What is Yield Farming?
Here’s a quick look at everything you’ll find in this article:
- What is Yield Farming?
- The Origin of Yield Farming
- How Does Yield Farming Work?
- An Example of Yield Farming
- How are the 'Yields' Calculated?
- Major Yield Farming Protocols and Platforms
- The Risks Associated with Yield Farming
- Before You Go...
Without further ado, let us see the details of Yield Farming.
What is Yield Farming?
We assume that you are at least familiar with the word Cryptocurrency or Crypto. Yield Farming (also known as Liquidity Mining though it is not entirely correct) is relatively a new entry in the world of Cryptocurrency.
Simply put, Yield Farming is a method through which you can increase your Crypto using Crypto. Seems simple? But in fact, it is not that simple as it sounds.
In other words, yield farming refers to putting your crypto assets to work and receive the maximum returns possible on these assets. The people involved in this process are called Yield Farmers. Let us try to understand this concept per the norms of traditional banking.
Suppose that you are depositing an amount in a bank. You would receive interest based on the amount you deposited. Yield Farming is something similar to this. You are lending or depositing your Crypto in a Liquidity Pool (consider it as a decentralized bank) running under some protocol based on a strategy, and you will get returns on the capital you invested. The persons who invest the Crypto assets are called Liquidity Providers. The merit involved with this investment is the type of returns you receive.
The goal behind yield farming is to maximize your return on investment by leveraging protocols. Each protocol in a liquidity pool would be working on a strategy.
If the yield farmer finds a selected protocol with a strategy giving him lesser yields, he can move on to another protocol working with a different strategy. Therefore a yield farmer will not be dealing with a single protocol all the time. This moving around helps him in collecting maximum yields.
Suppose that you have multiple fixed bank deposit options in front of you. You would choose one option and deposit in it. At a later point, you realize that another FD option gives you more returns. Then you go for the new one to maximize your returns. Yield Farming also can be viewed in this context.
Moving in between protocols can be compared to the scenario of choosing between different bank products for maximum returns in traditional banking. Now that you have understood the general idea behind Yield Farming, let us see how all these started.
The Origin of Yield Farming
Crypto enthusiasts from back in the day might remember the ICO boom that happened in 2017. Yield Farming is the next big thing after the ICO boom.
A sudden surge of interest in yield farming can be traced back to the launch of the COMP token, the governance token of the Compound Finance ecosystem during the summer of 2020. The governance token can grant governance rights to the token holders and can shape up even the future of a protocol.
It has been seen that distributing governance tokens algorithmically with liquidity incentives is one of the most efficient methods for kickstarting a decentralized blockchain ecosystem. This very concept would attract liquidity providers to farm new tokens by providing liquidity to the protocol.
Though this strategy is not the inventor of the yield farming concept, the introduction of governance tokens made this distribution model popular among liquidity providers. Since then, several Defi projects started coming up with various innovative strategies to attract liquidity providers into their ecosystems. This led to the origin and eventually the boom of yield farming.
How Does Yield Farming Work?
Yield farming is based on a successful model called Automated Market Maker (AMM). The main components of this model are Lenders aka liquidity providers (LPs), borrowers, and liquidity pools.
Liquidity providers deposit funds or assets into a liquidity pool on a platform. This liquidity pool powers a marketplace where users can lend, borrow, or exchange tokens. The borrowers have to pay fees for using the platforms. These fees are then given to liquidity providers depending on their market share of the pool. This is the basic idea of the AMM model.
When it comes to yield farming, in addition to these fees, liquidity providers receive one more incentive in the form of a new token. In open markets, you can buy tokens only in very small amounts. But through yield farming, an investor can yield additional tokens.
This would encourage an investor to pool in more funds to a specific liquidity pool. The bottom line is that liquidity providers get returns in the form of fees and tokens based on their share of investment in the liquidity pool.
Let us summarize the process in the simple steps below:
- An investor (liquidity provider) approaches a DeFi platform like Compound.
- The investor then lends or invests crypto assets in the liquidity pool.
- A borrower goes ahead and borrows assets from the pool after depositing a collateral fund.
- The investor receives returns in the form of fees and tokens. Fees can be either fixed or variable depending upon the rates decided by each DeFi platform.
- The borrower deposits double the borrowed amount in the form of collateral. This is a must before proceeding with the deal.
Note: The value of the collateral is very crucial in yield farming. Once the collateral amount goes below the borrowed amount, the borrower account is liquefied and the interest is paid to the lender. Therefore a borrower must be very keen on keeping his collateral under check.
Smart contracts are the magic wands that help to check the value of the collateral, at any point in time.
So what is a smart contract? A smart contract is a computer program or a transaction protocol that can automatically execute, control, or document legally relevant events and actions according to the terms of a contract or an agreement.
Therefore with the help of smart contracts, the collateral amount can be checked anytime. While checking, if the collateral amount turns out to be lesser than the borrowed amount, the intelligent smart contract triggers to liquidate the borrower’s account, and the interest is paid to the lender. In this scenario, an investor is never at a loss even if the borrower does not pay him back the borrowed assets.
An Example of Yield Farming
We have already covered the aspect that a yield farmer moves his assets within a platform constantly chasing for the best protocol that can give him the maximum yields or maximum returns on his investment.
This also means that every time the investor decides to move to a new pool, he might be moving into riskier pools. But as a yield farmer, you are required to have that kind of capacity and capability of taking a risk.
Liquidity providers generally deposit funds in the form of the Stablecoins such as DAI, USDT, USDC, BUSD that are pegged to USD. Protocols then mint tokens that represent your deposited coins.
For example, the deposit of DAI coins can mint you a cDAI token, a deposit of USDT coins can mint you a cUSDT coin, and so on. Where it all gets complex is when you deposit your cDAI to a protocol that mints a different token which can trace back to your original DAI deposit. Thus these chains can become complex and hard to follow.
This is how Yield farming works. The user looks for different protocols and cases in the system to increase his yield by investing in different pools and products.
How are the 'Yields' Calculated?
Typically, we calculate the estimated yield farming returns annually. The two common metrics that are used in calculating the returns or yields in yield farming are:
- Annual Percentage Rate (APR)- APR refers to the annual rate of return charged on borrowers, but paid to capital investors.
- Annual Percentage Yield (APY)- APY refers to the yearly rate of return charged on capital borrowers and paid to capital providers.
Though they sound similar, they are as different as chalk and cheese.
The main difference between them is that while calculating APR, we don't consider the effect of compounding. Whereas while calculating APY, compounding is a major factor. In this case, compounding means reinvesting the profits to generate more returns.
In other words, the APR interest earned on the capital cannot be added to the original principal capital to earn more interest; however, this can be done in APY. Even then, please keep in mind that users use the terms APR and APY interchangeably all the time.
It is also important to note that these are just projections and estimations. In yield farming, it is very difficult to calculate short-term rewards precisely. This is a highly volatile and fast-paced market where rewards fluctuate rapidly.
If a yield farming strategy yields high results for a while, many farmers will join it, and eventually, the strategy will fail to yield high returns. APR and APY are induced from legacy markets. In DeFi, weekly or daily returns make more sense rather than annual.
Major Yield Farming Protocols and Platforms
We already know that in yield farming you invest assets to a pool and receive returns for it. You must be aware that yield farming strategies are susceptible to changes every hour. Each platform and strategy has its own set of rules and risks.
With this basic understanding of Yield Farming, let us now take a look at the major players in the game, a collection of protocols that are the strong pillars behind yield farming strategies.
1. Compound Finance
The Compound is an algorithmic money market that allows users to lend and borrow assets. All the user needs, to begin with, is an Ethereum wallet to deposit assets to Compound's liquidity pool and collect rewards with immediate compounding.
The rates on this protocol are based on the supply-demand rate. On this platform, users can borrow up to 50-75% of their collateral value that is referred to as ‘cTokens’.
If you know anything about the Decentralized Finance (DeFi) space, you probably know about MakerDAO. After all, it is one of the most popular projects in the DeFi space. A fact that not a lot of people know about MakerDAO is that it is one of the pioneers of the industry who coined the term Decentralized Finance.
Maker is a decentralized credit platform that generates DAI, a stablecoin algorithmically pegged to the value of USD. Collateral assets such as ETH, BAT, USDC, or WBTC are locked in the Maker Vault. DAI is generated as the debt against this collateral that they locked. Yield farmers use Maker to mint DAI to use in yield farming strategies.
Just like Compound Finance, Aave is also a decentralized protocol for lending and borrowing. Aave follows algorithmic interest rates depending on the market state. Lenders receive aTokens for their fund deposit and start earning and compounding interest immediately. Aave also supports flash loans.
Note: Compound Finance, Aave, and MakerDAO are the simplest platforms available for yield farming.
Synthetix is a synthetic asset protocol where a user can lock up or stake Synthetix Network Token (SNX) or ETH as collateral. Synthetic assets which have a reliable price feed are minted for the collaterals deposited. In this method, any financial asset can be added to the Synthetix platform.
As the name implies, Uniswap is another decentralized exchange protocol that is primarily used for swapping trustless tokens. Liquidity providers deposit an equivalent value of two tokens to create a market. The platform rose to fame due to its frictionless nature.
6. Curve Finance
Curve Finance is a decentralized exchange protocol that is also used for stablecoin swaps. This protocol allows swaps with low slippage. We’ve already talked about the platform in our beginner’s guide to Ellipsis finance (which is built on top of Curve.finance). So make sure that you check the article out if you want to know more about the platform.
Yearn.finance is a decentralized ecosystem that automatically chooses the best strategies for farmers. We take a deeper look into the platform in one of our articles. Should you want to know more about Yearn.finance, please check our article out.
Balancer is a liquidity protocol similar to Uniswap and Curve. However, the key difference is that it allows for custom token allocations in a liquidity pool. It can also be used as an automated portfolio manager and price sensor.
Platforms such as Uniswap, Balancer, Curve Finance, Yearn Finance, etc. fall in the intermediate group depending upon the complexity level they possess. Some other platforms that need the expertise to deal with are:
- Alpha Homora
- Mirror Protocol
Tools that Help You in Yield Farming
There are some very efficient tools available for portfolio management and discovering new yield farms. As the DeFi industry is blooming and yield farming grows in popularity, it is better to use a few tools to simplify the life of a yield farmer. Here is a list of tools we have compiled for you.
- DeFi Pulse provides you easily the relevant market cap, TVL, and ranking data you could ever want or need.
- Zapper is a nifty DeFi dashboard. A Zapper can keep a track of all of your investments, farms, and yield earnings, and organize them in one place. It also provides the updated APY yield across platforms.
- Instadapp is a DeFi manager. The platform can manage liquidity across protocols like Uniswap and Aave.
- Debank is a one-stop DeFi powerhouse. The platform includes a portfolio manager, token swap, DeFi Market, DeFi list of projects, and a ranking page displaying DeFi TVL.
- Zerion is a platform for you to invest and get returns from yield farming. This can also track your DeFi portfolio.
- Shrimpy is a social trading platform. You can use the platform to increase your returns by automating Crypto trades.
The Risks Associated with Yield Farming
You would agree with us if we say Yield farming isn’t simple. The yield farming strategies that give maximum returns are highly complex. Only the advanced users can make a profit out of them.
Experts say that people with deep pockets (we call them whales in the world of crypto) can earn more profits. That means those people who can invest huge capital amounts are the ones who reap maximum benefits, and not everyone.
We have already seen how liquidation of collateral happens. Therefore, if you don't understand what you are doing, there are more chances that you would lose your hard-earned money.
Apart from whales and collaterals, what are the other possible risk factors involved?
Another inherent risk with yield farming exists in the form of smart contracts. We have already discussed that smart contracts are computer programs or transaction protocols.
Due to the decentralized nature of DeFi, there are enough protocols built by small teams with limited budgets. This may result in smart contract bugs. Even with bigger protocols that are audited by reputable big auditing firms are not free from bugs many a time. So you can imagine the situation of protocols from smaller teams.
The bugs from smart contracts pose a threat due to the immutable nature of blockchain. Immutable means unchangeability. Since transactions are immutable, there is no way to correct them if any bugs occur.
This can lead to the loss of user funds. Yield farming is also susceptible to hacks and fraud due to smart contract bugs. The fierce competition between protocols, unaudited protocols copied from their predecessors also results in smart contract bugs.
One of the greatest advantages of the DeFi market is its composability. What is composability? A platform is composable if the existing resources become the building blocks of higher order. Composability is also a risk factor when it comes to yield farming. How?
DeFi protocols are permissionless and can seamlessly integrate with each other. This means that the entire DeFi ecosystem is heavily reliant on each of its building blocks. Why is this a risk? The answer is simple.
If just one of the building blocks malfunctions, then the entire system may malfunction. Therefore, a yield farmer should not only trust the protocol in which he plans to deposit but also the other protocols related to it.
Before You Go...
Yield farming, the current craze in the cryptocurrency world is yet to become a mature and efficient market. Even then it has succeeded in attracting more and more people towards it.
Needless to say that it is a super complex strategy. So what more can we expect from this decentralized revolution?
Trustless liquidity protocols and other DeFi products are not to fade out easily. DeFi money markets may end up creating more open and accessible systems for everyone with an internet connection that can maximize returns.
Though the world of DeFi is shining and enchanting, it is intermingled with the dangers of loss. Therefore anyone who wishes to venture in must be aware of the potential pitfalls and be ready to face the consequences. After all, no pain, no gain!