What is yield farming in crypto world of DeFi (Decentralized Finance)?

Blockchain opened up a whole new world for making peer-to-peer transactions (sending and receiving money) seamless, secure and bankless. Yes, you heard it right, you don’t need an intermediary like a bank to store your funds and to request them to transfer to someone when you need. Blockchain powered cryptocurrencies is what you need and it is changing the entire banking and finance ecosystem.

What is yield farming?

When you deposit money in a bank, you’re effectively making a loan to bank, for which you get interest in return. Yield farming involves lending cryptocurrency to a liquidity pool. In return, you get interest and sometimes fees.

In very simple worlds - Yield farming is a way to make more crypto with your crypto. It involves you lending your funds to others through the magic of computer programs called smart contracts. In return for your service, you earn fees in the form of crypto. This hot new term yield farming in crypto world is a shorthand for clever strategies where putting crypto temporarily at the disposal of some startup’s application earns its owner more cryptocurrency.

Though it sounds simple but yield farmers use very complicated strategies. They move their cryptos around all the time between different lending marketplaces to maximize their returns. They are also be very secretive about the best yield farming strategies because the more people know about a strategy, the less effective it may become. Yield farming is the wild west of Decentralized Finance (DeFi), where farmers compete to get a chance to farm the best crops.

This innovative yet risky and volatile application of decentralized finance (DeFi) has skyrocketed in popularity recently thanks to further innovations like liquidity mining. Yield farming is currently the biggest growth driver of the still-nascent DeFi sector, helping it to balloon from a market cap of $500 million to $10 billion in 2020.

Yield farming protocols incentivize liquidity providers (LP) to stake or lock up their crypto assets in a smart contract-based liquidity pool. These incentives can be a percentage of transaction fees, interest from lenders or a governance token. These returns are expressed as an annual percentage yield (APY). As more investors add funds to the related liquidity pool, the value of the issued returns rise in value. 

Liquidity mining occurs when a yield farming participant earns token rewards as additional compensation, and came to prominence after Compound (money market for lending and borrowing assets) started issuing the skyrocketing COMP, its governance token, to its platform users. 

Most yield farming protocols now reward liquidity providers with governance tokens, which can usually be traded on both centralized exchanges like Binance and decentralized exchanges such as Uniswap. 

Compound (COMP), which was launched in June 2020, is the largest such service and currently has nearly $550 million in funds, according to tracker Defi Pulse. Other major players in this game — also called liquidity harvesting — are Balancer, Synthetix, Curve, Aave, Uniswap, MarketDAO, Yearn.Finance, Harvest, SushiSwap and Ren. Synthetix pioneered the idea. Today, these services hold more than $1 billion in locked user funds, which are funds that are used in lending.

How does yield farming work?

The first step in yield farming involves adding funds to a liquidity pool, which are essentially smart contracts that contain funds. These pools power a marketplace where users can exchange, borrow, or lend tokens. Once you’ve added your funds to a pool, you’ve officially become a liquidity provider.

In return for locking up your finds in the pool, you’ll be rewarded with fees generated from the underlying DeFi platform. Note that investing in ETH itself, for example, does not count as yield farming. Instead, lending out ETH on a decentralized non-custodial money market protocol like Aave, then receiving a reward, is yield farming.

Reward tokens themselves can also be deposited in liquidity pools, and it’s common practice for people to shift their funds between different protocols to chase higher yields.

It’s complex stuff. Yield farmers are often very experienced with the Ethereum network and its technicalities—and will move their funds around to different DeFi platforms in order to get the best returns.

It is by no means easy, and certainly not easy money. Those providing liquidity are also rewarded based on the amount of liquidity provided, so those reaping huge rewards have correspondingly huge amounts of capital behind them.

Yield farming in brief

• Yield farming lets you lock up funds, providing rewards in the process.
• It involves lending out cryptos via DeFi protocols in order to earn fixed or variable interest.
• The rewards can be far greater than traditional investments, but higher rewards bring higher risks, especially in such a volatile market.
• You can create complex chains of investments by reinvesting your reward tokens into other liquidity pools, which in turn provide different reward tokens.

Risks Associated with yield farming

Yield farming isn’t simple. The most profitable yield farming strategies are highly complex and only recommended for advanced users. In addition, yield farming requires a lot of capital and is generally more suited to those that have a lot of capital to deploy.

Yield farming isn’t as easy as it seems, and if you don’t understand what you’re doing, you’ll likely lose money.

Another bigger risk is - it is susceptible to hacks and fraud due to possible vulnerabilities in the protocols’ smart contracts. These coding bugs can happen due to the fierce competition between protocols, where time is of the essence and new contracts and features are often unaudited or even copied from predecessors or competitors.

DeFi protocols are permissionless and dependent on several applications in order to function seamlessly. If any of these underlying applications are exploited or don’t work as intended, it may impact this whole ecosystem of applications and result in the permanent loss of investor funds.  

As blockchain is immutable by nature, most often DeFi losses are permanent and cannot be undone. It is therefore advised that users really familiarize themselves with the risks of yield farming and conduct their own research.