Yield Farming: Everything to Know
By Beluga Research June 27, 2023
- Yield farming is a process that involves a user providing crypto liquidity to a decentralized finance (DeFi) platform or trading pool
- Yield farming allows users to earn passive cryptocurrency income
- Profiting from yield farming requires a deep understanding of a platform's mechanics and the risks involved
Yield farming is a decentralized finance (DeFi) application that allows users to earn passive income by providing cryptocurrency liquidity to DeFi platforms.
Users earn rewards for providing liquidity via crypto balances they own. The amount of rewards that a user can earn depends on the amount of liquidity provided, the length of the deposit and the platform's rewards system. Some platforms offer higher rewards for longer deposits. Other platforms offer higher rewards for providing liquidity to specific pools.
A Brief History
Yield farming emerged in mid-2020 with the launch of Compound. A DeFi platform, Compound allows users to earn interest on their cryptocurrency holdings. Compound rewards users with COMP tokens for providing liquidity to the platform. These COMP tokens can then be traded on cryptocurrency exchanges. The system that Compound established offers users an opportunity to earn returns on crypto investments.
Compound's success with the concept of yield farming led to the launch of several other DeFi platforms that offer similar services. The list of platforms that engage in yield farming includes Aave, Uniswap and SushiSwap among many others. Each platform has its unique rewards system and token, yet the basic principle is the same; users earn rewards for providing liquidity to the platform.
What is Yield Farming?
In yield farming, liquidity providers (LPs) deposit their cryptocurrency holdings into a liquidity pool. The pool facilitates trades on the platform. LPs earn rewards in the form of tokens unique to the platform. Users can trade the tokens on cryptocurrency exchanges. They can also use tokens to access other services on the platform.
Yield farming is a complex process. One of the main risks of yield farming is impermanent loss. Impermanent loss occurs when the value of tokens in the liquidity pool change relative to each other. Impermanent loss can result in a user getting a lower return on investment than they expected at the outset.
- Invest in cryptocurrency. A user will need a cryptocurrency wallet that supports the token they want to farm.
- Use DeFi protocols that offer opportunities to engage in yield farming. DeFi protocols are financial applications that run on blockchain technology. They allow users to earn interest on cryptocurrency holdings by lending out the holdings to other users. Users then receive tokens to trade on cryptocurrency exchanges.
- Incentivize users to provide liquidity to DeFi protocols. A user providing liquidity to a DeFi protocol is essentially depositing cryptocurrency into a pool that is used to facilitate trades on the platform. The user receives a token that represents their share of the pool. The user can trade this token on a cryptocurrency exchange. The value of the token is determined by the demand for liquidity for the DeFi protocol.
The concept of "farming" new tokens. Many DeFi protocols offer tokens as rewards for providing liquidity. The tokens can be traded on cryptocurrency exchanges.
The concept of impermanent loss. For example, say a user deposits units of the cryptocurrency for the Ethereum network (ETH) and units of the cryptocurrency for the Tether network (USDT) into a liquidity pool. The value of ETH increases relative to USDT. The user will end up with more ETH and less USDT when they withdraw their deposit. Impermanent loss is a risk that can result in an opportunity to profit. Knowing which token will increase in value can help a user secure a satisfactory return.
The level of risk. DeFi protocols are still relatively new. They are not well-regulated like traditional financial institutions. It is important for a user to do research and invest only the amount they can afford to lose.
- High potential returns. Yield farming can offer high returns compared to traditional savings accounts or other investment options. This is due to the high volatility of the cryptocurrency market. The practice can also offer high returns because rewards are often paid out in the form of newly minted tokens. Such tokens can appreciate in value over time.
- Access to new and emerging projects. Yield farming allows investors to participate in new and emerging cryptocurrency projects. Such projects may not yet be available on centralized exchanges. Participation offers users a chance to make a profit before other users are aware of the opportunity.
- Diversification. Yield farming allows investors to diversify cryptocurrency holdings. When a user invests in a variety of projects and tokens, they help spread risk. This minimizes market volatility and negative impacts from ups and downs.
- Liquidity. Many yield farming protocols offer flexible withdrawal options. Such options allow investors to easily convert their rewards into other cryptocurrencies or fiat currencies.
- Control. Yield farming allows investors to maintain control over cryptocurrency assets. The assets are held by the network, in which the user has a stake. The assets are not held by centralized exchanges or traditional financial institutions.
- High risk. Yield farming is a high-risk investment option. The value of cryptocurrency assets can be volatile and subject to rapid fluctuations. In addition, many yield farming protocols are relatively new and untested. This increases the risk of losses due to bugs or vulnerabilities in the underlying code.
- Complexity. Yield farming can be complex and difficult to understand, particularly for investors new to the cryptocurrency space. Investors must be able to navigate decentralized exchanges, smart contracts and automated market-making protocols (AMMs) to participate in the practice.
- Impermanent loss. Impermanent loss occurs when the value of the cryptocurrency asset being staked or lent changes relative to the value of the other crypto assets in the pool. This can result in a loss of value for the investor.
- Fees. Many yield farming protocols charge fees for transactions and reward distributions. The fees can eat into potential profits.