Yield Farming describes the range of opportunities within DEFI (decentralised finance) to generate a return on your cryptocurrency rather than leave it sitting in a wallet. DEFI is an umbrella term for a new breed of permissionless financial services built on blockchains like Ethereum and Solana.
The cryptocurrency ecosystem consists of thousands of coins and tokens with varying use cases. Some function as money, while others provide utility within a game or a specific service. Their value is constantly changing based on the perception of future adoption. While many people will passively invest - buy and hold - waiting to realise the value in the long term, others want to unlock potential value now.
DEFI enables this through decentralised versions of traditional financial services, such as lending, borrowing and swapping, as well as opportunities unique to crypto, such as providing liquidity for decentralised exchanges.
Yield farming is a way to mix and match the opportunities presented by DEFI to actively grow your cryptocurrency portfolio, chasing different levels of return based on risk and complexity.
Though Yield farming includes a broad range of opportunities to generate a return actively, it shouldn’t be confused with staking, which generates a return from helping blockchains process transactions.
There is a range of ways blockchains validate transactions, known as Consensus Mechanisms. Bitcoin and Ethereum use Proof of Work, while many blockchains that emerged since have focused on an approach called Proof of Stake - PoS for short.
Proof of Stake requires that participants in the consensus process hold a financial stake in the system to ensure that they will act in its best interests.
A Proof of Stake blockchain will allow anyone to act as a Validators by running specific software, downloading the entire blockchain and staking a required amount of the native cryptocurrency.
In return for validating new transactions and adding them to blocks, they will earn the associated fees paid by the end-users. Acting as a Validator requires a technical and financial commitment beyond an average crypto user. However, you can still participate and earn a consistent return by staking a more modest amount to a Pool.
More generally, staking is considered a long term approach to generating returns given requirements to lock in funds for a minimum period and a protracted withdrawal process known as unbonding.
Yield Farming is far more flexible, with returns calculated every block and the opportunity to move funds around as often as you like, with the understanding that every transaction has an associated Smart Contract transaction fee paid in GAS.
Yield Farming can be broken down into the following categories, which mirror services available from traditional financial services. These key terms will help understand what each offers:
Lend & Borrow crypto assets - Deposit crypto into a pool and immediately earn interest and tokens specific to the protocol as a reward for using the service. Alternatively, you can deposit crypto assets as collateral and then borrow a different token (such as a Stablecoin), paying interest on the loan. The rates are algorithmically adjusted based on supply and demand.
Examples - Compound & Aave
Collaterised Debt Positions - A more complex approach to borrowing against existing crypto, where funds are locked into a vault, minting a Stablecoin which can then be used for trading or yield farming elsewhere. To unlock the collateral, the loan must be repaid along with fees. Often abbreviated to just CDP.
Example - MakerDAO
Liquidity Provision - Deposit an equivalent value of two tokens with a decentralised exchange creating a liquidity pool for other users to trade against. Liquidity providers earn fees from the trades executed from their share of the pool.
Examples - Uniswap & Sushiswap
Stablecoin Liquidity Provision - Providing liquidity for a decentralised exchange that focuses on providing pools of like priced assets, such as Stablecoins.
Example - Curve
Custom allocation liquidity provision - Deposit tokens to create liquidity pools on decentralised exchanges, but instead of a 50/50 allocation, customising the ratio of the funds deposited. By providing liquidity, you earn fees from the trades executed in your pool.
Example - Balancer
Yield Aggregators - Decentralized ecosystems aggregate the various DEFI services and use algorithms to find the most profitable strategies. Deposits are converted into synthetic Tokens that periodically rebalance to maximise profit.
Example - Yearn.finance
To yield farm, you need assets for which the common types of yield farming apply, the most popular being ERC20 coins. You also need a decentralised wallet to connect to the application, the most popular being browser wallets like Meta Mask or Trust Wallet.
A simple Yield Farming strategy would be to deposit ETH with Compound and earn interest. Here are the steps:
The individual yields available within DEFI are set automatically by protocols offering the particular service. Algorithms will decide, for example, the interest available on deposits or payable on loans based on supply and demand, which constantly changes.
You simply have to connect with a protocol/application to earn yield, as described above. Yield Farming generally requires you to have crypto in the first place, though there are options that allow you to deposit fiat money (like USD), minting an equivalent Stablecoin (like USDC) and earn a yield on those funds.
So in its simplest form, yield farming is passive; once you’ve been through the initial steps and signed a transaction, the interest is earned in the background without you having to do anything.
Yield aggregators take this one step further by automatically applying complex strategies for you. Those advantages will, however, be eroded as more users take advantage.
The most experienced Yield Farmers will proactively seek out the optimal yield farming steps themselves, recursively moving funds between various protocols and calculating the net return minus the GAS fees, impermanent loss and slippage.
People are attracted to DEFI because they want to grow their funds and naturally want to know the best yield farming cryptocurrencies and available strategies. These are the wrong questions to ask.
You need to start by thinking about how much risk you are prepared to take, how much research you are willing to do and how much time you can dedicate to actively managing the different yield farming activities.
You can find returns from under 1% up to several thousand %. As yields increase, so do the associated risks and the volatility of the underlying asset you need to hold to earn that yield.
Coinmarketcap provides Yield Farming Rankings which, when sorted for the highest returns, regularly has APY of over 1,000,000%. Such high APY will obviously attract attention, but you have to also look at the TVL - Total Value Locked - and the direct connection level to Impermanent Loss.
Impermanent Loss is a DEFI euphemism for the change in the value of a coin that hasn’t been realised. As already mentioned, yields are based on supply and demand. Still, you also have to factor in the prices of the coins you are depositing, the value of the coin the return is paid in, and the protocol's trustworthiness.
Anchor is a very good example of the risk/reward trade-off. Built on the Terra blockchain it offers up to 20% APY on deposits in UST, a native Terra Stablecoin, but you’ll need first to acquire UST (either from a centralised exchange or DEX) then send it to a UST supported wallet before connecting with the Anchor App.
With over 11bn UST deposited, users are clearly prepared to jump through those hoops to earn 20% APY, but how many stop to consider how that return on a Stablecoin is sustainable? Terra has been actively buying huge amounts of Bitcoin to provide collateral to UST, which many see as a tacit admission that its current model was unsustainable.
Chasing the highest yield is fraught with risk and stress, and often it is only the earliest and most sophisticated investors that can take advantage.
The most sensible approach is to start by finding the best available interest for the coins you hold from a provider with significant TVL that has been operational for a while. That list would include names like Curve, Uniswap, Compound and Aave. But you have to look beyond the available APY to understand whether Yield Farming is profitable.
Yield farming crypto can be profitable, but it depends on how you measure the gains. Most crypto investors measure returns in fiat. Given that crypto is so volatile, you might make a decent return from Yield Farming measured in percentage return that is a loss in fiat terms.
This can simply be because of changes in the wider crypto market or something called impermament loss. If you are providing liquidity to a DEX this means contributing two assets with proportionate value, which could be 1 ETH and 3,000 USDT.
If the overall liquidity pool is 60,000 and you contribute 3,000, your share is 5%. As the price of ETH changes, the overall size of the pool will remain the same, but the proportion of ETH will increase or decrease.
If the price has fallen and you want to withdraw your 5% of the pool, it might be worth less than you contributed, realising the Impermanent Loss. Therefore, the net impact of the liquidity provision has to consider fees earned, the impact of impermament loss, and the GAS fees you pay to interact with the different services.
It can help to use a DEFI tracking tool, like Defi Yield, which will pull everything together for you in a dashboard but the reality is that yield farming only becomes profitable at scale. If you experiment with small amounts, GAS fees alone can make it unprofitable, so there has been a big rise in DEFI applications built on rival chains to Ethereum, with lower fees.
Profitability should also consider the opportunity cost of yield farming, which means considering what returns you could have otherwise earned on your funds through an alternative strategy, whether inside or outside of crypto.
If you are reading this and wondering whether you should try yield farming, your answer should come down to a few key considerations:
The final consideration, and arguably one of the most important considerations around Yield Farming, is security.
We’ve already highlighted the yield farming risks that come from crypto’s volatility and how that impacts the dynamic returns and the dangers of impermament loss. There is another dimension to safety that relates to being scammed or hacked.
Given the huge popularity of yield farming and the willingness of so-called crypto degens to take in a lot of risk chasing returns, there has been a big increase in DEFI services that are scams. The most common is known as a rug pull.
A rug pull is when a DEFI protocol is set up to attract a certain amount of locked value before the founders withdraw the funds and disappear. Chainalysis estimated that rug pulls accounted for 37% of all crypto scam revenue in 2021, at a value of $2.8bn.
If your funds are lost or impacted by a rug pull you will likely bear all the losses because funds held in DEFI protocols aren’t insured by any government scheme.
Of equal concern is the risk of using a non-custodial wallet like Meta Mask. Non-custodial means that you have complete control of the funds through a recovery Seed. You can read elsewhere on Learn Crypto what a recovery Seed is and how it works, but what’s important to understand is that losing that Seed means the loss of all funds within your wallet.
As a result, hackers using malware and social engineering to try to access your Seed has a huge and growing threat. Scammers will use every conceivable trick to get you to share it. You can mitigate the threat by making by constantly reviewing your online security and understanding that there is no circumstance where you should ever legitimately be asked to share your Seed.
DEFI is still so immature with so much growth potential that we’re likely to see a widening of the spectrum of ways to earn yield. We are already seeing the early DEFI brands establishing their place as safe services, offering modest but consistent returns. This is based on the reliability of the Smart Contracts and the effort they put into auditing and security, as well as improving usability, eating further into the territory of traditional finance.
The increase in rug pulls, and the growing threat from wallet hacking, is unlikely to dampen enthusiasm for yield farming at the other end of the risk spectrum, where they are considered an implied cost of being the sector. However, the scale of DEFI scams will likely lead to changes in the wild west nature of yield farming:
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