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What is Yield Farming: A Guide To How It Works, Pros, Cons

Updated: Nov 6


What Is Yield Farming?


Think of Yield Farming like lending your money in a traditional savings account, except in this case, you’re lending your crypto assets. Instead of a bank, you’re interacting with a DeFi protocol built on a blockchain. These protocols are essentially platforms running on smart contracts that automate various financial processes, including lending, borrowing, and trading. The "yield" you farm refers to the returns you generate by participating in these activities.


This might involve:

  • Supplying your assets to liquidity pools on a decentralized exchange (DEX) like Uniswap

  • Lending out your crypto on a lending platform like Compound

  • Engaging in other more complex DeFi strategies that aim to generate maximum yield.

You could think of Yield Farmers as market makers since they contribute to the liquidity and efficiency of decentralized trading platforms.


How Does Yield Farming Work?


Let’s look at an example to break this down:


Imagine a DEX like Uniswap needs ample amounts of various cryptocurrencies available to process trades smoothly. They create a liquidity pool specifically for, let's say, Ethereum (ETH) and a stablecoin like USDC. You decide to provide liquidity by depositing equal values of both ETH and USDC into this pool. Congrats! 🥳 You’ve now become a liquidity provider.


When users trade ETH for USDC or vice versa using this pool, they pay a small transaction fee. These fees are then distributed amongst all the liquidity providers proportionally to their contributions. In addition to those trading fees, many DEXes will offer extra rewards for liquidity providers, usually in the form of the platform's native token.



Staking

Another way to participate in Yield Farming is through staking. This is more common on proof-of-stake (PoS) blockchains like Hedera, where instead of miners, validators secure the network. As an investor, you can stake your crypto assets to support a chosen validator and earn rewards in the form of new coins issued by the protocol.


Lending

Lending platforms, such as the popular Ethereum-based Compound, enable users to lend out their cryptocurrency. Those borrowing the assets pay an interest rate on the loans, and a portion of that interest goes back to the lenders—that's you, the Yield Farmer.


Risks and Rewards


While it sounds incredibly lucrative and easy, Yield Farming, like any investment, comes with inherent risks and the rewards can vary drastically.


  • Volatility and Impermanent Loss: The value of cryptocurrencies can fluctuate wildly, leading to substantial losses. A significant concern is the potential for "impermanent loss," particularly for liquidity providers on DEXs. This happens when the prices of the assets in a pool change dramatically after you’ve provided liquidity. You could end up losing more than if you had simply held your coins outside the pool.

  • Smart Contract Risks and Rug Pulls: As these protocols are often experimental and operate on unaudited code, they can be vulnerable to attacks. "Rug pulls" are unfortunately common. This is when developers suddenly abandon a project, draining all the funds locked within their contracts, leaving investors with nothing. There's even the risk that the underlying protocol may have a serious coding bug. Compound suffered a “one letter bug” which resulted in a 90M loss, resulting in rule changes as the DeFi market adapted.

  • Regulation and Sustainability: Regulation around Yield Farming and DeFi, in general, is still evolving. Uncertainty about regulatory crackdowns and market volatility makes this strategy riskier than traditional investing. For example, cryptocurrency exchange Kraken was forced by the US Securities and Exchange Commission (SEC) to shut down its staking-as-a-service platform for US clients. Meanwhile, Coinbase is also facing regulatory disputes for its staking services though they maintain those services are not securities.


The Lure of High APY


It's easy to get lured in by astronomical advertised Annual Percentage Yields (APY) that often exceed returns seen in traditional finance by an enormous factor. You have to remember this is because of the greater risk. Platforms touting 1000% returns might disappear overnight, leaving you with empty pockets. Heard of “get-rich-quick” schemes? Yield Farming’s crazy yields come with similarly crazy risks.


Let's get this straight, you can stick your crypto assets on a platform like Compound and earn a modest return. This is somewhat similar to putting money in a bank savings account but with typically higher (and variable) interest rates.


But seasoned Yield Farmers might not find this basic strategy exciting. They’re hunting down clever strategies, navigating complex protocols, and optimizing every single angle to squeeze out those mind-blowing yields. That often means constantly shifting their crypto assets between various platforms and strategies, responding to the rapidly changing landscape of yields and rewards in the DeFi space. This is where the concept of "percentage yield" comes into play, as Yield Farmers try to maximize their returns from these strategies.


How Liquidity Mining Comes Into Play


What drives many experienced Yield Farmers to DeFi are lucrative incentives offered through a strategy called "Liquidity Mining." It adds fuel to the already fiery Yield Farming engine.

In essence, liquidity mining incentivizes users to become liquidity providers (LP) for specific protocols. By providing liquidity, not only do you earn trading fees, but you are also often rewarded with the protocol's own governance tokens. To participate in many yield farming opportunities, you will receive an LP token, which represents your share of the pool.


You essentially mine new tokens by injecting liquidity into the protocol, amplifying your potential profits. However, keep in mind the value of these newly earned tokens can fluctuate drastically as their inherent worth hinges heavily on the platform’s long-term success and adoption. A token trading at hundreds of dollars today might plummet tomorrow if the underlying platform faces challenges.


While many believe the Compound platform’s 2020 introduction of their COMP governance token ignited the craze, there is debate over the precise origin of this concept. Some point to Fcoin, a Chinese exchange launched in 2018 that rewarded traders with its token. Others argue it began in earnest when the synthetic asset platform Synthetix offered users SNX tokens for supplying liquidity to its sETH/ETH pool on Uniswap in July 2019.


Regardless of its genesis, there’s no denying liquidity mining dramatically altered the DeFi scene, transforming it into a vibrant ecosystem brimming with opportunity (and often a good amount of speculation). This is a key difference from traditional financial systems, where such high-yield opportunities are rare. You can learn more about Liquidity Mining here.


Key Strategies and Examples


Here’s how different platforms employ liquidity mining and yield generation to engage users:

  1. Compound: Distributes its COMP token to lenders and borrowers. By participating on the platform, users earn both interest (if they're lending) and COMP tokens proportional to their activity. Those earned tokens grant voting rights in Compound’s governance system, directly influencing its future.

  2. Uniswap: One of the largest decentralized exchanges, Uniswap utilizes liquidity pools funded by users. In return for providing liquidity, these users receive LP tokens. They also earn a share of the platform’s 0.3% trading fee for the pools they participate in. This is pure, no-frills Yield Farming.

  3. Balancer: Unlike Uniswap’s strict 50/50 liquidity model, Balancer offers greater flexibility, letting users contribute assets in varying ratios. These customized liquidity pools add another dimension to yield generation as investors optimize their portfolios for greater efficiency.


This constant interplay between yield-bearing DeFi activities and platforms is where things start to get interesting. For example, a yield farmer could initially deposit a substantial sum of USDC into Compound. This earns them cUSDC (Compound USDC), a representation of their stake in the protocol. That cUSDC could then be further deployed into a Balancer pool. This clever combination lets users accumulate multiple layers of yield, boosting their potential profits.

 

Conclusion


Yield Farming requires you to actively monitor and manage your investments due to the constant fluctuations of APYs and changing reward schemes. Always proceed with caution, prioritize platform security, understand potential vulnerabilities, and never solely rely on promised astronomical yields as guarantees. By keeping a balance between profit potential and risk mitigation, you too can explore the exciting opportunities of this emerging DeFi revolution!


FAQ

Is yield farming still profitable?

Yield Farming can be profitable but remember the crypto market is super volatile. Just because it worked well for some folks in the past, doesn’t guarantee those results are repeatable today. Do thorough research, stay alert to market trends, and be prepared for the risks inherent in DeFi.

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Disclaimer

The information contained herein has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for financial, legal, or investment advice. Wirex and any of its respective employees and affiliates do not provide financial, legal, or investment advice.


The value of cryptoassets may fluctuate significantly over a short period of time. The volatile and unprecedented fluctuations in price may result in significant losses over a short period of time. Any Cryptoassets may decrease in value or lose all its value due to various factors including discovery of wrongful conduct, market manipulation, change to the nature or properties of the Cryptoasset, governmental or regulatory activity, legislative changes, suspension or cessation of support for a Cryptoassets or other exchanges or service providers, public opinion, or other factors outside of our control. Technical advancements, as well as broader economic and political factors, may cause the value of Cryptoassets to change significantly over a short period of time.


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