Decentralized Finance has continued to expand as time elapses, with different features being incorporated into this space regularly.
Yield farming is one of the several decentralized finance processes that are designed to reward crypto holders. It is the process of using crypto to earn more tokens. Typically, a crypto enthusiast has to lend their funds to others using smart contracts before they can benefit from yield farming. Generally, they earn fees from undergoing this process.
What is Yield Farming in DeFi?
Yield Farming is also called liquidity farming, and it involves locking up cryptocurrencies with the aim of earning rewards. Though it may bear some similarities with staking, it is far more complex. In the case of staking, those that lock their tokens to the network are called delegators. The process is done to protect the network and ensure that it runs safely. The risks attached to staking are not as high as those obtainable in yield farming. Usually, delegators may be penalized when the Validators or nodes that they delegated their tokens to misbehave.
As a result of the complexity of yield farming, the risk attached to this DeFi activity is greater. Secondly, those that lock their tokens in a pool to undergo yield farming are called liquidity providers. A liquidity pool is a smart contract that holds cryptocurrencies. People deposit their tokens into the pool to earn rewards from the fees that are generated by the DeFi project. Sometimes, they may be rewarded with multiple tokens.
For instance, the funds deposited in a liquidity pool may be deposited in another pool to earn extra rewards, thereby availing the liquidity providers access to multiple cryptocurrencies as their incentive.
The process can be repeated, making yield farming quite complex. Crypto holders tend to inject liquidity in pools that hold Ethereum -based tokens, which may be because of the great activity in that space.
It is typical to see yield farmers jumping from one protocol to the other searching for high yield. Yield farmers are prone to moving their liquidity to a DeFi platform with better incentives. For example, when Sushiswap was relatively new, the decentralized protocol decided to offer attractive benefits to liquidity providers, motivating them to move their funds from UniSwap to Sushiswap. This activity by Sushiswap is called Vampire Attack.
What is a liquidity pool?
Liquidity pools are important in DeFi activities, as they are the backbone of Decentralized Exchanges. Each pool is designed to allow crypto enthusiasts to pool their assets in a smart contract, thereby offering liquidity for traders to swap tokens, lend and do other activities.
As the demand for DEXs is on the rise, the number of liquidity pools that exist is increasing because they offer the liquidity that the Decentralized Finance space needs. Liquidity has been an issue for decentralized exchanges before the conceptualization of liquidity pools and AMMs.
Different Reward Elements of Yield Farming
Yield Farming offers different benefits to liquidity providers, and they will be discussed below.
Cryptocurrencies
By providing liquidity in a pool, the user can benefit from token rewards over a period, such as weeks or months. The token reward given to LPs can be used for regular activities in the crypto space such as trading. Most times, they are the governance token of a platform.
Transaction fee
Liquidity pools are necessary for decentralized trading, lending, and similar activities. When a person uses the decentralized exchange, they pay fees, which are shared with LPs.
What are the yield farming steps?
It is important to note that different protocols have varying steps that they expect their users to follow before providing liquidity. Generally, the procedure takes the following steps.
- Head to the protocol of your choice, and scroll to the section designed for the different pools. Usually, this section shows the yield percentages attached to pools.
- Link your crypto wallet to the pool, then choose the coins that you want to add. Once that is done, click on deposit.
- The transaction can occur if it is approved from the wallet. A pop-up option with the word, ‘Confirm’ may be displayed.
- Add liquidity to the pool. Usually, Liquidity providers are given LP tokens to show their percentage of ownership of the funds in the pool.
Benefits of Yield Farming
DeFi yield farming activities come with benefits to the users.
High incentives
Usually, the yield farming program gives the LP access to high APY compared to other activities like staking. When a pool is new, the incentives attached to it are usually more attractive compared to others.
Transparency
As a result of the decentralized element of yield farming, everything that occurs in the pool is available to the public.
Access to new tokens
Some decentralized platforms use liquidity pools as a way of injecting a new token into the crypto ecosystem.
Disadvantages of Yield Farming
Like most things that exist, yield farming also has disadvantages that should be considered.
- Liquidity mining comes with risks that could lead to the LP losing their funds and earning little or no incentives in the process.
- It is not easy to formulate profitable strategies, as the user has to try out varying elements before settling on one.
- Providing liquidity in an Ethereum based pool may not be as lucrative as one may expect because of the high gas fees linked to transactions in the network. Farmers may end up receiving lesser incentives.
Common Yield Farming Protocols
While deciding on a yield Farming protocol to opt for, it is crucial to consider those with a reputation in the space. Some platforms may reimburse LPs if their funds are hacked because of smart contract exploitation. Analyzing the records of a protocol is important before injecting liquidity.
Since implementations vary greatly, it is unwise to deposit your funds into any smart contract that offers a liquidity pool. Below are popular yield farming protocols in the decentralized finance space.
Aave
Aave is a Non-custodial Decentralized trading platform that was created to develop money markets. This protocol has one of the highest TVL locked compared to its counterparts. Users can earn as high as 15% APR.
Compound Finance
Compound is a money market permitting its user to borrow and lend digital assets. Everyone is allowed to inject liquidity into the pools run by Ethereum as long as they have an Ethereum wallet. Usually, the incentive rates change based on demand and supply.
Synthetix
This is a synthetic asset platform that permits people to mint synthetic assets after locking up their SNX – Synthetix Network Token – or Ether as collateral.
Uniswap
UniSwap is a DEX that uses liquidity pools for its operations. It is designed to allow users to swap tokens without the need for a centralized structure.
In this DEX, LPs deposit a similar value of two tokens in the pool to create a market. By providing liquidity, they earn fees from transactions.
Curve Finance
Curve Finance is a Decentralized protocol that permits crypto enthusiasts to undergo high-value stablecoin swaps with relatively low slippage. This is designed to permit highly efficient swapping of stablecoins.
Yearn.finance
This is a platform that focuses on acting as an aggregator for different lending protocols like Compound and Aave. Token lending is optimized because users can find the protocol with the highest incentives using Yearn’s automated aggregator.
Farmers use Yearn.finance because it chooses the best strategies. Once the funds are injected into a pool, they are turned into yTokens, which ensures that rebalance occurs regularly and profit is maximized.
What are the differences between APY and APR?
Potential returns that come from yield farming are usually calculated annually. With this, farmers can estimate the incentives that are allocated to them. The returns are captured with Annual Percentage Rate (APR) and Annual Percentage Yield (APY). Both terms are used interchangeably, but they are different. Annual Percentage Yield considers the effect of compounding, while its counterpart does not. By compounding, we mean plowing back the profits to earn more returns.
What are the risks attached to yield farming?
Though the rewards attached to yield farming may be lucrative, this activity is plagued with risks that should be considered before providing liquidity.
Potential scam
Developers have power over the funds in the liquidity pool and history has shown cases of scammers running off with the locked tokens. This risk is higher if the identity of the developers is not known, and their credibility has not been tested in the past.
Volatility
Yield Farming is a highly volatile activity with the possibility of the price of tokens falling drastically. It is advised to invest funds that the user can stand to lose. A mistake from the team could lead to the loss of funds of liquidity providers.
Some common yield farming scams are fraud and rug pulls. The team behind the project may run off with the LP’s funds. Sometimes, they may end up not keeping to their end of the bargain. Exit scams are quite common in this activity, especially when the identity of the team is unknown.
Smart contract risk
This is a common risk that LPs face when they inject liquidity into a pool. Smart contracts are coded by developers and there is the probability that they may have bugs or loopholes that can be exploited by hackers. It is common to see hackers draining a liquidity pool because they found a bug in the code.
To ensure that code is not compromised, many developers tend to pass the architecture of the smart contract through a third-party audit.
Impermanent loss
When the token is locked, its value could rise or fall, leading to unrealized profit or loss. When the LP withdraws its token, the profit or loss can become permanent. Sometimes, the loss may end up being greater than the interest that the user earns.
There is an overview of yield farming. Keep in mind this activity is advanced so if you do decide to try, begin with a very little amount to get a feel for it and try out different strategies.
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