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    What Is Yield Farming & How Does It Work?

    Updated: Aug 3rd, 2022
    Kevin Groves
    Kevin Groves
    What Is Yield Farming & How Does It Work?

    One way to make money in the decentralized finance (DeFi) economy is to use the process of yield farming. If you have crypto assets, you can stake them or lend them out to others in order to receive a return. This can be one way to put your digital assets to work on your behalf and is called yield farming.

    But what is yield farming and how can you make it work for you? This article will take a closer look at what yield farming is, how it works and why it has become an attractive investment strategy for investors to earn additional crypto.

    What Is Yield Farming?

    Yield farming is a popular method for investors to maximize the returns on their cryptocurrency coins or tokens by leveraging decentralized finance systems. Crypto owners can deposit assets to provide liquidity for cryptocurrency exchanges for others to lend, borrow and exchange for other coins. In return, they will receive a return in the form of interest paid back or a portion of user's trading fees. The earnings are paid in the native cryptocurrency that allows the owner to accumulate more coins and tokens for their portfolio.

    Once the asset owner receives the additional coins that can be staked or lent out. It’s also possible to exchange them for another token, coin or fiat currency while stored on the exchange. By locking cryptocurrency tokens into a pool, and allowing them to be used for various purposes, an investor has the ability to earn income on these assets that are typically higher than a traditional savings account with a bank.

    Is Yield Farming The Same As Lending?

    The concept of yield farming is similar to traditional finance which involves providing liquidity that is used for other products and services. When a person deposits money into a bank account, they earn interest as a reward for providing the bank with liquidity. The bank then uses the money to invest and offer customers products with higher interest rates and fees to repay the interest owing and profit from the difference. This is a similar process to yield farming, however, the bank is replaced with a cryptocurrency exchange, decentralized exchange or DeFi protocol.

    How Does Yield Farming Work?

    Yield farming can be carried out using a reputable yield farming platform that can comprise of centralized crypto exchanges or decentralized providers. Essentially, both methods involve two components that are the liquidity provider (i.e. an investor that owns crypto) and a liquidity pool (i.e. a crypto exchange or DEX).

    Using a cryptocurrency trading platform, the investor delegates their crypto assets to combine in a liquidity pool. The liquidity pool contains deposits from various persons that are then used by others to lend, borrow or exchange tokens. When another party borrows or uses funds from the liquidity pool, they will incur fees that are paid to the liquidity provider. The distribution of the interest or fees earned is based on the allocation of funds provided to the pool.

    Depending on the platform with the liquidity pool, it’s possible to receive pay-outs in tokens on a regular basis. Some platforms payout each day, while others compound daily but might only distribute the rewards once a week or month. The image below shows the liquidity pools available on the crypto trading platform, Binance.

    Binance liquidity poolBinance liquidity poolOverview of the available assets in the Binance liquidity pool.

    Is Liquidity Pool Farming Different To Yield Farming?

    For those that prefer using a DEX, liquidity pool farming is similar to yield farming. However, the person will provide liquidity to a decentralized exchange (DEX) instead of a centralized platform for others users to swap their tokens. When an individual deposit their tokens, they are referred to as a liquidity provider. The tokens are held in a liquidity pool governed by a smart contract. A yield farmer commits tokens to the pool and this provides liquidity so that the DEX can operate smoothly.

    Related: The best crypto decentralized exchanges to earn yield.

    In some cases, liquidity pools can fund lending and borrow on the exchange. Liquidity providers receive a portion of the fees generated when people exchange the involved tokens on the exchange. The return received from keeping coins in the pool is expressed as an annual percentage yield (APY), similar to what investors see when receiving returns from a savings account. However, the returns are often much higher with yield farming than with a traditional bank.

    How Are Yield Farming Returns Calculated?

    Yield farming offers greater returns than traditional financial institutions such as banks. It is relatively common to see yield farming tokens with returns above 100% per annum. The reason for the high pay-out is due to the compound interest that can be earned.

    The return for a yield farming product is calculated using the estimated performance over a 52 week period, which will either include or exclude the gains as a result of compounding. Returns that do not include compounding are represented as Annualised Performance Rate (APR). Rates with compounding are generally reflected as APY. It is important to understand the difference between APR and APY when finding a liquidity pool and that the figures are estimates only and can change at any time.

    The APY for yield farming can be calculated using the formula:

    APY = (1 + r/n)n - 1

    • r = listed APR of the asset
    • n = compounding periods during the year

    If a liquidity pool offers an APR of 15% and compounds every day (365 times), the equation is as follows:

    APY = (1 + 0.15/365)^365 = 1.16%

    An investor who added 20,000 tokens to a liquidity pool would, at the end of the year multiple the original 20,000 by 1.16. The individual would have 23,200 tokens or 3,200 more tokens than they had to begin with.

    Overall final returns also take into account the price of the cryptocurrency, and whether the token has increased in value since the investor delegated the coin in the pool, or lent it out to someone else.

    If an investor’s tokens had a value of $0.50 each when they added them to the pool, but the tokens are worth $5 at the end of the year, that represents a much larger gain. The original tokens were worth $10,000 when added to the liquidity pool. After a year, that original investment is worth $100,000. Next, the investor considers the 3,200 tokens received over the course of the year. These are worth $16,000. The total gain over the course of the year would be $116,000 - $10,000 which equates to $106,000. This represents a 1,060% increase on the initial capital outlay.

    Are There Risks With Yield Farming?

    While there are benefits of providing liquidity and earning higher than average returns, there are several risks involved in yield farming that should be researched as part of a due diligence process. Some of the common risks associated with farming yield in liquidity pools include:

    • Fraud. Not every DEX, token, or liquidity pool is legitimate. An investor might be invited to a project, only to stake their tokens in a pool that is taken by individuals behind the exchange or protocol.
    • Cyber theft. Depending on the situation, there might be vulnerabilities in the software used to manage assets. Someone could potentially hack in and steal others’ digital assets. Another concern is if a user reveals their keys, allowing for someone to access the wallet and steal crypto assets.
    • Regulation. Crypto assets and exchanges are relatively new and faced with uncertainties and risks associated with Governments and regulatory bodies. Depending on how these assets are regulated in the future, a liquidity provider's funds could be frozen if the exchange was locked-down by the authorities.
    • Buggy contracts. Liquidity and yield farming mainly rely on smart contracts for execution. As the transactions are stored in DeFi blockchain protocols, any bugs in the code can pose problems that can cause the platform or a protocol to have downtime or be vulnerable to hackers. This was the case for Compound, which suffered one of the biggest DeFi hacks due to an incorrect piece of code wrongly distributed over $150 million worth of native COMP tokens.
    • Frozen assets. Depending on the situation, a liquidity provider's assets could be locked up. An investor can’t withdraw or exchange the funds as it’s being used elsewhere. Many liquidity pools allow investors to withdraw their share of the pool at any time. However, as long as a yield farmer wants to earn a return, the tokens must remain in the pool. When an investor lends assets, they won’t have access to the tokens until they’re returned, or until they begin receiving loan payments in the agreed-upon token.
    • More participants. Because yield farming can be so lucrative, it has the potential to attract more participants. The more people who join a liquidity pool or get involved in some other way, the more diluted an investor’s return will be. If there are 10 people providing liquidity in a pool, the user fees will be split 10 ways. However, if that pool rises to 20 people, then the user fees are split even more ways, with each investor’s share decreasing.
    • Price volatility. Tokens are volatile in price, changing regularly. If the price of a token moves higher, an investor sees a much bigger return. However, if the price drops, an investor might still have many tokens, but they might not be worth as much. For example, if, instead of the price of the tokens in the above example rising, they dropped to $0.15, the investor would still have 23,200 tokens, but they’d be worth $3,480. With an initial investment worth $10,000, that represents a loss of 65.2%.
    • Impermanent loss. This situation describes what happens when a liquidity provider could have made more money by simply selling their tokens on the market. However, this is usually temporary, based on price fluctuations.

    What Are The Most Popular Yield Farming Protocols

    Yield farming makes use of a variety of protocols that offer rewards and incentives for providing liquidity. In many cases, a yield farmer can expect to receive the associated token as an interest payment. Additionally, some protocols divide user fees among liquidity providers on top of offering an interest payment. Here are the most well-known protocols for individuals to participate in and earn a return for providing liquidity.

    1. UniSwap

    UniSwap is a Decentralized Exchange (DEX) that allows anyone to swap any ERC-20 token. It’s even possible for those in the blockchain ecosystem to launch their own tokens on Uniswap. However, it’s important to note that those providing liquidity must stake both sides. So, if there’s a liquidity pool of ETH/UNI, a participant would need to stake about ETH and 1,143 UNI (at the time of writing) to ensure that the liquidity pool retains its 50/50 ratio. Uniswap offers a portion of the transaction fees, in proportion to a provider’s position in the liquidity pool, as well as UNI governance tokens as rewards to participants.

    2. Compound

    Compound is a decentralized finance protocol that operates on the blockchain. The purpose of the protocol is to allow individuals to lend and borrow assets. The algorithm adjusts the compound interest rate that lenders receive as a result of letting others use their crypto. On top of receiving a return in the form of interest from borrowers, lenders also receive rewards in to form of the COMP governance token.

    3. Aave

    Aave is another lending and borrowing protocol on the blockchain that is decentralized in nature. In order to participate, a lender first needs to convert their assets to Aave and lend using that token. Then, lenders receive interest and payments in Aave tokens as a form of return.

    4. Curve Finance

    For those interested in less volatile pricing, Curve Finance is an Ethereum-based protocol that offers a decentralized platform based on exchanging stablecoins and wrapped assets (like wrapped Bitcoin). There’s low slippage with this exchange, as well as relatively low fees. Stablecoins such as Tether and GUSD are pegged to a specific asset, the values aren’t as volatile compared to other DeFi protocols.

    5. Yearn Finance

    Rather than just limiting potential yield farmers to one place for their tokens, Yearn.Finance uses an algorithm to compare various protocols and determine where an investor is likely to get the best yield. An investor can join Yearn.Finance, decide which assets to use, and the algorithm will determine where the assets will earn the highest yield.

    Frequently Asked Questions

    Yield farming can be a profitable investment strategy for investors that delegate their assets for a long period of time. The returns for deposit crypto assets into a liquidity pool can be as high as 100% APY, however, the pay-outs can vary in frequency. Moreover, farming yield has several risks that can reduce profitability, or even result in total loss of funds.

    Decentralized finance is a relatively new market that has attracted new money to earn passive income. The high yields can be associated to several reasons such as market inefficiencies, lack of regulation, greater demand for DeFi lending and borrowing products and an influx of speculators taking bigger risks to earn above average pay-outs.

    Staking is the activity of delegating Proof-of-Work (PoW) coins to a staking wallet, exchange or pool to validate transactions to earn staking reward. Yield farming is different as it's involves lending and borrowing funds using a decentralized finance protocol to earn interest or portion of trading fees.

    Conclusion

    Yield farming is an excellent way to earn additional crypto while taking advantage of the long-term appreciation in tokens over time. Individuals that participate in yield farming have the potential to earn very high returns, as long as they are willing to shoulder the risks. All investors should carefully research their strategies and options and invest in ways that align with their own portfolio strategy and risk tolerance.

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    Kevin GrovesKevin GrovesKevin Groves

    Kevin started in the cryptocurrency space in 2016 and began investing in Bitcoin before exclusively trading digital currencies on various brokers, exchanges and trading platforms. In 2019, he started HedgewithCrypto to publish informative guides about Bitcoin and share his experiences with using a variety of crypto exchanges around the world.

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