What is yield farming and how does it work? 📖
Resembling staking, yield farming (also known as liquidity farming) is a process in which an investor or a user of cryptocurrencies pools in their currencies with other users to earn rewards, and interests or get more currency for staking what they already own. Yield farming is done through decentralized finance (DeFi).
The idea of yield farming in DeFi in crypto is very similar to centralized finance (CeFi). Farming on DeFi helps to maximize returns on crypto.
While yield farming and liquidity farming are both forms of earning rewards in DeFi and DEX (Decentralized Exchanges), there is a term known as liquidity mining which also pretty much does the same job and is another form of earning returns and token rewards.
Farmers that are interested in increasing their crop production might use more sophisticated strategies. For instance, yield farmers might continuously switch their crypto holdings between several lending platforms to maximise their profits.
By depositing coins or tokens in a DeFi dApp, it enables investors to earn a return or yield. Cryptographic wallets, decentralized exchanges, decentralized social media and other applications are some examples of dApps.
But why ‘yield’ and ‘farming’?
That’s a great question! Let’s quickly learn about the two terms.
So, yield is a term used in both finance and farming. Yield in crypto refers to the returns earned for investing in a cryptocurrency and the returns are generally in the form of more currency. And the returns are typically expressed in percentages. There are different ways of earning yield such as staking, lending, and providing liquidity on DeFi platforms. Don’t be scared of these terms as these will be explained later on.
Okay, then where does farming come from? So, farming in finance refers to the process of looking for opportunities to invest. You put ample focus on places that have the potential to grow in the future and that can give you more and more returns on investment.
In the context of DeFi yield, farming in crypto will refer to the process of actively seeking out high-yield investment opportunities.
The relationship between yield and liquidity farming
We talk about liquidity and DeFi in this section. So, yield farming is also known as liquidity farming and you may wonder why.
The reason it is sometimes called liquidity farming is that the process often involves providing liquidity to DeFi platforms by depositing currency in a liquidity pool.
1. What does providing liquidity to DeFi mean?
Before we jump into that, let’s understand what liquidity is. It refers to the phenomenon that deals with how quickly and at what pace an asset like cryptocurrency or a stock or a bond can be converted to cash without it losing its market value.
In simpler terms, when an asset is liquid, it almost always has investors or buyers, or sellers available for that asset.
Thus, providing liquidity to DeFi means stacking your crypto assets or currencies into a liquidity pool arranged by DeFi. By doing so, DeFi ensures that it does not run out of investors, buyers, sellers, and users.
2. But then what is DeFi and why is it obsessed with liquidity pools?
DeFi or Decentralized Finance is a system or a network of financial applications and services that are decentralized and primarily work on blockchain technology.
The reason why DeFi looks forward to liquidity pools is that it is a common practice and is also widely used when it comes to trading coins and cryptocurrencies.
Although liquidity pools are not the only way to trade, they surely are the most commonplace way of trading coins. While liquidity pools are not the only way DeFi generates revenue, they are surely a key component for many DeFi platforms to make a profit off of.
3. Okay then how is liquidity created in crypto?
There is a process called liquidity provision. Liquidity in crypto is created using that process. The process involves depositing an equal value of two different tokens into a liquidity pool, which is a smart contract that automatically trades the tokens based on their prices.
In return for providing liquidity, users receive a pool token that represents their share of the liquidity pool. These pool tokens can be traded or held to earn yield farming rewards, which are distributed proportionally based on the user’s share of the liquidity pool.
4. How do liquidity pools work?
The way a liquidity pool is created on a DeFi platform is that users and those interested in staking their currency deposit two different tokens into a smart contract. The smart contract thus facilitates trades between the two tokens using an automated market maker algorithm.
Smart contracts have different protocols based on the different DeFi platforms. Based on the protocols, the traders get different rewards for providing liquidity.
Benefits of yield farming
Yield farming in crypto began in the second half of 2020 and since then many yield farmers have earned good returns on their investments in the form of Annual Percentage Yields (APY) because yields are usually measured in percentages. Apart from high returns, some of the benefits of yield farming are as follows:
1. Experimentation with new DeFi projects
Yield farming in crypto incentivizes new and old users to try DeFi, and its protocols, invest and stack their currencies, and then see for themselves how they like the whole experience. This also leads to more and better innovations in decentralized finance systems.
2. Stable cryptocurrency markets
Yield farming essentially deals with users and investors stacking their currencies and holding them for a prolonged period of time. When this happens for different currencies, the market for cryptocurrencies becomes more stable. This is also because investors won’t be selling their currencies for a long time.
Flexibility is something that is usually discussed in cryptocurrencies. As you know, yield farming is done on DeFi platforms which usually deploy smart contracts for it. These smart contracts have protocols that are flexible.
This means that if you want to be a dark horse of yield farming, you can bear the risks and stack your assets for as long as you want or if you feel there is too much risk, you can withdraw your holdings and reclaim them. You are not obliged to hold your currencies for a certain period of time.
Types of yield farming 🌾
- Liquidity provider: Users deposit two currencies to a DEX to act as a liquidity provider for trading. To switch the two tokens, exchanges levy a nominal fee that is given to liquidity providers. Sometimes, fresh liquidity pool (LP) tokens can be used to pay this cost.
- Lending: Coin or token owners can use a smart contract to lend cryptocurrency to borrowers, earning yield from the interest that is charged.
- Borrowing: Farmers may borrow another token by pledging one as security. The borrowed cash can then be used to increase farming productivity. In this manner, the farmer retains their initial investment, which may rise in value over time, and earns return on the coins they borrowed.
- Staking: In the universe of DeFi, there are two types of staking. The primary implementation is on blockchains using proof-of-stake, where a user receives interest in exchange for pledging their tokens to the network as security. The second is to stake liquidity pool (LP) tokens obtained by providing liquidity to a decentralized exchange. Because they are compensated for providing liquidity in LP tokens, which they may later invest to earn more interest, this enables users to earn yield twice.
Yield farming vs. staking – a comparison
One of the most asked questions is about the differences between yield farming and staking as in principle, both have more-or-less the same method but their works vary from each other and make them two different forms of investing and earning returns on it.
|Purpose||Earning high returns by providing liquidity to DeFi protocols and receiving rewards in the form of tokens||Holding a certain amount of cryptocurrency to support the network and receive additional tokens|
|Risk factor||High-risk factor due to market volatility||Comparatively low-risk factor due to market volatility|
|Participation||Usually requires shifting investments and making moves based on market conditions||Doesn’t require much movement as it takes more of a passive approach|
|Rewards||Rewards tend to be higher but are less predictable and also more dependent on market conditions||Rewards tend to be lower but are more predictable and comparatively less dependent on market conditions|
Platforms for yield farming in crypto
There are many platforms for yield farming in crypto but some of the common and most used ones are as follows:
Essentially allowing users to make decentralized trades, UniSwap – founded by Hayden Adams – is a decentralized exchange (DEX) platform that also offers liquidity pools.
Similar to UniSwap, SushiSwap is more community-driven and it offers liquidity pools. The rewards that the users get for providing liquidity to SushiSwap are generally in the form of Sushi tokens.
Lending and borrowing are also types of yield farming and liquidity pools. Aave is a DeFi platform that allows the lending and borrowing of different types of cryptocurrencies. Users can also provide liquidity to the Aave protocol and earn rewards in the form of AAVE tokens.
Compound is a lending and borrowing protocol in crypto and it majorly deals with interest on holding cryptocurrencies.
Risks of yield farming
While there are a lot of different benefits of yield farming, there are some risks associated with it as well which aren’t negligible unfortunately. Here’s a list:
1. General losses
Token values in a liquidity pool are relative to each other. When these values change, the tokens can suffer when withdrawn from the pool. This may incur losses to the user withdrawing the tokens.
2. Liquidity issues
While liquidity can be, at times, the very reason users provide liquidity using their hard-earned currencies, some platforms may not allow quick withdrawal of currencies and may charge extra fees or penalties on withdrawing the assets without letting them sit for some time.
3. Market volatility
Market volatility is yet another risk in yield farming. This is primarily because the crypto market can be a little extra volatile affecting users’ investments and can lead to liquidity providers incurring losses.
In conclusion, yield farming is a relatively new method of earning returns on cryptocurrencies and it has different and unique methods of incentivizing users. DeFi and DEX may revolutionize the centralized finance systems if all goes well.