Yield Farming Explained

Yield Farming is a way to generate rewards based on crypto holdings by staking cryptocurrencies into a liquidity pool to receive an interest or other returns on investment.

Many investors refer to this procedure as liquidity mining. Those who own cryptocurrencies can block their assets, lending them (or stalking) to others and thus earn fixed or variable commissions.

A parallel can be made with loans made to banks, using fiat currency. In those cases, the borrowed amount is repaid with interest.

When it comes to yield farming, a crypto asset, which would otherwise have been in an exchange or in a wallet, is borrowed based on DeFi protocols, bringing rewards to the one who owns them.

This process takes place through ERC-20 tokens on Ethereum, including rewards also coming in their form.

What are the key elements in Yield Farming?

Yield Farming is closely related to AMMs, being interdependent with liquidity pools and liquidity providers.

The first step is adding assets to a pool. From it, various investors can borrow or exchange tokens.

Using a trading platform based on such pools involves some commissions.

Liquidity providers are therefore rewarded from the fees generated, in exchange for locking up the assets held in that pool.

Rewards are calculated and paid based on the share of the provider’s assets in the pool, as well as the rules of the protocol.

Deposited funds are usually USD pegged stablecoins such as USDC, USDT and DAI.

Some protocols operate with native tokens, which represent the deposited coins. For example, if you deposit ETH on Compound, you will receive Compound ETH or cETH.

Liquidity providers are encouraged to keep adding new funds to a pool, earning rewards in a token unavailable on the open market.

Annual Percentage Rate (APR) and Annual Percentage Yield (APY) are some of the metrics commonly used to estimate the yield of Yield Farming.

The difference between the two values is that APY takes into account the so-called compounding effect, which involves the direct reinvestment of profits, to generate even more rewards, while APR does not.

Yield Farming Strategies

Investors, i.e. Yield Farmers, take one or more of the following steps to increase their rewards:

Lend and Borrow

For example, a provider offers a stablecoin like USDC on a DeFi platform.

Some more popular ones, like Compound, reward investors with tokens for both sourcing and lending capital.

They can thus make a deposit and then borrow against it to earn tokens.

They provide funds to a liquidity pool and reinvest rewards there as well

Staking with LP tokens

Several DeFi protocols, including Synthetix, Ren, and Curve, incentivize investors by allowing them to stake.

Yield Farming Risks

Strategies that generate higher rewards are complex and recommended only for advanced users.

Some of the risks involved are as follows:

1. Liquidation risk

When an investor borrows assets, he must create a collateral deposit to guarantee against it.

If the value of that deposit falls below that set by the protocol, the deposit will be liquidated.

2. Impermanent loss

If the investor provides liquidity to a pool, but the price of the invested assets changes after that time, the proportion of tokens must be rebalanced and then there will be differences resulting from the equalization.

If funds are withdrawn once price differences are valid, Impermanent Loss becomes Permanent Loss.

3. Risks related to Smart Contracts

BUGS
Loss of Admin Key
System risks
Platform changes

4. DeFi specific risks such as cyber attacks on Liquidity Pools

Platforms and protocols

Some of the most popular platforms for Yield Farming are:

• MakerDAO
• Uniswap
• ensue
• Synthetix
• Balancer