Yield farming is a relatively new phenomenon in the world of cryptocurrency and decentralized finance (DeFi) that allows investors to earn rewards or “yield” on their cryptocurrency holdings by providing liquidity to decentralized exchanges or lending platforms.
But how exactly does yield farming work and what kind of rewards can yield farmers expect to reap as a result of all their hard work? We take a closer look in this article.
Yield Farming: The TL;DR
Yield farming is a complex but potentially lucrative practice that allows investors to earn rewards on their cryptocurrency holdings by providing liquidity to decentralized exchanges and lending platforms. It can be seen as similar to staking, but with a greater degree of complexity.
To participate in yield farming, investors become liquidity providers (LPs) by adding funds to liquidity pools. These pools are essentially smart contracts that hold funds and facilitate transactions on the underlying DeFi platform. In exchange for providing liquidity, LPs receive rewards in the form of fees generated by the platform or other sources.
Some liquidity pools offer rewards in multiple tokens, which can then be deposited into other pools to earn additional rewards. This can create highly complex strategies, but the basic idea is that LPs deposit funds into a pool and earn rewards in return.
The majority of yield farming is currently done on the Ethereum blockchain, which holds 28 billion out of the market’s total value locked (TVL) of 48 billion. Yield farmers often move their funds between different protocols in search of the most favorable yields, and DeFi platforms may offer additional economic incentives to attract more capital to their platform. After all, liquidity pools are often considered the lifeblood for the continued existence of DeFi platforms such as decentralized exchanges (DEXes), and as such incentivizing liquidity contribution is of paramount importance.
How does Yield Farming Work?
Yield farming typically involves LPs and liquidity pools. The LPs deposit funds into a liquidity pool, which facilitates the liquidity necessary for users to lend, borrow, or exchange tokens on a DeFi platform. Fees are incurred when users perform transactions on the platform, which are then distributed to LPs based on their contributions to the liquidity pool.
In addition to fees, another incentive for LPs to add funds to a liquidity pool could be the distribution of a new token. For instance, the conditions to purchase a particular token could involve the contribution of liquidity to a specific liquidity pool. This provides an additional incentive layer for users to contribute liquidity to the pool.
Whether it be via dividends extracted from transaction fees or qualifications to be put on an allowlist to mint an NFT or buy a token, there can be various ways for DeFi platforms to encourage participation in liquidity pools.
The funds deposited into the liquidity pools are often stablecoins pegged to the USD, although this is not a general requirement. Some of the most common stablecoins used in DeFi are DAI, USDT, USDC, BUSD, and others. Some protocols will mint tokens that represent the LP’s deposited coins in the system. For instance, if the LP deposits DAI into Compound, they will receive cDAI, or Compound DAI. Similarly, if the LP deposits ETH into Compound, they will receive cETH.
Some of the more popular trading pairs in the market right now include WBTC/ETH, which sits at a TVL of $219.02 billion, and DAI/USDC, which sits at a TVL of $211.51 billion.
As yield farming may involve multiple sub-farming procedures, LPs can deposit their cDAI to another protocol that mints a third token to represent their cDAI that represents their DAI, which can become increasingly complex as more layers are added to the process.
Risks Associated With Yield Farming
While yield farming may sound like a lucrative way to earn some passive income, it is nevertheless still a complex process that requires advanced knowledge and is primarily suited for users with significant amounts of capital to invest. As with all kinds of financial investments, due caution has to be taken before committing to it. Besides the risk of collateral liquidation, there are also several other risks that prospective yield farmers ought to be aware of:
Smart Contract Vulnerabilities
One significant risk is the vulnerability of smart contracts, which are oftentimes heavily relied on by yield farming protocols and are used to automate and facilitate yield farming. Smart contract exploits have become increasingly commonplace, especially as more smaller DeFi protocols begin to spring up that may not necessarily have access to large amounts of funding and therefore may not have put their smart contracts through extensive vulnerability testing.
That being said, even well-audited protocols may still have vulnerabilities that can result in the loss of user funds due to the immutable nature of blockchain, and can be targets for experienced hackers and malicious attackers.
Another major risk associated with yield farming is the concept of composability. DeFi protocols are designed to be composable, meaning they can seamlessly integrate with each other, but this also means that the entire DeFi ecosystem relies heavily on each of its building blocks. If one protocol malfunctions, it may potentially cause a domino effect throughout the ecosystem and put yield farmers and liquidity pools at risk. As DeFi ecosystems grow to become more and more intertwined, especially as we approach the era of greater multi-chain interoperability, it is essential to trust not only the protocol you deposit your funds into but also all the others it may be reliant upon.
Similar to most DeFi protocols and DEXes in general, liquidity risks are also present on Yield Farming protocols. Yield farming is also subject to market risks, such as volatility and liquidity fluctuations, which can result in high slippage rates and may cause significant impacts for yield farmers. High slippage occurs when the executed price of a trade is significantly different from the expected price, which can be a result of low overall market liquidity, thereby resulting in a significant difference between the expected price of a trade and the actual executed price of the trade.
Yield farming is indeed an innovative and novel hallmark of the DeFi landscape, and has steadily grown in popularity as a means of generating passive income. However, users still need to be aware of the risks associated with yield farming, such as composability and smart contract risks, and should only participate in yield farming if they have comprehensive knowledge of DeFi protocols and are well-versed in risk management strategies.
Keen to try your hands at yield farming? Bitget Wallet (Previously Bitget Wallet (Previously BitKeep)) Wallet’s integrated DApp explorer provides access to a wide variety of different DApps at your fingertips that you can experience to have a taste at yield farming, such as MakerDAO (for DAI), and Synthetix!
Take the necessary precautions, engage in substantial research, and best of luck!