all articles

What Is Yield Farming And How Crypto Farming Works?

January 16, 2023
12
min. read

What is yield farming crypto investment?

What is crypto yield farming and how yield farming works?

Yield farming refers to the process of earning income by providing your digital assets to a DeFi project. In this context, the funds coming into the project from users are commonly referred to as liquidity, attracted to the so-called liquidity pools, thanks to which such projects provide interaction between users. 

What is yield farming crypto investment? On centralized exchanges (CEX), customer funds are stored on the exchange itself, but this contradicts the very essence of decentralized finance (DeFi), which means that it requires other mechanisms for conducting trades and other forms of financial transactions. In order for a decentralized exchange to offer market trading in a pair of assets to its clients, it needs to attract this pair of coins to the liquidity pool, otherwise there would be no assets to conduct even a single transaction with this pair. This is done by investors on very favorable terms.

What is yield farming?

Yield farming in DeFi is somewhat similar to a bank deposit in conventional finance. By transferring their money to the bank, the user earns interest. However, there are different types of fundraising incentives in DeFi. Imagine that the bank not only pays you interest, but also issues you a promissory note (bank IOU), which is accepted as an asset by other banks. You can go to the next bank and pawn this asset there, and also receive interest income for it and maybe receive another asset, etc.

The bottom line is that in DeFi, as the protocols interpenetrate each other, the investment opportunities are much more extensive than in the traditional financial system, the profitability is higher, but at the same time the risks are higher. Let's look at yield farming in more detail. Our next stop is crypto farming explained.

How yield farming works

Conditionally, yield farming comprises income from staking, and from providing liquidity to lending protocols and liquidity pools. As a rule, any DeFi project is most profitable in the very first days of its existence, since liquidity pools are practically empty and the rewards are distributed among a narrow circle of early investors. At this time, the yield can reach thousands of percent. Then, as the number of participants grows, profitability decreases to normal values - in DeFi it is 10-20%, sometimes up to 50%, but in such cases we advise to take a closer look at the project and try to understand what the reason is and whether it exists at all.

How yield farming works with staking

Formally, staking is not a type of yield farming, but as of now, no clear system of categories and terms has emerged in DeFi in particular and in Web3 in general, so in some publications it is referred to as part of crypto farming

It is important to understand what kind of staking we are talking about here. If you mean staking cryptocurrencies (e.g., Ethereum), then really yield farming has absolutely nothing to do with it. But if by staking we mean the staking of tokens, i.e., their blocking in the liquidity pool of a project, then why not? This can well be called yield farming, since users receive passive income by providing the DeFi project with liquidity. In this case, it is more correct to call it "DeFi staking".

Crypto farming explained through DeFi staking

Let's examine staking as yield farming on the example of the Minto DeFi project. Minto is a mining farm with tokenized hashrate, which allows project token owners to use them for Bitcoin mining instead of buying physical mining hardware of similar mining power. 

In order to start Bitcoin mining, Minto users purchase hashrate tokens on a decentralized exchange (100 BTCMT = 1 TH/s), stake them (on Minto liquidity pool), and receive daily mining rewards in Bitcoins in proportion to invested funds as a result. 

Thus, BTCMT hashrate token staking is a Bitcoin farming tool for users, while the project itself is engaged in physical Bitcoin mining on a real-life mining farm and thereby infrastructurally provides a respective financial service in DeFi.

In simpler cases, when a DeFi project has no underlying physical assets, but is able to offer a high-quality idea, staking its own tokens is used to raise funds for the project development. Entrusting their funds to such projects, users act at their own risk. However, if the concept is really good and the project team implements it in the best way, the price of such a token can grow tens or hundreds of times, and investors will be rewarded with both staking income and token growth.

How yield farming works with lending

Lending protocols are projects where users can borrow and lend funds. It’s similar to a bank that attracts customer funds and issues loans, profiting from the difference in interest rates.The same thing is possible in DeFi, however, due to the absence of a central repository, other algorithms are in place.

Of course, lending protocols work only with collaterals, sometimes multiple. Nevertheless, there are many situations when such a financial service can be useful. Let's say you are in need of a certain stablecoin; meanwhile, your portfolio is filled with cryptocurrencies and tokens and you’re hoping for them to rise in price very soon. You can simply sell part of your assets for this stablecoin and lose part of the estimated profit, or you can borrow the stablecoin secured by your asset, and then simply return everything to the way it was before. 

You pay the lending protocol a commission for funds received and don't lose any profits if that growth really occurs. The opposite transaction is the lending of funds to the lending protocol for a fee, which is one of the yield farming options for the user. Also, margin farming can be singled out as a separate direction, i.e., farming using leverage, when the user can multiply the income by a multiple increase in risk.

How yield farming works with liquidity pools

When it comes to yield farming and liquidity pools, we are usually referring to projects that use so-called automated market makers (AMM).

AMM is a mechanism for automatic price regulation in DeFi, where the parties to a purchase/sale transaction are not two users (buyer and seller, as on a regular exchange), but a user and a liquidity pool. 

The thing is that in decentralized finance it is very difficult to ensure trading, unlike on a centralized platform with its order books, depth of market, central storage, etc. On the one hand, there is the problem of blockchain bandwidth, on the other hand, decentralization itself. Therefore, when making a transaction on a decentralized exchange, you are actually conducting it with a liquidity pool, rather than with another client. In other words, in DeFi, the buyer does not need a seller, and the seller does not need a buyer: everything is determined by the sufficient amount of assets in the liquidity pool, where assets are typically attracted by trading pairs. The larger the pool, the more liquid the trades.

Liquidity pools are filled with users who want to earn on yield farming. The leading decentralized exchanges have no problems with liquidity, moreover, they can provide it in the precise pairs they want, thanks to a flexible incentive system. One of these incentives is the issuance of so-called LP tokens or tokens of liquidity providers, which refer to the users who have entrusted their funds to the liquidity pool.

LP tokens are a kind of promissory notes, which in turn can also be pledged with interest in other DeFi projects. Thus, by engaging in yield farming in liquidity pools, it is possible to build very complex and multi-stage investment strategies, which on their own would increase profitability along with risks.

This type of yield farming is also called "liquidity mining", since it results in LP tokens (i.e., liquidity tokens) being issued to users as debt receipts. Liquidity farming crypto investments in large well-known projects have the least risks.

How AMM works

Let's say there was 1 ETH and 1600 DAI in the pool (50:50 in value). After the purchase of 100 DAI, 1500 DAI remained in the pool, but a little ETH was added, for which these 100 DAI were bought. Accordingly, before the transaction 1 ETH in the pool was worth 1600 DAI, and after - 1.0625 ETH became worth 1500 DAI (50:50 in value is a constant for the pool). That is, the value of ETH has dropped, and DAI has risen in price. This serves as an excellent incentive for people engaged in arbitrage, i.e., equalizing the exchange rates of assets on different platforms, buying cheaper in one place and selling at a higher rate in another place. Thus, the balance in the ETH/DAI pair is leveled. 

The same thing happens if the ETH/DAI exchange rate has shifted on other platforms, but remains the same here - the resulting imbalance is compensated by the activity of arbitrageurs in the opposite direction. Today, arbitrage operations are mainly carried out by bots, i.e., specially written programs, so everything happens almost instantly.

What is impermanent loss

Impermanent loss in yield farming is a risk arising from exchange rate fluctuations:

  1. Let's say you add 1 ETH и 1,600 DAI (1 DAI = $1) to the pool, which constitutes 10% of the entire pool. That is, there are 10 ETH x 16,000 DAI = 160,000 coins in the pool (constant).
  2. Let ETH rise to equal 2500 DAI. 
  3. Due to the resulting price imbalance, arbitrageurs increase the amount of DAI and reduce the amount of ETH in the pool, so that their prices are equal to external prices. The total number of coins should remain the same - 160,000.
  4. Now there are 8 ETH x 20,000 DAI = 160,000 coins in the pool, where 1 ETH = 2,500 DAI.
  5. 10% of the pool that was invested turned into 0.8 ETH + 2,000 DAI. Their value was 4,000 DAI (or $4,000) against $3,200 invested. $800 was earned.
  6. However, if these funds had just remained in the wallet, they would now be worth 2,500 DAI + 1,600 DAI ($4,100). Thus, impermanent loss amounted to $100.

The loss is called impermanent since it is fixed only after the withdrawal of invested funds. In other words, as long as the funds are in the pool, the rate can bounce back, there will be no impermanent loss, and the investor earns only yield farming rewards.

Benefits of yield farming

The main advantage of yield farming compared to financially successful projects is its high profitability with minimal effort. Invested tokens or cryptocurrency farming provide you with returns above 10%, which is a rare find in traditional markets. Yield farming is the golden mean between profitability and risk.

Even if passive strategies like crypto farming seem boring to you, and you prefer aggressive trading, there are always times in the market when you shouldn’t trade. Yield farming is the safe haven to ride out market uncertainty.

Is yield farming safe?

The security of yield farming directly depends on project quality - its popularity, interface, team qualifications, etc. In yield farming, there is a term "rug pull", when a fraudulent project attracts liquidity and then disappears. Also, projects can use unaudited low-quality smart contracts, because a pool is a smart contract that can be hacked, and all funds withdrawn.

Even fairly successful projects may contain vulnerabilities that may lead to loss of funds - it’s a staple of crypto industry news. Nevertheless, there already are many proven DeFi projects, with which you should start your acquaintance with yield farming.

Is crypto yield farming profitable?

The terms APR and APY are typically used to assess profitability in yield farming. APR is the annual percentage rate, APY is the same with compound interest (i.e., assuming reinvestment of income in the same project). While a bank’s APR or even APY is a constant value simply because the value of money changes relatively slowly, in DeFi, APR or APY can only be calculated after the fact. The APR or APY values that you see in a particular project reflect the past period, but do not guarantee the same profitability in the future (in both directions). In addition, the projects themselves often tend to overestimate their profitability data.

Therefore, in DeFi, the choice of a suitable project for yield farming is fraught with uncertainty. 

Nevertheless, yield farming is undoubtedly profitable, and billions of dollars worth of digital assets blocked in DeFi pools speak about its attractiveness.

Yield farming protocols you to know about

Aave

Aave is a popular open-source lending protocol where you can borrow and lend funds, earning through yield farming.

Aave is a popular open-source lending protocol

Aave charges minor fees for all types of transactions. The Aave governance tokens are used as an incentive: you can vote on the development of the project and earn on its staking. The Aave token is traded on many major exchanges and is in the top 50 by market cap.

Compound

The open-source Compound lending protocol was the first to offer liquidity mining of the COMP token as an incentive to work with the platform. On the wave of success, the COMP token grew tenfold, and other platforms had to catch up and implement this idea in their projects. Despite the fact that the COMP token popularity is not as high as before (it is in the second hundred by market cap), the Compound platform is very popular and offers relatively high returns.

You can estimate Compound and Aave profitability using the DefiLlama service:

The open-source Compound lending protocol

Uniswap

Uniswap is one of the better-known decentralized exchanges with the UNI governance token, which is in the top 20 by market cap. Uniswap is a kind of flagship of the crypto industry, the first DEX where the idea of an automated market maker was implemented. Initially, the exchange was supposed to be called Unipeg (Unicorn + Pegasus), but courtesy of Vitalik Buterin it got the name by which we know it today. Uniswap also became the first decentralized exchange to overtake the centralized Coinbase exchange in terms of trading volume.

In the first Uniswap version, assets could only be exchanged for Ether, but now the interface allows you to exchange “anything for anything”. At the beginning of 2023, a decision was made to deploy the exchange protocol on the BNB Chain.

Curve Finance

Curve is a decentralized exchange with billions of TVL (the volume of locked funds in liquidity pools), which shares the first place in popularity with Uniswap. Curve provides a simple interface for performing operations with cryptocurrencies and tokens and for adding liquidity. Along with Uniswap, yield farming has the least risks in terms of project stability when working with Curve.

Yield Farming: FAQ

Is yield farming risky?

Yield farming is less risky than crypto trading, but requires more careful preparation when choosing a farming project. Trust only well-known projects and limit the risks in case of atypically high returns. Some projects that attract funds may turn out to be fraudulent, some may close down for natural reasons. Also consider regulatory risks that may affect the DeFi industry as a whole.

Is yield farming profitable?

Yield farming is certainly profitable, and at the early investment stages in some projects, you can earn thousands of percent in the first days. However, on average, the profitability of yield farming is 10-20%. When investing in more profitable projects, you should carefully manage risks, and the higher the advertised yield, the more you should limit your investments.

Is yield farming a good investment?

Yield farming is a good investment in your portfolio, since investing in high-quality projects brings good income and is the least risky. A reasonable combination of crypto trading and yield farming is the best strategy in DeFi, if you correctly assess the risks of investing in different projects and skillfully combine them.

Read more articles