Yield farming, also known as liquidity farming, is a cryptocurrency investment strategy that enables investors to “lend” their crypto to other investors to generate more crypto.
In other words, it is a way of earning interest on your cryptocurrency, similar to how interest is paid out on money held in a savings account.
As with investing money in a traditional bank, yield farming involves locking up your cryptocurrency for a certain period of time (in a so-called liquidity pool) in order to generate returns (equivalent to the interest rate in traditional banking). In the world of cryptocurrency, the process of investing your cryptocurrency in a liquidity pool is called “staking”.
How does yield farming work?
The first step in yield farming involves an investor (also known as a liquidity provider) staking some of their existing coins by depositing them into a lending pool or DeFi protocol (DeFi stands for decentralized finance). An example of a protocol of this type is Uniswap – a decentralized finance protocol that is used to exchange cryptocurrencies.
From there, other investors can then borrow coins from the pool. Usually, the coins are used for speculation or arbitrage. Speculation means investors try to profit off of short-term changes to the price of a given cryptocurrency. Arbitrage trading is the act of buying a cryptocurrency on one exchange (market) and selling it for a higher price on another.
Yield farming is a common way to kickstart a new decentralized blockchain. By distributing tokens with liquidity incentives, liquidity providers are encouraged to “farm” the new token by providing liquidity to the protocol.
Benefits of yield farming
For speculators, the benefits of yield farming can be considerable, as the process provides easy access to crypto, just like a bank loan provides rapid access to funds. Savvy traders can make returns off of their borrowings that allow them to profit considerably from crypto market swings, with earnings to spare even after borrowing fees have been paid over.
For liquidity providers or lenders, the benefits are clear too. Investors who lock up their coins on a yield-farming protocol can earn both interest (passive income) and more cryptocurrency coins — often the real value to the deal. If the price of those additional coins appreciates, the investor’s returns rise as well.
What coins are involved?
Most cryptocurrencies can be used in yield farming. Yet the altcoins deposited are commonly Ethereum-based or stablecoins pegged to the USD – though this isn’t a general requirement. Some of the most common stablecoins used in DeFi yield farming are DAI, USDT, USDC and BUSD.
The reason stablecoins are often used in yield farming is that, if farmed intelligently, these coins can become high-yielding currencies that claim to have no risk of depreciating against the U.S. dollar, locking in their real-world value.
There are also newer tokens that advanced farmers are looking to in order to profit from new strategies and ways to earn returns. These include YFI (Yearn Finance, an open-source, decentralized finance lending protocol based on the Ethereum blockchain) and SNX, the native token of the Synthetix platform, a permissionless derivatives protocol. With SNX, users can tap into any of the protocol’s incentivized liquidity provisioning programs, giving participants multiple opportunities to earn an attractive yield with exposure to a wide range of different assets.
What is total value locked (TVL)?
For investors looking to understand more about the overall health of the DeFi yield farming scene, total value locked (TVL) may be a helpful metric. TVL measures how much crypto is locked in DeFi lending and other types of money marketplaces.
In essence, TVL measures the overall liquidity in liquidity pools. For this reason, it’s a useful index to measure the health of the DeFi and yield farming markets as a whole. It’s also a good way to compare the market share of different DeFi protocols.
By checking TVL metrics, you can get an instant sense of which platforms have the highest amount of Ethereum or other crypto assets locked in DeFi. It’s worth noting that you can measure TVL in ETH, USD, or BTC. Each will give you a different outlook for the state of the DeFi money markets.