What is Yield Farming in DeFi?
What is yield farming, how did it start and how can you make this strategy work to your advantage? Find out more in our short guide.
Decentralised finance (DeFi) is a hot topic within cryptocurrency at the moment. Similarly, yield farming is getting crypto enthusiasts and investors very excited. Although agile and complex strategies need to be developed to perform yield farming effectively, this method can return high profits if done correctly.
What is yield farming?
To understand yield farming, it helps to have a basic understanding of the principles and processes of DeFi. A set of cryptocurrency systems that started to develop in the late 2010s, DeFi is an open source financial system that uses a blockchain rather than a financial institution as its source of trust.
Sitting outside of the control of companies and governments, DeFi is open to anyone who has the knowledge to access the protocols and build applications on the blockchain. It also has minimal central legislation, meaning users are free to invest and innovate in a way that isn’t possible in traditional financing.
Yield farming is one result of DeFi’s regulatory freedom. Simply, it’s a process of lending out cryptocurrency via DeFi platforms such as Compound or Uniswap, locking up this crypto investment to earn rewards. Otherwise known as liquidity mining, ‘yield farmers’ are rewarded with interest on these investments through smart contracts or earn tokens for making a stake in these projects e.g. if you lend crypto on Compound, you’ll earn COMP tokens back.
How did yield farming start?
Compound is a platform based on the Ethereum protocol. In June 2020, it released its COMP governance tokens to its user base. This led to a higher demand for the token and helped Compound to reach the top ranking position in DeFi.
As well as distributing their ERC-20 tokens via an algorithm, Compound provided incentives for lenders to lock their cryptocurrency into their platform by rewarding them with these tokens on top of any interest. The combination of the popularity of these tokens and these incentives lead to the beginning of a growth in yield farming.
How does yield farming work?
In a traditional financial system, banks or other organisations lend out money to individuals within regulatory control and on the basis of the perceived safety of the investment. Borrowers then pay the loan back with interest, meaning that the lenders are rewarded for their investment.
Decentralised systems enable individuals to lend and borrow freely between themselves through the medium of DeFi platforms. This enables borrowers to get the cryptocurrency they need and individual lenders to earn high rewards on their investments rather than locking it away as an asset.
As yield farming has grown, other platforms and protocols have started to develop systems where investors can earn rewards by lending and borrowing coins. This has led farmers to develop complex systems of staking and borrowing assets from different protocols and platforms or using liquidity pools.
Many profitable strategies work by leveraging as much out of the fewest possible DeFi protocols. Successful yield farmers are agile and move their funds between protocols or swap their coins to more profitable ones as their strategies stop working.
How are the returns calculated?
The returns of yield farming investments are calculated annually via two main metrics, Annual Percentage Rate (APR) and Annual Percentage Yield (APY). APR looks at the overall percentage profit or loss that an investment has made, whereas APY can be used to track reinvestment of an investment return (known as compounding).
The presence of smart contracts makes the reinvestment of profit or returns more common in yield farming, hence APY is a metric that is used more frequently. To be successful and profitable, yield farmers need to have a comprehensive understanding and a strong strategy that enables them to respond to changes in the cryptocurrency market. The most successful yield farmers have reported earning triple figure percentage rates of return on such strategies.
What are the risks in yield farming?
Although these DeFi processes can return high yield in finance terms, a solid understanding of DeFi systems, protocols and platforms is required in order to return the best percentage rates. This highly technical knowledge makes yield farming riskier than other types of staking or passive incomes, particularly when it comes to the use of smart contracts, so only the most advanced users will be able to access the highest return rates.
The vulnerability of the blockchain systems and protocols can also be a risk to investors looking to farm yields. Due to their open source nature, even the bigger blockchain systems and protocols can be subject to vulnerabilities and bugs, posing a risk to anyone who locks their funds in a smart contract.
Protocols are also completely permissionless and integrate with each other. Each stage in a protocol blockchain is broken down by individuals or a mining farm, meaning anyone, reputable or not, can work to break down each block. As a result, if one of the blocks doesn’t work as expected, then the whole ecosystem can be damaged. So even if you trust the protocol you’ve invested in, others that are linked to it might not be as reliable.
In short, if you’re thinking of making a start in yield farming, it’s key that you perform due diligence and gain a thorough understanding of DeFi systems to ensure your investments will be safe and profitable.