What is Yield Farming in Crypto, and Does it Work?

Yield farming is a way that crypto owners and investors earn rewards, or yields, by depositing cryptocurrency into a DeFi protocol. It’s somewhat similar to earning interest on traditional assets.

Yield farming emerged in the crypto space as an investing strategy in 2020. One of the first opportunities was “liquidity mining” on the Compound protocol, a decentralized, blockchain-based protocol where crypto owners deposited their assets to earn interest or “yield.”

Yield farming opportunities subsequently grew rapidly, and suddenly, billions in crypto were locked up in DeFi platforms. Yield farming came at a time when interest rates were low in conventional finance, which may have contributed to its attractiveness.

There are many yield farming strategies; some are active and some passive, but the three main types are providing liquidity, lending, and staking.

• Liquidity provider (LP)

Liquidity providers deposit two cryptocurrencies to a decentralized exchange (DEX) to provide liquidity. When exchange users transact these cryptos, the liquidity provider receives a percentage of the transaction fee.

• Lending

Smart contracts enable investors to lend crypto to borrowers. The investor then earns yields from the interest borrowers pay on the loan.

• Borrowing

Investors are able to lock up crypto funds as collateral and take a loan on another crypto or token. They then use the borrowed crypto to yield farm.

• Staking

Investors staking crypto lock their assets in staking pools to earn yields, or in proof-of-stake blockchains to support the network and receive rewards.

Yield farming protocols incentivize liquidity providers (LP), the crypto owners, to stake or lock up crypto assets into the smart contracts of a liquidity pool.

Incentives can be a percentage of transaction fees, interest, or governance tokens. Interest, or returns, are calculated by annual percentage yield (APY). If more investors contribute to a liquidity pool, the value of returns will decrease in proportion.

When an investor deposits, stakes, or locks up their assets to a smart contract, it holds the assets and keeps track of the rewards. The investor receives a token that acts like a receipt and allows them to collect outstanding rewards or withdraw their crypto from the contract.

Benefits

• Passive income and higher yields —Yield farming allows crypto investors to hold on to their assets but also earn extra returns. It can help diversify crypto investments. At a time when conventional interest rates were low, yield farming gained popularity because it offered potentially higher APY.
• Liquidity provision—Providing liquidity to DeFi platforms and DEXs helps these projects function and thrive, and crypto investors receive a reward in return. Sometimes, the reward is in governance tokens that provide voting rights, allowing users to have a say in the project’s future. There can also be other perks.

Risks

In addition to the usual risks associated with cryptocurrencies and the crypto market, yield farming has specific risks.

• Volatile crypto prices—The changing value of cryptocurrency prices can affect the value of assets locked up in crypto staking and yield farming and the value of the rewards received. Profits can be eroded substantially if the value of the cryptocurrency deposited or staked falls.
• Changing yield rates—Yields vary with supply and demand in the sector, which can lead to a risk that rates will fall as more investors get involved in yield farming.
• High gas fees—gas fees can also erode yield farming rewards. Some networks have high gas fees, and gas fees can rise during high demand. Savvy investors will time their transactions when gas fees are lower or use networks with lower fees for transactions.
• Scams and rug pulls—There is the risk that a DeFi project is a scam or poorly constructed, allowing assets to be stolen or otherwise abused. Rug pulls occur when a bad actor creates a DeFi project and token and a liquidity pool for the token but retains much of the supply. In the pool, investors contribute the token and its pair. When the pool is established, the bad actors can flood the pool with their tokens and remove the paired token, which is usually a valuable, popular token. This leaves the LPs with the now worthless new tokens.
• Smart contract flaws—DeFi projects and DEXs rely on smart contracts, which can have flaws that lock capital or weaknesses that make funds vulnerable to theft.
• Impermanent loss—When providing liquidity to a DEX, There’s also the risk of “impermanent loss” from market volatility. This happens when the value of a crypto falls, and investors make a lower return than they would simply by holding on to the crypto. In an automated market maker (AMM) pool, there is a mechanism to maintain liquidity between the tokens in the pool. If the price of a token falls the AMM system may buy more of the cheaper tokens and sell the expensive ones to balance the pool. This rebalancing can lead to losses for investors.
• Regulation—Both yield farming and the broader cryptocurrency market may see new and changing regulations in the future.

Investors who want to be successful in yield farming take care in researching and selecting yield farming projects, usually choosing those that are more established and have a good genuine reputation that can be ascertained from other crypto users in the community.

As a very brief summary, the following steps are involved in starting to yield farm as a liquidity provider.

• Selecting a platform – choosing a credible yield farming DeFi protocol that offers an investor’s required level and type of return and accepts their preferred crypto
• Providing liquidity – depositing the chosen pair of crypto tokens into the liquidity pool to earn a proportion of transaction fees on the protocol
• Receiving LP tokens – the tokens that represent the share of the liquidity pool
• Staking and yielding – staking the LP tokens on the same platform or another yield-farming platform. This earns additional rewards
• Claiming tokens – investors will claim rewards and can reinvest them for further gains

Yield farming is a competitive sector in crypto. There are lots of new projects emerging all the time, and alongside wider crypto innovation, there are likely to be new features and better user experiences developed. Some yield farming protocols are beginning to offer insurance, for example. As more investors yield farm, the available rewards may decline. Additionally, the popularity of yield farming means DeFi projects will need to be sustainable, balancing rewards and long-term viability. The sector could also fall under the eye of regulators.

There are substantial risks associated with yield farming. Here at Coin Hint, we strongly believe that these risks should be considered carefully, along with an investor’s wider strategy, risk awareness, and risk tolerance. However, the space is popular and one day may see some cross-over with traditional finance.