a long list of related stories will come up.
Beyond the risk of hacks and schemes, there are also additional risks like high gas fees, the complexity of interacting with the protocols themselves, and the fact that DeFi applications depend on several underlying applications to work correctly. If something goes wrong on any layer, it could disrupt the whole thing.
Is Yield Farming Right for Me?
Yield farming is likely to appeal to a very select group of people — those who have both the required technical skill and high risk tolerance.
If you’re reading an introductory article on the idea of yield farming, chances are it’s not for you. This kind of risk-taking isn’t for crypto beginners or those who can’t risk losing much capital.
Recommended: A Beginner’s Guide to Cryptocurrency
The Takeaway
Yield farming can be a high-risk, high-reward venture for the curious, tech-minded few who are comfortable with the possibility of losing their principal investment.
Since the summer of 2020, when DeFi was at the height of its popularity, enthusiasm has waned somewhat. Tales of extravagant returns have been tempered by tragedies of hacks and rug pulls.
Photo credit: iStock/PeopleImages
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