What is Yield Farming?
In 2020, there was a boom in decentralized finance (DeFi), which provided new ways to generate income by investing in cryptocurrencies, known as yield farming. Also, cryptocurrency holders can increase their profits through profitable farming or reduce losses when the cryptocurrency rate falls.
At first glance, the idea seems simple, but if you dig deeper, to earn a significant income, farmers use sophisticated strategies that allow them to maximize profits. In this article, we will talk about what yield farming is, how it is organized, what types of it are, as well as its benefits and risks.
What is yield farming?
Yield farming , or yield farming in simple words, is a set of methods to generate income from cryptocurrencies in DeFi protocols. It is also called liquidity mining . In fact, you provide your digital assets to other users through smart contracts, receiving a commission for it. Farming has allowed cryptocurrencies to be used to generate additional income for holders instead of sitting dead in their wallets.
The name “yield farming” is symbolic, because the return on investment in DeFi can be compared to getting a harvest: the better a farmer tries, the more harvest he will get. And the “yield” can be affected by weather conditions – crypto market volatility. For example, the “crypto winter” can not only reduce the harvest, but also “destroy” it; these are the risks of yield farming, which will be discussed in more detail in another part of the article.
Yield farming emerged with the launch of liquidity protocols like Uniswap or Synthetix. Its users use it to generate income (liquidity mining, for example). The foundation of the DeFi ecosystem was the Ethereum platform, the first protocol to use smart contracts. This enabled the creation of various decentralized applications (DApps) on top of the blockchain network.
Later, other platforms appeared that surpassed the Ethereum network. Due to scalability issues, as well as the growing number of users and applications, the network faced heavy load, leading to costly and slow transactions. One of the most productive networks was Binance Smart Chain, the second platform in terms of number of users and number of transactions after Ethereum development.
How does yield farming work?
You will first need any cryptocurrency pair available on the selected liquidity protocol, such as Uniswap, 1Inch, or PancakeSwap. If you do not have the correct pair, the missing asset can be purchased on the same platforms. These protocols are decentralized, that is, they are not controlled by a centralized node.
Note: Although all transactions go through a smart contract, it is just a program that executes the instructions given to it. But miners (or network validators) add transactions and blocks. The smart contract does not manage them, it only ensures the fulfillment of the obligations between the parties to the transaction.
Once you have received the required cryptocurrencies, they must be locked into the protocol so that other users can use them. They will pay you a commission for this. In other words, you need to add assets to the liquidity pool or provide liquidity to the exchange. These users are called liquidity providers.
To better understand the mechanics of yield farming, let's understand what a cash pool is.
What is a liquidity fund?
A liquidity fund or Liquidity Pool is a smart contract that stores all funds from liquidity providers. Holders can withdraw their assets from the smart contract at any time with no restrictions. But not everything is so simple: the fact is that liquidity providers face the risk of transitory losses.
Impermanent loss in simple words is a temporary loss borne by liquidity providers due to the volatility of cryptocurrencies. In other words, volatile losses occur when traders make large purchases of one or the sale of another cryptocurrency in pairs. If the liquidity provider withdraws funds during this period, the losses will be permanent.
The mechanics may differ on different platforms. For example, on Uniswap, users can add assets to the pool directly. But in other protocols, the mechanics may be different: for example, in PancakeSwap, holders must first get LP tokens corresponding to the pool, and only then can they be added to the pool for farming.
Another way to mine liquidity is crypto lending (lending) backed by cryptocurrency. This approach helps investors hedge risks and apply sophisticated profitable farming strategies. However, landing carries high risks due to the fact that collateral can be liquidated if the collateral exchange rate falls sharply.
Therefore, DeFi protocols require high security, which can range from 200% to 750%. This means that to get $100 you will need to lock in a smart contract from $200 to $750 worth of cryptocurrencies.
How are the rewards accumulated?
For adding assets to the liquidity pool, farmers receive rewards that are generated via smart contract from commissions paid by merchants or otherwise. As a general rule, the DeFi platform accumulates rewards in native tokens, that is, issued by this platform.
For example, cryptocurrency exchange Uniswap pays UNI farmers, 1inch pays 1INCH tokens, and PancakeSwap pays CAKE. But this is not necessarily the case: platforms can pay rewards with other tokens, but any of these tokens must belong to the core network on which the infrastructure is built. Platforms on the development of Ethereum can generate income only in ERC-20 tokens and in Binance Smart Chain – BEP-20.
Note: this approach may change in the future. Blockchain developers are actively working on cross-chain solutions that will create bridges between different blockchains or, in other words, make them interoperable. This means that the platforms will become independent of a particular blockchain and will be able to operate even on multiple blockchains. This, for example, will generate income from ERC-20 tokens, receiving BEP-20 as a reward and vice versa.
The current situation makes the different DeFi platforms inflexible and “locked” in an ecosystem, which fragments the industry. Holders are currently unable to transfer assets from one blockchain to another without a centralized intermediary. But soon such solutions will appear. For example, the Polygon platform is building a layer 2 ecosystem that will not only scale the Ethereum network development, but also link it to other ecosystems.
What to draw attention to when choosing a decentralized platform?
One of the most important indicators of DeFi platforms is the TVL – Total Value Locked ratio or the total number of locked assets. The term co-emerged with DeFi and essentially means the liquidity known to traditional traders. TVL shows how much total assets the providers have contributed to the liquidity pools and is usually expressed in equivalent currency.
The TVL ratio is common to all types of DeFi platforms: AMMs, DEXes, Landing, and Assets. This is one of the main indicators that measure the current dynamics of the DeFi market. With this index, you can compare the size of DeFi platforms to assess their popularity and other qualities.
Large DeFi protocols with large TVL are considered the most reliable and tested by many users. However, this also indicates that the return of liquidity pools on them is unlikely to be high: most of the time they do not exceed 100% per year.
On the other hand, less liquid platforms provide high returns, sometimes exceeding 1000%. But this means that the protocols have only recently appeared on the market and are still poorly tested, so they may pose a higher risk.
Note: in fact, a large TVL does not always provide a lower performance and a small one provides a higher one. The profitability of farming also depends on the activity of traders: the higher it is, the higher the income of liquidity providers.
The total value locked indicator can be tracked on sites like DeFi Pulse and DappRadar . The latter can monitor DeFi platforms not only on Ethereum, but also on other networks, such as Binance Smart Chain or Tron.
What determines the profitability of farms and liquidity funds?
The platforms automatically calculate the profitability indicators annually based on the algorithms established in the protocol. Two metrics are used to calculate profitability: Current Percentage Yield (APY) and Annual Percentage Rate (APR) .
APR and APY change regularly depending on the activity of traders on the exchange and the amount of assets locked (TVL). The only difference between the indicators is that the APY takes into account the effect of addition, that is, a complex percentage - the reinvestment of profits for even more profits. These coefficients can be interchangeable.
The problem is that it is extremely difficult to predict long-term APR and APY, because in just one day these metrics can change by several or even tens of percent. This is due to high competition – when the opportunity for a high APR arises, investors are more likely to add assets to the pool to get the highest return.
At this time, other pools are launched, the profitability of which, on the contrary, is growing. To predict short-term changes in performance, you can use the TVL ratio as an indicator and monitor trends across different DeFi platforms.
Popular protocols for yield farming
Now the number of DeFi protocols is in the hundreds, and new ones appear almost every day – not all of them can be followed. But this is not necessary, since there are well-known decentralized platforms, which are enough to start earning in yield farming.
There is no single system of income: it depends on the specific platform and the experience of the investor. Also, they change regularly. You need to understand how a protocol is set up before you start mining liquidity. These are the popular DeFi protocols for yield farming.
Aave
The largest decentralized platform in the entire DeFi ecosystem at the time of writing. Aave is a landing platform on Ethereum, which allows you to receive and issue cryptocurrency loans. More recently, Aave became a multi-chain protocol and now runs on Binance Smart Chain as well.
Curve Finance
The second most capitalized DeFi protocol (TVL), which became multi-chain after Aave. Curve Finance became the first decentralized exchange (DEX) to operate on two blockchains at once: Ethereum and Binance Smart Chain. The exchange is notable for allowing large traders (whales) to trade large sums of stablecoins with virtually no slippage.
Compound Finance
The second largest landing platform. It not only accumulates interest on the tokens provided on credit, but also rewards creditors with their own COMP tokens. Income is generated simply - you need to add assets to the credit fund, after which the rewards will start accumulating immediately.
Maker
One of the first and largest decentralized platforms in the DeFi industry. It was the developers of Maker Dao who developed the DAI stablecoin, pegged to the dollar.
To generate a DAI, the user needs to lock ETH or some other tokens, after which the resulting stablecoins can be used for various profitable farming strategies.
uniswap
The largest automatic market maker of the moment. Uniswap has simplified the mechanics for adding crypto assets to liquidity pools. On the same platform, you can quickly trade ETH and ERC-20 tokens. Liquidity providers are rewarded from commissions paid by merchants on the Uniswap platform.
The platform quickly became one of the most popular due to its ease of use and intuitive interface.
Year Finance
This DeFi protocol gained so much popularity in 2020 that the exchange rate of the native YFI token shot up 30,000% in less than a month, making it one of the fastest growing assets in cryptocurrency history. For comparison, Bitcoin had to overcome more than 5 years to show the same result.
Yearn Finance offers a combination of financial services: liquidity funds, deposit and crypto deposits (vaults) , similar to bank deposits. It has a simple interface, which is suitable for beginners, but the mechanics are not that obvious.
Synthetix
One of the most unique DeFi protocols. Synthetix allows ETH and token holders to issue virtually any synthetic (tokenized) asset backed by a base cryptocurrency. In other words, you can lock Ethereum coins and get tokenized Google or Apple shares, oil, and even gold in return.
An important condition: a synthetic asset must have a measurable price. The list of available synthetic assets is already quite large and will only expand in the future.
PancakeSwap
The largest AMM platform in the Binance Smart Chain ecosystem. PancakeSwap users can engage in farming and earn income in native CAKE tokens. In addition to lucrative farming, non-tradeable tokens (NFTs) and lotteries are also available on PancakeSwap.
The Advantages and Disadvantages of Yield Farming
The main advantage of yield farming is affordability. It is not necessary to open a bank account to access financial services or receive income from agriculture. Age, geographical and social situation are not important. The minimum requirements help anyone to access DeFi platforms. All you need for farming is a personal wallet and cryptocurrencies. In addition, there are no intermediaries who must pay a commission for their services. All transactions are made directly between users through a smart contract.
But this, unfortunately, also has the disadvantages of profitable farming: lack of experience and minimal knowledge of how the DeFi industry and crypto security works leads to higher risks. First of all, it is important to understand how to protect yourself when using decentralized protocols .
Agriculture can benefit both investors and project developers. For example, in this way, they can attract many holders to the platform, distributing their own tokens among themselves instead of holding ICO or IEO tokenseils, which require considerable costs. It also solves the problem of placing tokens on exchanges, which can take several months.
One of the main disadvantages of profitable farming is high complexity, making it difficult for beginners to understand the mechanics of farming. To earn high returns, you need to understand how different platforms work, develop strategies, and quickly switch between different liquidity pools and DeFi protocols. Therefore, liquidity mining is more suitable for professionals.
The risks
The first risk is associated with the non-permanent losses that we talked about earlier. The value of the share in the group may decrease due to the fall in the price of cryptocurrencies. For holders, however, this can hardly be considered a disadvantage, as they are likely to continue to hold their assets anyway. On the contrary, liquidity mining in this case helps them to reduce losses and consequently reduce the risks of investing in cryptocurrencies.
Another risk is the growing popularity of DeFi, which attracts not only crypto enthusiasts and investors, but also scammers. Due to the large number of platforms that appear regularly, it is difficult to understand which of them is aimed at the long term and which one seeks to “profit” on inexperienced headlines.
Many new platforms offer high returns to attract as many investors as possible. The problem is that even without malicious intent, developers can run a "raw" protocol in which hackers can detect vulnerabilities and remove user assets. This has even happened with well-known platforms like SushiSwap and Yam Finance.
How are investment risks reduced?
To do this, holders add a stablecoin pair, such as Tether (USDT), DAI, Usd Coin (USDC), or Binance USD (BUSD). In this way, liquidity providers cover risks, that is, they open opposite positions. As Ethereum gets cheaper, the exchange rate of stablecoins against it will increase.
To minimize risks, users can add stablecoin pairs, such as USDT-BUSD, USDT-DAI, UST-USDC, etc. In this case, investors will be protected from the volatility of cryptocurrencies, but the return will be lower: as a rule, it rarely exceeds 20% per annum, especially during periods of correction in the cryptocurrency market, when many investors withdraw its assets to stable currencies.
The conclusion
You are now familiar with the basics of Yield Farming and the general working principle of DeFi protocols, and you can already start taking the first steps in profitable farming. He does not forget the risks and learn strategies to invest effectively in liquidity funds. The better you master farming strategies, the more useful it will be in the future.