Yield Farming has continued to evolve since its rise in popularity in 2020. Many DeFi platforms have improved their user infrastructure and exchange efficiency to help build greater trust and increased participation in yield farming. But is it possible to earn high farm yields from DeFi platforms?
Part of the attraction of decentralized finance (DeFi) systems is that any individual can invest in, lend and borrow cryptocurrencies with a non-custodial wallet. With no institutions or banks involved as a “middle-man” or in control of the distribution of assets, anyone with the knowledge and understanding of DeFi systems can earn significant interest and profits within various cryptocurrencies.
This freedom to lend and borrow as part of decentralized exchanges led to rampant growth in the popularity of yield farming following its rise during the “DeFi Summer” of 2020. In the most basic form of DeFi, users can lend their crypto assets to other users, who then use the assets as collateral to borrow other cryptocurrencies. The lenders can then earn interest on their loans, while the borrowers have access to the funds they need.
Furthermore, the release of tokens by DeFi platforms in 2020 also contributed to the growth of yield farming. These tokens were designed to incentivise users to participate in the platforms and offered rewards in these native tokens for doing so. Yield farming allowed users to earn even more rewards by utilising these tokens in other farms – generating even greater rewards for users
Although some report earning huge profits from this process, others have put large investments into various crypto assets only to return significant losses. So what exactly is yield farming and how do you grow crypto profits from your investments?
What is yield farming?
Simply put, yield farming is a method through which investors can earn interest on their digital assets. By lending their own cryptocurrency to DeFi protocols or platforms, investors provide liquidity to the market and are rewarded by earning interest back on their investment through the distribution of transaction fees.
These fees are collected from trades and interactions on the platform – usually a small amount such as 0.3% from every trade – and then distributed back to users as “rewards”. Additionally, DeFi platforms and protocols have also started to reward investors with their own governance ‘tokens’.
These tokens are the equivalent of a shareholding in a traditional finance system and enable owners to debate, propose and vote on how the protocol is used and changed. One example is Uniswap tokens, which can be used to vote on governance proposals within the Uniswap DAO.protocol
Through a combination of these tokens and interest, yield farmers can start to earn a real profit from their cryptocurrency investments.
How does yield farming work?
In its simplest form, yield farming is the equivalent process of lending and borrowing in the traditional finance system – without any controls being placed on interest rates or loan applications by central banks or institutions. However, unlike traditional systems, DeFi platforms enable users to interact with these platforms in a decentralised manner and without an intermediary.
At the base of yield farming (and many other types of exchanges) are liquidity pools. This is where investors lock their tokens and assets into a pool via smart contracts. The assets in a pool can then be borrowed by other users at a set interest rate or used to lend out to others – earning the depositor yield rewards.
As well as having many different cryptocurrencies that are farmed for their yields, there are many different liquidity and platforms for each type of digital asset. This means there are lots of options for investors based on the types of digital assets they want to trade.
How do you farm DeFi tokens?
As well as investing your own crypto assets into platforms or liquidity pools to earn interest, yield farmers can also earn DeFi tokens through this process. These tokens are valuable assets in themselves and, in the case of pool tokens, can be earned and retraded to return even higher profits.
These pool tokens are tradeable across lots of different pools and platforms such as Compound or Uniswap. As part of increasingly complex lending chains, yield farmers can earn pool tokens and then put them into the same or different pools or platforms in order to earn more tokens or interest. Although these strategies can be highly profitable, they can quickly become complicated and unwieldy if an investor doesn’t take a logical, well-informed approach.
Pros And Cons Of Yield Farming
While yield farming has the potential to provide significant profits, it also comes with significant risks. Some of the potential rewards include high returns and flexibility, as well as the risks, such as market volatility, and encountering scams. These are some most notable pros and cons to consider before investing your cryptocurrency in this activity.
Advantages of Yield Farming
Yield farming can offer high returns on investment, as users earn interest on their cryptocurrency holdings and receive rewards in the form of additional tokens.
Yield Farming can provide liquidity to the market, as users lend their assets to others who use them as collateral to borrow other cryptocurrencies. This increases the overall liquidity of the market.
Yield Farming is part of decentralised finance (DeFi), which allows users to participate in financial activities without relying on traditional financial institutions. This gives users more control over their finances and reduces the influence of centralised institutions.
Yield farming allows users to choose which assets to invest in and which platforms to use, giving them greater flexibility in their investment strategies.
Yield farming is open to anyone with access to the internet and knowledge of DeFi systems, making it accessible to a wider range of people than traditional financial investments.
Disadvantages of Yield Farming
As with any investment, the cryptocurrency market is highly volatile, and the value of cryptocurrencies can fluctuate rapidly. This can lead to significant losses if the value of the assets being lent or borrowed declines.
When providing liquidity to a pool, the value of the assets being lent may change in relation to the other assets in the pool. This can result in a loss when withdrawing the assets, even if the price of the individual assets has not declined.
Smart contract vulnerabilities
Yield farming involves interacting with smart contracts, which are computer programs that automate transactions on the blockchain. These contracts can have vulnerabilities that can be exploited by hackers, resulting in the loss of funds.
High gas fees
Transactions on the blockchain require gas fees, which can be expensive during times of high network traffic. Yield farming involves frequent transactions, which can result in significant gas fees.
Scams and fraud
Given the lack of regulation in the DeFi space, it’s relatively easy for scammers to create fake dApps that promise high APYs to liquidity providers. In some cases, these dApp creators will take the cryptocurrency deposits of yield farmers and disappear, or “rug pull” them. The rug pull often occurs suddenly and without warning, leaving investors with no recourse.
How do you make money with DeFi?
Many potential investors may wonder what yield farming strategies are the most profitable and effective. The short answer is, it’s dependent on how much asset and time investment you’re prepared to put into yield farming.
Although some high-risk strategies promise significant returns, these often require an in-depth understanding of DeFi platforms, protocols and complex chains of investments to be most effective.
If you’re an investor looking to earn some passive income without making too much investment, then you might consider putting some of your cryptocurrency into a trusted platform or liquidity pool and see how much it earns. Once you’ve established this base and gained confidence, you may look to invest elsewhere or even purchase tokens directly.
As with any digital asset investment, you get out what you put into it. So ensure you have a thorough understanding of any protocol or platform before you invest and ensure any strategy you build matches the amount of currency and time you’re prepared to input into yield farming.
Is yield farming profitable in 2023?
Since its rapid rise to popularity in 2020, DeFi platforms have improved their user interfaces and introduced new features to make it easier for users to navigate and interact with their protocols. From simplified user experiences to improved documentation, these changes help users understand the platform better and reduce the likelihood of making costly mistakes. Uniswap and Aave are just a few of the DeFi platforms that have undergone major upgrades.
One of the most important improvements is implementing measures to mitigate the risks associated with yield farming. One significant improvement is the increased availability of audited smart contracts, which help to reduce the risk of hacking and fraudulent activities to encourage greater trust in DeFi platforms and increased participation in yield farming.
These changes in recent times are making yield farming a more attractive way to earn on your latent assets. However, yield farming is an extremely dynamic and fast-changing space that requires farmers to be vigilant and spend time to identify the best strategies.
This includes plenty of preparation and research before investing. It’s not just about selecting the highest yield-generating platform, but also understanding the protocol’s history, audit reports, reviews, and ‘tokenomics’. You should also set up a decentralised wallet like Metamask or CoolWallet to leverage the true potential of yield farming.
Overall, Yield Farming has vastly improved since 2020, and can be profitable in some cases, but it remains a high-risk, high-reward investment strategy. It is important for investors to do their research and understand the risks before participating in yield farming.
This publication is for informational purposes only and is not intended to be a solicitation, offering or recommendation of any security, commodity, derivative, investment management service or advisory service and is not commodity trading advice. This publication does not intend to provide investment, tax or legal advice on either a general or specific basis.