What is Yield Farming? – What It Is and How It Works

Our topic today says ‘Yield Farming’, a term that is greatly associated with DeFi.

Yield Farming is the way DeFi users maximize their return rates while making use of the DeFi products.

The whole idea is for DeFi users to earn tokens while using it.

So at the end of this post, you would have understood fully what and how Yield Farming works.

Let’s get to the next section to view the subheadings of this post.


Post Summary

The subheadings under which today’s post will be discussed are:

Clicking on any of the subheadings opens up to its details.

Let’s get started at once.


What is Yield Farming?

Yield Farming is a way of increasing the possibility of earning higher returns on DeFi protocols by leveraging on them.

Yield farmers do this by sandwiching between strategies especially the most profitable ones.

Once a strategy stops working, the farmers can either:

  • move their funds around to the one that works, or
  • swap some of their coins for another that is currently generating more yield

The procedure is what is called Crop Rotation in Yield Farming.

This way, the farmers never have to lose out on any coin with some strategies generating Annualized Percentage Yield(APY) of almost 100%.

This is unheard of in traditional finance where APYs are pretty much within 1 – 3%.

The elements that can be used to achieve this high yield are what I discussed in the next subheading.

Just scroll down.


Yield Farming Elements

Some of the Yield Farming elements include the elements of Liquidity Mining and that of Leverage.

Liquidity Mining

This is the process of distributing tokens to the users of a protocol.

One of the first DeFi projects that introduced liquidity mining is Synthetix. It started rewarding its users with SNX tokens.

This helped to add liquidity to the SETH/ETH pools on UniSwap.

Liquidity Mining has additional incentives for yield farmers because the coins earned are added on top of the yield that they already have.

Because of this, yield farmers are even willing to lose on their initial capital in other to earn more tokens from liquidity mining.

This now makes the whole strategy profitable.

A good example of this is the Compound platform that was giving higher rewards to users who were borrowing assets with the highest APY.

This incentivized farmers to borrow more of these tokens.

Leverage

This also makes ultra high returns possible.

It is the process of using borrowed money to increase the potential returns of an investment.

In Yield Farming, farmers can deposit one coin as collateral and borrow another coin.

They can now use the borrowed coin as further collateral to borrow even more coins.

By repeating this process, farmers can leverage their initial capital a few times over to make even more profit.

There you have the elements of Yield Farming listed.

Now, these elements can be used in various strategies.

Let’s check them out below.


Yield Farming Strategies

This is a set of steps that aims to help the yield farmers to generate high yield on their capital.

They include:

  1. Lending and Borrowing
  2. Supplying capital to liquidity pools
  3. Staking LP(Liquidity Provider) tokens

Find details on each below.

1. Lending and Borrowing

This is a simple way of getting high APY.

Farmers supply stablecoins like DAI or USDC to a lending platform and start earning interests on them.

Liquidity mining can be used here by farmers to earn more.

They can earn more Compound tokens by supplying them for lending and borrowing on the Compound platform.

They can leverage on them and earn more coins too.

2. Supplying Capital to Liquidity Pools

Yield farmers can supply coins to the liquidity pools in protocols such as Uniswap, Balancers, etc.

They are then rewarded with fees that are charged for swapping different tokens.

Liquidity mining also applies here. The farmers supply tokens to pools and get rewarded with extra tokens.

For example, Balancer rewards suppliers with the BAL token thus increasing their APY.

3. Staking LP Tokens

Some protocols incentivize users further by allowing them to stake their LP(Liquidity Provider) tokens.

This represents their participation in a liquidity pool.

For example, Ren, Synthetix, and Carif got into a partnership where users can provide WBTC, SBTC, and RENBTC to the CurveBTC pool.

In return, they receive Curve LP tokens as reward.

Now, this Curve LP tokens can be staked on Synthetix Mintr to earn CRV, BAL, REN, and SNX.

Now these strategies can also be used together to further maximize returns.

Note that these strategies can become outdated due to a change in protocol or incentive.

In such cases, you will find that something that is profitable this minute will become useless the next minute.

So it becomes necessary that you keep an eye on the strategy that is working and rotate crops when required.

Though very profitable, there are some risks one can come by when involved in Yield Farming.

Let’s discuss the details of that in this next section.


Risks Associated With Yield Farming

As is with every other venture, there are risks attached when you are involved in Yield Farming.

Some of the risks include:

1. Leverage Risks

The loans by farmers are over collateralized.

Hence, there is a possibility of liquidation if there is a fall in the price and interest rate of your initial asset.

Liquidation here can be in part or fully plus one can even get penalized for such acts.

To ensure this does not happen, you have to follow closely the price and interest rates.

This way, you will know when it rises or falls and take the appropriate action.

2. Smart Contract Risks

Here, you stand the risk of implementation bugs and design flaws in Smart Contracts, platform changes, systemic risks, regulation changes, etc.

This goes a long way to affect your earnings.

What one can do here is to purchase an insurance coverage on the Smart Contract with companies such as Nexus Mutual.

This way, you can be compensated should something happen with the Smart Contract.

3. Liquidity Pools Attacks

Yes…this happens!

These pools can come under attack and users funds will be greatly affected.

For example, the case with Balancer pools as reported on CoinDesk.

One needs to be careful when choosing pools. Be wary of pools that have their liquidity unlocked.

4. Hot Wallet Risks

Most times, wallets that are used for Yield Farming are mostly hot wallets e.g Metamask, etc.

If not properly secured, a users coin can be wiped off by hackers.

So always ensure you secure your wallet properly.

But with all these risks, what does the future hold for Yield Farming? Is it for keeps or not?

I answered that question in this very next section.


What Does The Future Hold For Yield Farming?

The future of Yield Farming is greatly tied with that of DeFi.

The DeFi concept is gaining grounds and so is Yield Farming.

This is largely due to the failures of CeFi(centralized finance) in various aspects.

And with the world going all digital and crypto, the advantage tilts more to the side of DeFi and consequently, Yield Farming.

The only challenge I see is that most DeFi projects are hosted on the Ethereum Blockchain.

This has posed critical challenges for DeFi users as they battle high fees and scalability because of transactions piling up.

But that too is being checkmated with the Ethereum 2.0 upgrade and the establishment of other platforms where DeFi projects can be hosted e.g Binance Smart Chain.

So, in all, I will say the future for Yield Farming is really bright.

Let’s head on to the Conclusion part so I can hear what you have to say.


Heads up!!

If you want to learn how to trade cryptocurrencies profitably, then enroll in our Crypto Trading Mastery Course by going to www.ctmastery.com.

You can also join our Telegram community at https://t.me/ctmastery.


Conclusion

That is all I have on Yield Farming for you.

Hope you enjoyed it?

In this part, I won’t bore you with another epistle. I will just drop few questions that you will help me answer and that is it!

So tell me:

Will you try out Yield Farming if you are not into it already?

And if you are a yield farmer, what has been your experience?

Do you have any fave coin or platform?

Have you encountered any of the risks? How did you deal with it?

Leave me your answers in the comment section below.

Have your own questions? Drop them in the comment section too.

Will be checking back to read through your answers and provide answers to all your questions.

And need I remind you to share this post? Okay, I just did!

Just use the buttons right below to share and one reader at a time, we will keep educating the world on crypto matters.

 
Follow me

Leave a Reply

This site uses Akismet to reduce spam. Learn how your comment data is processed.