Are you looking to maximize your earnings in the booming decentralized finance (DeFi) industry?
If your answer is “yes”, then we have some good news to share. However, you need a high risk appetite to achieve great (potential) returns with this strategy.
In this article, we will explore yield farming, one of the most popular, profitable, and also the most complex and riskiest activities in the DeFi space.
Let’s dive in!
Table of Contents
- DeFi Lending and Staking
- Automated Market Makers (AMMs), Liquidity Pools, and LP Tokens
- Yield Farming Rewards
- DeFi Yield Farming Example
What Is Yield Farming?
In the simplest terms, yield farming refers to the DeFi activity in which you make more crypto with your digital assets.
While this sounds great, it’s not as easy as it may first seem. On the contrary, yield farming is one of the most complex ways to earn crypto in the decentralized finance space.
Sometimes referred to as liquidity mining, yield farming involves moving around your funds across multiple DeFi protocols where you stake, lend, and even borrow stablecoins against your digital asset holdings to reinvest them and maximize your returns.
Most yield farming strategies (and also the most profitable ones) are rather complex and involve increased risks for farmers (more on this later).
That said, there are also simple yield farming strategies that only involve supplying liquidity to a DeFi protocol’s pool to facilitate efficient trading on the platform while earning a combination of transaction fees and token rewards in exchange.
Later on, we will explore an example of a yield farming strategy to better understand our topic.
How Does Yield Farming Work?
Now that we have discussed the basics of yield farming let’s see how DeFi’s favorite crypto-earning activity works in practice.
Since our topic is super complex, we will take a look at the most important yield farming-related components and processes one-by-one in this section.
DeFi Lending and Staking
To start, it’s important to explore cryptocurrency lending and staking via DeFi protocols.
As a recap, DeFi refers to the collection of financial products and services that allow users to borrow funds, earn money, and trade assets in a decentralized, open, democratic, and permissionless way. Simply put, DeFi offers users the decentralized alternatives of financial solutions found in the traditional finance industry at providers like banks, brokers, and insurance companies.
One of the most important components of decentralized finance is smart contracts, digital agreements between parties that automatically enforce and execute pre-agreed rules.
For DeFi protocols, smart contracts allow them to operate in a non-custodial way, which means that the services do not hold your funds on your behalf. Instead of depositing coins in centralized wallets to use a solution, you have to connect a compatible wallet and send money into a smart contract. This way, you have full control over your wallet’s private keys without the ability of the service provider to access your funds.
Now, let’s take a look at crypto lending and staking, two widely popular activities in DeFi that are often included in yield farming strategies.
Staking is a practice in which you lock up your tokens for a specific time in your wallet to support a particular blockchain network or DeFi protocol. For blockchains based on the Proof-of-Stake (PoS) consensus mechanism and its variants, validators are required to stake the native token to validate blocks and verify transactions. In exchange for securing the network, stakeholders earn staking rewards.
In terms of DeFi, many protocols have implemented staking as a mechanism to reward liquidity providers (LPs) for contributing tokens for a trading pair (e.g., DAI/ETH) in a pool. While this doesn’t involve any block validation, you support the DeFi solution’s ecosystem (facilitating enhanced token swaps by providing liquidity) and earning rewards in exchange. Many yield farming strategies include this type of staking to generate a passive income.
On the other hand, DeFi lending protocols allow borrowers to access extra capital (usually in stablecoins) by using their cryptocurrencies as collateral (e.g., deposit ETH as collateral to borrow DAI or USDT). At the same time, lenders can generate a passive income by depositing stablecoins in a pool and earning interest after their coins (and allowing other users to borrow them).
Since crypto lending is overcollateralized (e.g., you can only borrow $60 of DAI after your $100 worth of ETH holdings) at DeFi protocols, the lenders’ funds are protected against non-paying borrowers or defaults.
In terms of yield farming, many farmers utilize lending pools to earn extra yields on their tokens or borrow stablecoins against their crypto holdings to reinvest them via DeFi solutions.
Automated Market Makers (AMMs), Liquidity Pools, and LP Tokens
While staking and crypto lending are secondary activities in yield farming, such strategies usually center around automated market maker (AMM) protocols and liquidity pools.
In a nutshell, AMMs are supercharged decentralized exchanges (DEXs) that provide a viable solution to the liquidity problems of DEXs. To achieve that, the protocols allow users to create liquidity pools for specific trading pairs (e.g., DAI/ETH).
In these pools, liquidity providers (LPs) contribute both tokens of the pair with a 50/50 ratio based on the current exchange rate between the two coins (e.g., 1 ETH and 2,500 DAI). In exchange for supplying liquidity, LPs receive the trading fees of a pool proportional to their share.
Most importantly, after they deposit cryptocurrencies in a pool, liquidity providers receive LP tokens. Automatically generated by the platform, LP tokens represent a user’s share in a pool (e.g., if you possess a 10% share in the DAI/ETH pool, you receive 10% of the DAI-ETH LP tokens). To withdraw the digital assets contributed to a pool, liquidity providers can redeem their LP tokens at any time.
With LP tokens, AMMs do not have to hold the cryptocurrencies liquidity providers have supplied to pools, which allows them to operate on a non-custodial, decentralized basis.
Since LP tokens are not locked, liquidity providers can utilize the same tokens multiple times despite having already used them to supply coins into a pool. Simply put, this means you can move your LP tokens around multiple DeFi protocols to stake them, use for governance, lend them to others, and borrow funds. Basically, LP tokens are like shares and you can do lots of things with them and it wont affect the liquidity it represents.
As you can see, this opens up numerous opportunities for yield farmers to leverage their LP tokens to maximize their returns with DeFi.
Yield Farming Rewards
Most DeFi protocols calculate yield farming rewards annually.
It’s important to note that, while DeFi rates are annualized, they are solely estimates based on a pool’s or a protocol’s stats and data.
Furthermore, yield farming rates change rather frequently (often daily), which means that you have to regularly monitor your strategies and the platforms involved to stay updated with the performance of your coins.
To calculate yield farming rewards, DeFi protocols commonly utilize two metrics: Annual Percentage Rate (APR) and Annual Percentage Yield (APY). The difference between the two is that APY takes compounding interest into account while APR doesn’t. Simply put, compounding interest refers to the practice of reinvesting your profits to enhance your returns.
That said, you should be aware that DeFi protocols may use the two terms (APY, APR) interchangeably.
In terms of rewards, it’s important to mention that (viable) yield farming strategies are usually the most profitable when fewer people are utilizing them. After more farmers identify the same opportunity, the tactic will likely provide lower yields than previously due to the increased usage. This is the reason why most farmers refuse to share their strategies with others so they can maintain their profitability.
Earlier, we have mentioned that yield farming is usually centered around AMMs where farmers can get LP tokens in exchange for supplying liquidity, which they can use for other activities to maximize their returns.
One of the reasons why this activity has become so popular is due to the native tokens of DeFi protocols, which projects usually distribute to liquidity providers as an incentive.
However, for LPs to receive those tokens, they have to contribute cryptocurrency for a coin pair and also stake their LP tokens in a separate pool. Locking their LP tokens for a specific time guarantees the protocol that they won’t remove liquidity from a pool until the lock period ends.
Yield farmers have taken advantage of this opportunity to “farm” the DeFi tokens of projects by staking their LP tokens. This way, they can receive both a share of the transaction fees in a pool along with the DeFi protocol’s cryptocurrency rewards.
Solana tip: One example of this is to add liquidity to the STEP-USDC pair on Step.Finance and then staking the LPs in a fusion pool on Raydium.Learn more about Step.Finance on AAX.
DeFi Yield Farming Example
Now, let’s see an example yield farming strategy to better understand our topic.
Suppose you are a farmer that seeks to enhance his returns on the DeFi lending protocol Compound Finance.
As you may know, Compound rewards users for both borrowing and lending coins on the platform by compensating them in native COMP tokens. Whenever you borrow or deposit coins, Compound will show you the borrow APY or the supply APY along with the distribution APY for each cryptocurrency, with the latter referring to the estimated yields of your COMP token rewards.
Let’s say that you deposit 1 ETH to the platform to borrow the stablecoin DAI. With a 70% LTV, this means you can get 1,750 DAI (based on the current ETH exchange rate of 2,500 DAI).
However, after borrowing funds, you realize that the borrow APY for DAI is higher (5%) than the distribution APY for COMP (10%). Since this means you can earn double the sum in COMP rewards than the interest you have to pay back after your loan, this presents an excellent yield farming opportunity.
As the next step, you reinvest your newly borrowed 1,750 DAI by becoming a lender on the platform. For that, Compound offers you a 3% supply APY along with a 7% distribution APY.
As a result, you make 175 DAI (1,750 DAI x 0.1) by lending out your borrowed coins in addition to a 125 DAI profit (2,500 DAI x 0.05) by cashing out the COMP rewards you received for borrowing DAI, achieving a 12% APY during 12 months.
As a side note, please keep in mind that we didn’t consider the changes in ETH’s and COMP’s prices as well as the APYs on Compound to calculate the returns.
How Risky Is Yield Farming?
While yield farming offers the ability for users to maximize their rewards, such strategies usually involve high risks.
However, how risky a yield farming strategy is based on several factors, such as:
- The number of cryptocurrencies and DeFi protocols
- The actual activities
- The cryptocurrencies used (stablecoins are considered the least risky options)
- The smart contracts of DeFi platforms
- Gas fees
- The reputation of the projects
- Your knowledge about DeFi, cryptocurrencies, and the actual protocols and activities you use in your strategy
Based on the above, the safest yield farming strategies involve only a few stablecoins invested throughout 1-2 activities on a single, reputable DeFi protocol that features audited smart contracts.
On the other hand, if you use numerous non-stable cryptocurrencies with smaller market capitalizations to generate returns across multiple, relatively new DeFi protocols with non-audited smart contracts, you will face much higher risks.
It’s crucial to mention the composability-related risks in DeFi. One of the main benefits of decentralized finance applications is that they can be easily integrated. Imagine each protocol as a Lego brick that is built on top of the others.
While this allows them to work with each other seamlessly, many DeFi protocols rely heavily on additional decentralized finance services to operate. For that reason, if one major protocol experiences a significant issue, it will likely affect several other DeFi platforms as well.
As a result, in addition to the actual protocols included in your yield farming strategies, you also have to know and trust all the other DeFi platforms they rely upon.
Learn more about Solana on AAX
In terms of yield farming risks, it’s also important to talk about impermanent loss. Almost exclusive to AMMs, impermanent loss occurs when the price ratio of a token pair experiences a significant change after a liquidity provider deposits the coins into a pool.
For example, while you deposited 2,500 DAI and 1 ETH in the DAI/ETH pool (with a total value of 5,000 DAI) to supply liquidity, the exchange rate between the two tokens changed to 5,000 DAI/ETH after a month.
In such a case, arbitrageurs will step in to add DAI to the pool and remove ETH to make a profit.
As a result, when you redeem your LP tokens, you will withdraw 0.5 ETH and 2,500 DAI. While your tokens are worth the same sum (5,000 DAI), you could have made better returns if you had kept holding your 1 ETH and 2,500 DAI (which would be worth 7,500 DAI with a 50% ROI after a month).
However, due to impermanent loss, your originally deposited coins generated zero returns.
That said, you still collected trading fees from the pool during the period, which can eliminate the impacts of impermanent loss in many cases. It’s also a great way to mitigate this risk by staking LP tokens to earn DeFi coin rewards.
That said, while you have to take impermanent loss into account, it only becomes dangerous when there are heavy changes in the price of a token pair and your returns from trading fees and other yield farming activities are lower than what you could have made by simply holding the coin.
The Yield Farming Market: Ethereum vs. Binance Smart Chain vs. Solana
By now, you know what yield farming is, how it works, as well as its risks. But which blockchain should you use for farming tokens via DeFi protocols?
As the original smart contract blockchain powering the DeFi boom, Ethereum has been serving as the dominant platform for yield farming for some time.
However, Ethereum has been struggling with limited scalability, which led to a rather heavy network congestion in the past few months. As a result, gas prices have increased significantly, making yield farming unsustainable for users with small or limited budgets.
For that reason, competitor platforms with much better scalability than Ethereum have gained traction, with Binance Smart Chain (BSC) becoming one of the leaders in this field.
According to DeFi Llama, BSC features a $17.43 billion TVL (total value locked), which is a key indicator to measure the performance and popularity of decentralized finance solutions. As a result, Binance Smart Chain quickly grew its DeFi market share to 15% as of June 9.
At the same time, while still operating in beta, the DeFi ecosystem of the highly scalable blockchain platform Solana is expanding rapidly.
Based on the analytics’ platform stats, Solana’s TVL increased from March 18’s $149 million to $876 million on June 9. While the project only has a market share of 0.75%, it also represents a nearly 500% increase in DeFi activity for Solana.
However, despite the increasing popularity of competitors, Ethereum still leads the DeFi industry with an $86.09 billion TVL and a 74% market share.
Yield Farming: a High-Risk Way to Enhance DeFi Rewards
With the launch of AMMs and the native tokens of DeFi projects, yield farming has become one of the most popular activities in the decentralized finance industry.
And for an excellent reason.
By leveraging complex strategies across multiple DeFi protocols, farmers can enhance their returns to generate a (potentially) great passive income.
However, if you want to increase your profits, it also means that you have to take more risks. And, based on several factors, yield farming is among the riskiest strategies to earn crypto in the DeFi space right now.
For that reason, it’s crucial to do your own diligence on the protocols involved in your strategy and invest only what you can afford to lose to ensure your funds’ safety.
We also recommend learning more about the core mechanisms behind crypto and DeFi, which you can do so by checking out the extensive collection of educational content on AAX Academy.