Yield farming is an investment strategy when users provide liquidity for decentralized finance. In return, they earn rewards. These rewards are paid as interest, fees, or governance tokens. The main difference from a traditional savings or investment account is that yearn farming relies on smart contracts and is fully automated.
Table of contents
- How Yield Farming Works
- Top Yield Farming Platforms
- Types of Yield Farming
- Risks and Drawbacks of Yield Farming
- How to Start Yield Farming
- Benefits of Yield Farming
- Conclusion
The Emergence of Crypto Farming
The concept of yield farming evolved in 2020 when the Decentralized Finance platform appeared. While traditional banks offer low interest rates, yield farming is a good alternative to a bank account. It offers significantly higher rewards. The first yield farming activities were enabled by protocols like Compound and Yield Finance. They introduced new ways for users to lend and borrow crypto and earn rewards from those activities.
Why Yield Farming Became Popular
Yield farming gained popularity very fast. It happened mostly because yield farming offers high potential returns. The rapid growth of DeFi also impacted the development of yield farming. When governance tokens were introduced, it again served as a boost to yield farming popularity. Those who had governance tokens received voting rights and additional rewards.
How Yield Farming Works
Yield farming works in the following way.
Users deposit their coins in special liquidity pools within a platform. Such users are called liquidity providers, and the pools are used for trading, lending, and borrowing. For each activity, users pay a transaction fee, and when they borrow money, they also pay interest. Liquidity providers get their share of fees and interest depending on how much funds they’ve provided to the pool. Also, they can get the tokens of the platform.
The income of liquidity providers is measured in the annual percentage yield (APY). It differs depending on the platform, as well as demand and supply.
Key Participants: Liquidity Providers and Users
Liquidity providers and users are the key participants in yield farming.
Liquidity Providers (LPs) are Investors who deposit their funds into liquidity pools and with it, enable seamless trading and lending.
Users are borrowers and traders who use these liquidity pools to make transactions. Users pay fees that are further used to contribute to the LPs’ earnings.
Yield Farming vs. Staking: The Difference
Users often confuse yield farming with staking. Both ways allow users to get passive income but they function differently.
In staking, users lock their assets in a blockchain network to support security and consensus. In return, they earn staking rewards.
In yield farming, users provide liquidity to DeFi protocols. They earn from transaction fees and interest that users pay.
Top Yield Farming Platforms
Here are the major yield farming platforms that you may consider.
- Uniswap – It is a decentralized exchange that rewards liquidity providers with transaction fees.
- PancakeSwap – It is a Binance Smart Chain-based DEX that offers farming opportunities.
- Curve Finance – It is optimized for stablecoin liquidity.
- Aave – It is a lending protocol that allows users to earn interest on deposits.
How to Choose a Reliable Platform
When you are choosing a platform for yield farming, consider the following details.
- Check if the platform has undergone smart contract audits.
- Make sure the platform offers high liquidity levels. It indicates stability and reduces risks.
- Check reviews and past performance of the platform.
Security Considerations
Here are some tips on how to check whether the platform is secure.
- Use platforms with a proven track record.
- Avoid projects with unaudited or experimental contracts.
- Diversify investments to reduce risk.
Types of Yield Farming
There are the following types of yield farming.
Liquidity Mining
In liquidity mining, users deposit funds into liquidity pools. In return, they get rewards. These rewards are normally paid in the platform’s governance tokens. This type of yield farming is one of the most popular.
Yield Farming
Yield farming includes lending, borrowing, and staking. In yield farming, users move funds across different protocols to maximize rewards.
Advanced Yield Farming Strategies
If you are an experienced investor, you can use such advanced yield farming strategies as leveraged yield farming and auto-compounding. In leveraged yield farming, investors borrow assets to farm more rewards. In auto-compounding, investors get rewards and reinvest them to earn more.
Risks and Drawbacks of Yield Farming
Yield farming can be very profitable but it also has some risks.
Impermanent Loss
Coins in a liquidity pool are volatile. The prices of tokens can change compared to when you first added them to the pool, and these changes are not always in favor of a user. For example, you added 100$ worth of ETH and 100 USDT in a liquidity pool. So, you added $200 in total. If the ETH price grows, people will trade USDT for your cheaper ETH in the pool.
Cryptocurrency Volatility
Cryptocurrencies are very volatile, their prices change a lot. These price changes may impact your returns significantly.
Smart Contract Risks
Yield farming runs on smart contracts. They are susceptible to hacks and bugs. A compromised contract may cause the loss of your money.
Scams and Fraudulent Projects
There are DeFi platforms that engage in exit and other scams when developers receive the money of investors, withdraw it, and disappear with that money.
How to Start Yield Farming
To start with yield farming, follow these steps.
Select a Platform and Cryptocurrency
Research the available platforms. Check such factors as security, fees, and liquidity level. Check if it has the crypto that you would like to use.
Add Liquidity to Pools
Add assets to a liquidity pool or liquidity pools. After that, you start earning rewards. Their distribution depends on the platform’s distribution model.
Manage Yield and Withdraw Profits
Check constantly APY rates to maximize your earnings. Reinvest the rewards if you believe that it will bring more profit, and withdraw some profits to reduce risks.
Benefits of Yield Farming
Yield farming offers impressive benefits. The main advantages are the following.
Passive Income Generation
Yield farming allows you to earn passive income. You can provide your cryptocurrency for liquidity instead of just keeping your coins.
Higher Returns Compared to Traditional Investments
If you want to get higher returns than banks offer, you can try yield farming. Usually, yield farming platforms offer a much higher potential of income than traditional savings accounts of stock dividends.
Growth of Decentralized Finance
When you participate in yield farming, you make a contribution to the DeFi ecosystem. You not only provide coins for trad
Conclusion
Yield farming has become a very important component of DeFi. It offers attractive opportunities for investors who understand DeFi and can handle the technical complexities of it. However, yield farming also comes with risks. If you want to try yield farming, you need to learn its mechanics and use risk management strategies.
