Last updated on July 11th, 2023 at 10:34 pm
Yield farming is one of the most trending topics in the world of DeFi. While the DeFi summer is known for the surging prices of DeFi tokens, it is yield farming that provides the most value in the DeFi ecosystem.
As an investor, your main goal is always to look for opportunities to maximize returns on your capital. Yield farming allows you to do just that.
When you follow a yield farming strategy, you are rightly chasing the highest yield amongst different DeFi protocols. Moreover, investors continuously switch between different platforms and go wherever the highest APY is being offered. When it comes to comparing yield farming returns with traditional yield strategies, there is absolutely no comparison. Traditional savings accounts have an APY ranging from 0.1%-3% with 3% being almost unheard of. In comparison, yield farming offers investment opportunities when you can get as much as 100% APY. There have been stories of DeFi natives making the most of market irregularities to earn 1000% APY on their capital.
In this article, you will learn about yield farming, some strategies, and risks associated with yield farming.
Let’s go…
What Is Yield Farming?
Simply put, yield farming is a way for you to make more crypto with your crypto. It is a way of maximizing your return on capital by leveraging different financial products across the DeFi ecosystem. The process of yield farming involves locking up cryptocurrencies on different DeFi platforms and getting rewards for the same. Yield farming is a high-risk, high-return investment opportunity. Through yield farming, investors seek to achieve double or even triple-figure returns on their investment.
How did it start?
We believe that the concept of yield farming gained popularity with the launch of the COMP token. COMP token is the governance token of the Compound protocol, one of the most used lending protocols in the DeFi ecosystem. While Compound did not invent yield farming, it introduced a token-based distribution model in DeFi. For example, COMP token holders were given governance rights on the platform. To decentralize the network, these tokens were distributed algorithmically, with liquidity incentives. This motivated liquidity providers to “farm” the new COMP token and provide liquidity to the protocol. Since then, many DeFi projects have used similar programs to attract yield farms to boost liquidity on their platform.
How does it work?
In DeFi, three main elements make such high returns possible. They are:
1. Liquidity Mining
Through liquidity mining, yield farmers can earn higher yields. This is because liquidity mining provides additional incentives for yield farms in the form of token rewards.
For providing liquidity to a specific protocol, yield farmers can earn token rewards. This works similar to the example of Compound shared above.
To make higher returns, yield farmers are even ready to take a loss on their initial capital if it enables them to get more rewards in the form of distributed tokens.
Synthetix was one of the first DeFi protocols to introduce the concept of liquidity mining. It rewarded users who helped the protocol by adding liquidity to the sETH/ETH pool on Uniswap with SNX tokens.
2. Leverage
Leverage is another way of earning high returns in DeFi. It is a strategy of borrowing money from different protocols and using it to increase the potential of returns on investment. In yield farming, farmers deposit their crypto as collateral on one of the lending protocols. In return, they are allowed to borrow other coins in a specified ratio. Using these borrowed coins as collateral, yield farmers can borrow even more crypto. By repeating this process many times, yield farmers can leverage their capital to generate higher returns on their initial investment.
3. Risks
Yield farming is a high-risk high-reward investment strategy. Farmers are willing to take high risks in the quest to achieve high returns. We will discuss yield farming risks in more detail later in the article.
Yield Farming Strategies
To achieve high returns, yield farmers use complicated strategies that involve the active movement of capital. Yield farmers move their capital around from one lending platform to another, looking for the liquidity pool offering the highest APY. Currently, the yield farming strategies mostly involve and revolve around the following elements:
1. Lending & Borrowing
Lending and borrowing capital is one of the simplest strategies to earn a return on your capital. Yield farmers supply their crypto on one of the lending platforms and start getting a return for their capital investment. This comes with a risk of potential liquidations in the liquidity pools. For example, Aave is a decentralizing lending and borrowing protocol that is used by most yield farmers. On Aave, interest rates are adjusted algorithmically depending on the market conditions. When farmers lend funds to Aave, they receive, aTokens. Using these tokens, lenders can earn and compound their interest upon depositing. Moreover, Aave offers many other advanced features to users such as flash loans.
Yearn Finance is an aggregator of lending protocols such as Aave, Compound, Maker, and others. It allows farmers to automatically choose the best lending and borrowing strategy for them.
2. Supplying Capital To Liquidity Pools
Yield farmers can earn fees on liquidity protocols by supplying crypto to one of the liquidity pools. Decentralized exchanges like Uniswap, SushiSwap, Balancer, and Curve are some of the most popular platforms used by yield farmers. For example, yield farmers can supply tokens to a specific liquidity pool on Balancer and earn fees. In addition to fees, Balancer also provides liquidity mining benefits to yield farmers in the form of extra BAL tokens increasing their APY.
3. Staking LP Tokens
Many protocols offer incentives to yield farmers to stake their LP tokens that represent their participation in a specific liquidity pool. This enables yield farmers to maximize their returns. For example, yield farmers can provide wBTC, sBTC, and renBTC to the Curve-BTC liquidity pool and in return, receive Curve LP tokens as a reward for participation. This partnership between Synthetix, REN, and Curve allows yield farmers to stake their Curve LP tokens on Synthetix Mintr and be rewarded in CRV, BAL, SNX, and REN tokens.
In yield farming, farmers need to stay active and keep an eye on the trending strategies. Strategies can become obsolete very quickly. This is because something very profitable right now, may not offer the same returns in the future. Or, another protocol will come up that offers much higher returns.
It has been seen that yield farmers use a combination of all the strategies to maximize their returns.
Yield Farming Risks
Yield farming isn’t as easy as it sounds. The strategies mentioned above are quite complex to execute in the marketplace. Moreover, there are many risks associated with yield farming. Let’s take a look at some of them in more detail:
- Smart Contract Risk – Smart contracts are essentially just lines of code and no code is perfect. As a result, there is a risk of bugs in smart contracts.
- Leverage – When things are going well, leverage can help yield farmers gain tremendous returns. However, when leverage also over-exposes yield farmers and increases the risk potential of the investment.
- Liquidation Risk – Since farmers use leverage to take loans, the loans are overcollateralized. As a result, the collateral that is supplied is at the risk of being liquidated in case the collateralization ratio drops below the threshold.
- Impermanent Loss Risk – In cases when there are sharp price movements, the risk of impermanent loss increases tremendously. Impermanent loss takes place due to the arbitrageurs taking advantage of the market inefficiencies caused due to the algorithmically driven token rebalancing formula of AMMs
- Systematic Risks – The inherent risks associated with the DeFi ecosystem are ever-present.
- DeFi specific attacks – Some risks are unique to DeFi. For example, attacks aimed at draining liquidity of specific liquidity pools.
In Conclusion…
Yield farming is still a relatively new concept in DeFi. It is far from being an efficient market. There are many opportunities for investors to make tremendous returns on their investments. However, this prospect of high returns comes with its own set of risks and anyone looking to participate in the world of yield farming should be aware of them.
- At the moment, yield farming can be too technical for new investors in DeFi. But, there are many protocols like Yearn Finance that make it easier.
- Furthermore, we can expect many new applications in the future that help investors earn with yield farming.
- The goal of investing is to maximize returns. Why keep your assets idle when you can put them to work while you HODL?
- Dare to DeFi and earn passive income with yield farming.
So, have you tried yield farming yet? If so, what’s your favorite yield farming strategy?
Comment down below and let us know.
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