Crypto is often considered to be the Wild West of finance. There is a lot of confusion, misinformation, and fear around this new development, but as anyone knows, new frontiers are often the most profitable. One of the most common ways that people make money through crypto is through a process known as yield farming. To understand yield farming, a basic understanding of crypto is recommended but not strictly necessary. If you are considering putting some tokens into a yield farm but want to learn a bit more about them first, this article is for you. Let’s learn: What is Yield Farming in Crypto, and How Do You Do It?
Let’s get started!
What is Yield Farming?
Yield farming is the process of earning rewards through the utilization of staking, lending, or liquidity contracts commonly found throughout DeFi (Decentralized Finance).
Most often, yield farming is measured through its APY (Annual Percentage Yield), which represents the current estimates of return if the contract was to remain exactly as it is at the moment. To provide a comparison, a bank often offers an APY of .5-1% on money held within a savings account. In DeFi, APYs in the triple digits are common, although in many cases, these high returns aren’t sustainable and carry additional risk. Still, it’s easy to see why a savvy investor may consider yield farming to tap into high APYs offered on various protocols.
There are a few standard methods that people use to yield farm, three of which we are going to cover in some more detail below.
What are the Possible Types of Yield Farming?
So, knowing the results of yield farming is great, but what does it entail? Generally speaking, there are three primary methods to participate in yield farming. Those methods are:
- Providing liquidity
“Staking” is essentially the lifeblood of any blockchain (if you don’t know what the blockchain is, things may get a bit complicated from here on out). Blockchains are decentralized and immutable ledgers (digital notepads with a list of transactions that can’t be tampered with) that are stored on computers around the world. A blockchain is essentially a public list that can’t be fooled because everyone using it has access to a record of every transaction. For the creators of a blockchain, this list needs to be constantly updated as people transact on the network. One of the most common ways that protocols make this happen is through proof-of-stake systems.
A proof-of-stake system works by allowing users to lock in certain amounts of a protocol’s currency into a smart contract and then validate new transactions on the chain. This is where yield farming comes into play. A user can buy tokens, stake them, and earn a chance at being selected to validate the transactions that happen across the blockchain. The more tokens you stake, the most likely you are to be chosen to be a validator.
Generally speaking, the more validators, the more secure a blockchain. As a result, protocols will often incentivize users to stake their token, usually by paying out more of that token from an internal reserve or as a percentage of transactions. Staking allows you to gather (farm) these rewards (yields) without any direct action on your end. Simply stake and forget. Protocols will advertise their APY as a way to encourage users to add more of their tokens into the staking contract.
Lending is an alternative option to staking to earn a yield on your tokens. Since most people understand how loans work, this option is much easier to understand if all of this is new to you. In traditional lending, you give someone a lump sum, and they pay you interest on that lump sum of money. With smart contracts in crypto, this can be done collectively.
There are certain apps (decentralized applications) that act as a lending service for anyone looking to borrow cryptocurrencies. They usually require an individual to place collateral into a digital vault and then allow that individual to take out a certain percentage of that collateral in the form of more crypto. In a lending protocol with a 20% collateral ratio, depositing 10 tokens of any currency into a locked vault would allow you to get two tokens as a loan (as either more of the same currency or a different one).
Often, these lending protocols rely on groups of individuals to provide funds to someone looking to take out a loan. This is where yield farming is an option. Many protocols offer the simple option for individuals to contribute funds to the pool to be dispersed as a loan. As a result, users lending the protocol funds will earn rewards (farm) through fees and interest revenue (yield) that the loans accumulate. When users want to use their tokens again, they simply pull their funds from the lending pool.
A third option that yield farmers utilize is known as liquidity pools. A liquidity pool is a unique pool that exists on a dex (decentralized exchange) and allows the swapping of one currency to another. Dex is an exchange that allows users to exchange supported tokens for other tokens, at the cost of a small processing fee.
For dex to work, however, they must have enough of both tokens to allow the swap to happen. Instead of owning massive amounts of all cryptos ever, these dexs rely on users to help provide liquidy. These opportunities exist in the form of liquidity pools. A liquidity pool requires that a user (known as a liquidity provider) locks two amounts of tokens that are equal in value into the pool, allowing the dex to easily provide swaps back and forth.
To incentivize LPs (liquidity providers), the dex will distribute (farm) a percentage of the fees taken (yield) from the swap with the LP. When an LP wants to use their tokens again, they simply de-stake them from the liquidity pool.
How do You Yield Farm?
The process of yield farming looks different for each type of yield farming.
To stake a token, the token must operate on a proof-of-stake system. Depending on the protocol, individual or pooling staking may be offered. Ethereum, for example, offers solo staking but requires at least 32 ETH (a total value of over $90k). Third parties offer pooled staking, but the procedure will usually vary for each one. Generally, staking a token looks like approving a transaction in your wallet, enacting the transaction, and paying the gas fees associated with both. Once your tokens are staked, you will either passively receive rewards in your wallet, or you will need to harvest them.
Lending is usually the easiest of the options. Simply find a trustworthy lending protocol and approve the transaction. After the transaction has been approved, the second step of actually initiating the transaction is usually next. Once you are funding a lending pool, you will receive rewards, usually through a harvesting mechanism.
Providing liquidity is a bit more complicated but still pretty easy. Choose a dex and read up on their process, as they all may be a bit different. Still, it generally looks like purchasing two types of tokens, making sure they are equal in value (not necessarily equal in amount), and approving both of them in the protocol. Once approved, you can initiate the transaction. LP payouts are often given in the dex’s native token.
What are the Possible Returns on Yield Farming?
The options are pretty endless when you are dealing with crypto. Still, that doesn’t mean they are always safe. Additionally, the returns almost always depend on the protocol, with more established protocols offering smaller, more secure rates and newer protocols offering insane APYs as a form of marketing.
Most of the common staking options on well-established protocols range from 1-15% APY, but can occasionally hit triple digits. As a general rule, the lower the APY, the longer it can give stable returns. That said, the marketplace is always volatile and you never know for sure.
Lending protocols usually have lower APYs but are probably more stable in the long run. Popular pools offer between 2-4%, with lesser-known pools covering double-digit APYs.
Liquidity pools also vary depending on the protocol and incentives being offered.
Is Yield Farming Safe?
As a general rule, calling something “safe” in crypto isn’t a good idea. Still, some things are less risky than others.
Firstly, the most important rule of thumb when dealing with DeFi is the longevity of the project. The longer and more established a project has been around, the better. Staking on Ethereum, for example, is less risky because a rug pull is extremely unlikely.
Aside from that, there are other risks inherent to each type of yield farming. The biggest risk between all of them is an inherent risk of a loss of token value. When you purchase tokens that can fluctuate in value, they will do just that. Even if you stake tokens in a protocol with a 10% APY, a 50% drop in token value is going to net you a loss.
A unique risk to liquidity farming is known as impermanent loss. Impermanent loss is quite a complicated topic. Essentially, impermanent loss occurs when there is a discrepancy between the value of the two tokens that were deposited into the pool. When withdrawn, the value of the two tokens could potentially be less than if you had just held them in the first place. Often, the profit is still more than the initial investment, but the impermanent loss means you would have been better off holding the tokens in your wallet instead.
Additionally, many protocols pay out their rewards in the form of their platforms token. For example, Pancakeswap distributes their LP and staking rewards in the form of $CAKE. If $CAKE were to reduce in value, even if the token you staked hadn’t, your profits would be affected.
What are Some of the Most Popular Yield Farms?
There are hundreds of protocols that people use to yield farm. Here are some of the most common:
- Curve (stable coin liquidity pool staking)
- Aave (lending platform)
- Uniswap (decentralized exchange)
- TraderJoe (decentralized exchange)
- Pancakeswap (decentralized exchange)