Unless you have had your head under a rock for the last years, you should have heard the term ‘yield farming’. The latest hype bubble to hit the blockchain and crypto space is making a lot of noise right now. But what is Yield Farming, how can people benefit from it, and how much risk is really involved? This is what this article is all about. Read on to learn more about this DeFi strategy.
What is Yield Farming?
Yield farming is nothing more than putting cryptocurrency assets into use by earning a return on the capital invested.
This return is generated through what is known as a ‘staking’ process, whereby the crypto holder locks up their tokens in order to earn rewards. These rewards usually come in the form of interest payments or newly minted tokens.
The key difference between yield farming and traditional forms of investment is that yield farmers are usually rewarded with high returns for taking on additional risk. This is because most yield farming opportunities are found in the DeFi space, which is notorious for being highly volatile.
What is DeFi?
DeFi, or Decentralized Finance, is a growing ecosystem of financial protocols and applications that are built on a blockchain.
These protocols and dapps offer a wide range of financial services that traditionally fall under the remit of centralized institutions, such as banks, brokerages, and traditional exchanges.
By using DeFi protocols and dapps, you can enjoy the same financial services as you would through a centralized institution, but without the need to trust a third party.
What this means in practice is that you can trade cryptocurrencies, take out loans, and earn interest on your assets, all through decentralized protocols and applications. And that’s when Yield Farming comes in.
How Does Yield Farming Work?
The basic process of yield farming can be broken down into four steps:
You find a suitable opportunity by scouting out protocols that offer high returns;
Deposit your crypto assets into the protocol;
Earn rewards in the form of interest payments or newly minted tokens;
Exit the position and withdraws your assets.
Of course, it’s not always this simple. In practice, yield farmers often have to juggle multiple positions in different protocols in order to maximize their returns.
And as the DeFi space is constantly evolving, yield farmers need to be nimble and adaptable in order to take advantage of new opportunities as they arise.
What are the Best Yield Farming Protocols?
The best yield farming platforms are those that offer high returns with minimal risk. Unfortunately, there is no such thing as a risk-free yield farming opportunity.
There are numerous “money markets” and Decentralized Exchanges (DEX) that provide a straightforward road to earning a yield.
Compound, Curve, and Aave are some of the first and most used lending and borrowing protocols, but DEXs with liquidity pools, such as those available on Uniswap or PancakeSwap, provide more flexibility and better yields.
However, it’s important to point out that they also come with increased risk.
Yield Farming Using Money Markets
Compound and Aave are DeFi’s top lending and borrowing protocols and both have witnessed an explosion in activity since Yield Farming first began in 2020.
Borrowing capital from a money market is the simplest way to earn a return on your cryptocurrency and has proved to be a popular method.
In order to participate, users need to deposit a stablecoin in their chosen platform and start earning returns immediately.
The decentralized non-custodial liquidity protocol Aave offers borrowers the ability to choose a stable rate of interest. Rather than a variable rate so is generally able to offer better rates than Compound.
The stable rate tends to be higher for borrowers than the variable rate, thus increasing the marginal return to lenders.
Money Market Risks
DeFi money markets function by offering over-collateralization. Meaning that the assets deposited by a borrower must have more value than their loan.
To calculate the collateralization ratio, an equation of the value of collateral/value of the loan can be used.
When the collateralization ratio falls below a certain threshold, the collateral is liquidated and repaid to lenders. This setup provides an optimal situation for speculators that want to gain leverage. It also ensures that lenders don’t lose their money if borrowers default.
One other factor to consider is smart contract hacks, but Aave and Compound have avoided this risk to date.
Using Liquidity Pools
Uniswap offers one of the best liquidity pools in DeFi. Effectively luring liquidity providers with rewards for adding their assets to a liquidity pool. It is important to note that liquidity pools on Uniswap are configured between two assets in a 50-50 ratio.
Every time a user makes a trade through a Uniswap liquidity pool, the liquidity providers that contributed to that pool are rewarded by earning a fee for helping to facilitate this.
Uniswap pools have traditionally offered liquidity providers fairly healthy returns over the past years as DEX volumes increased dramatically.
However, it is important to note that optimizing profits requires investors to consider the risk of impermanent loss.
What is Impermanent Loss?
Impermanent loss is the loss created by providing liquidity for an asset that rapidly appreciates.
Something that can happen in this industry without warning and quite often.
It’s important to take this into consideration as it can have a significant impact on the profitability of liquidity farming.
The key to mitigating impermanent loss is to select what assets are going to be pooled together carefully.
This can be done by analyzing the historical price volatility and correlations of assets to get a better idea of what will pool together well.
Avoiding Impermanent Loss
One dapp offering liquidity pools that circumnavigates impermanent loss by facilitating trades between assets pegged to the same value is Curve Finance.
For example, there is a Curve pool containing USDC, USDT, DAI, and sUSD: all USD pegged stablecoins. There’s also a liquidity pool with sBTC, RenBTC, and wBTC: all pegged to the price of BTC. Since all of the assets are worth the same amount, there’s no impermanent loss to concern users.
However, it’s worth noting that trading volumes will always be lower than other liquidity pools like Uniswap.
In summary, Curve Finance eliminates impermanent loss, but Uniswap will result in a higher fee collection.
How to Choose a Crypto Yield Farm?
For those reading this that are risk-averse who just want to earn a yield on their stablecoins, money markets or providing liquidity on Curve Finance is the best option for lower-risk interest.
For those who have large cryptocurrency holdings and want to put them to productive use, liquidity pools like Uniswap are a good choice.
Yield Farming vs Staking
The main difference between yield farming and staking is that with yield farming, you are providing liquidity to decentralized exchanges, while with staking, you are locking up your tokens to help validate transactions on a blockchain.
With staking, you can earn rewards for simply holding crypto in your wallet as your tokens help to secure a network. The biggest benefit of staking is that it’s a relatively passive income stream as you don’t need to do much other than holding your crypto in a wallet that supports staking.
Yield farming, on the other hand, is a bit more complex. At the end of the day, both staking and yield farming are great ways to earn passive income with your crypto. It’s important to understand the risks and rewards of each before you decide which one (if any) is right for you.
