Last updated on March 11th, 2023 at 08:11 am
Cryptocurrencies have seen their extreme highs and lows over the past few years. Despite a pandemic affecting people all across the world, cryptocurrencies have given substantial returns to their investors. With more and more corporates and large investors acknowledging the potential of cryptocurrency.
Sometime back Cryptocurrency developers found a new way for users to invest and generate passive income from their cryptocurrency investments apart from mining and staking. The concept here is yield farming!
Suggested Read: What is Staking of Cryptocurrencies? An amazing way to claim rewards
Yield Farming (also known as cryptocurrency farming) is when you lend your crypto investments to a liquidity pool to generate returns in terms of cryptocurrencies.
A liquidity pool refers to the funds invested under a smart contract. The concept is quite similar to depositing money to the bank, where you generate returns as an annualized percentage(interest) of your deposited amount.
1. What is Yield Farming?
It is a set of a complex set of strategies to earn rewards when a crypto asset owner forwards his asset to a Decentralized Platform (DeFi) so that it can be lent to borrowers.
The owner earns rewards by lending his crypto asset just like Interest in the case of traditional banking.
In many cases, the yield farmer gets a share of fees that the DeFi platform charges from borrowers apart from the interest. A classic example of this arrangement was Compound, which distributed Governance tokens to both lenders and borrowers for using its platform.
Yield Farming does not have a lock-in period and the users can pull their assets anytime they want. They are also free to use multiple platforms to farm. This means if a particular platform is providing lower rewards, the user can change and yield farm at another platform
2. How does Yield Farming Work?
As discussed above, Yield farmers provide liquidity to DeFi platforms by forwarding their crypto assets to them. These platforms like Uniswap, Pancakeswap, Alpaca etc are often called Automated Market Makers (AMM).
Farming takes place with the help of Trading pairs. Wherein, a yield farmer lends his crypto asset paired with stable coins like USDT, USDC, BUSD, BNB, ETH, ETH2 to such AMMs.
All AMMs use mathematical equations to balance the value of the trading pair mentioned above. For simplicity sake, let’s say an AMM uses a formula
A*B = X
here A and B are values of your cryptocurrency and stable coin respectively. X is a constant.
The whole concept is based upon the principle of demand and supply of assets. Here, if the price of Token A increases, people would sell Token A and get Token B i.e. a stable coin. This price change has disrupted the supply of our tokens in the pool.
Token A is now in abundance and Token B in scarcity. As per the principle of demand and supply, if a commodity gets abundant its price reduces. So, over time the price of Token A will reduce. If you see on the flip side the price of Token B should have increased by now because it is scarce in the pool.
Further, look at the equation above since X is a constant if the price of A increases, the price of B will decrease to get accommodated as per the equation and vice versa.
I know this is a bit technical but AMMs keep doing this to balance their inherent mathematical equations in order to calculate rewards in farming.
3. Why do exchanges pay for Yield Farming?
The cryptocurrency market is still in its nascent stage compared to Stock exchange, commodity exchange and Forex markets. Its asset circulation is miniature when compared with the other markets. There has to be enough circulation of assets in the cryptocurrency exchanges for transactions to happen seamlessly.
Hence, in order to maintain liquidity in the exchanges, they have to allure customers. Yield farming helps provide that liquidity to such exchanges. And in return, the exchanges give rewards to the liquidity providers. This is the same case for other DeFi platforms.
There are a number of DeFi platforms like Uniswap, Compound, Aave, Alpaca, Farm Harvest. You can also yield farm at exchanges like Binance.
4. Is Yield Farming a Scam?
“Is Yield Farming a Scam?”, this one seems like an obvious question. Given that the average APY can also go up to 250%, it seems “Too Good to be true”. I am sure you would be hesitant in parking funds in Yield Farming unless you get a good reason for getting such rewards.
Let me begin by asking you if you find Mining and Staking scams? In both staking and Yield farming, you are doing a similar thing with your cryptocurrency i.e handing it over to someone else. If you want to know the difference between staking, yield farming, mining and liquidity mining, please visit here.
As discussed earlier, in order to ensure liquidity for transactions, each exchange allures users to forward their assets to them. This in itself is a good reason for the high APYs offered in Yield Farming.
To top it up, there is a marginal commission charged by all Defi platforms. Compared to what you would otherwise pay to a Bank for lending or borrowing. Practically the whole amount goes to the beneficiary avoiding the middlemen.
I hope yield farming doesn’t look like a scam to you anymore. Please fo your own research before investing in any platform.
5. How do you calculate returns in Yield Farming?
Yield farmers calculate their returns on investment in terms of APY (annual percentage yield). The concept is quite similar to the return earned in the money market. Essentially, the returns are compounded regularly and added to your contributions at the end of the year.
During 2020, cryptocurrency farming had generated more than 1000% APY for yield farmers. Although, cryptocurrencies are highly volatile and you have to book your profits at the right time. Yield farming provides a stable stream of return. Also, the returns are crypto tokens, which in themselves are highly volatile & subject to market trends.
6. Benefits of Yield Farming
Even though crypto investments are highly volatile, yield farming can be risky. Still, there are some advantages to yield farming.
1. Cryptocurrency Farming is Better than Money stored in the bank!
The biggest advantage of cryptocurrency farming is that it is better than storing funds in your Bank. When you put your crypto assets into a liquidity pool then you are putting your crypto assets to work & generate returns. The returns here are in crypto assets, which though are subjective to volatility, but can generate more returns in the future.
2. Passive Income Opportunity
Yield farming creates an opportunity for you to build your passive income through crypto investments. Here’s what you can do:
“Start investing with one liquidity pool. When you start getting some APY on your investments, then reinvest them in another liquidity pool. Using this you can generate returns on your cryptocurrency by generating interest (APY).”
Remember, as mentioned above the returns are in terms of cryptocurrency. It creates a future proposition that it is going to appreciate in the long term.
3. Better than Cryptocurrency Mining
Cryptocurrency mining is the process where you earn cryptocurrencies by solving equations with computing powers with a high hash rate. Yield farming is better & profitable than mining because it does not require additional capital to buy high-end computers.
These high-end computers are expensive and there is a certain amount of capital that you need to invest before you can earn anything.
On the other hand, if you have cryptocurrency, then yield farming can give you better returns. The risk quotient is the same in both, as they are equally prone to volatility. But yield farming does not require any extra capital investment to start. Also, there are dedicated networks and protocols for yield farming that you can use for better risk assessment.
7. Risks in Yield Farming
Just like any other investment, there are multiple types of risks in yield farming! To name a few:
1. Theft
Make sure that you keep a check on your crypto assets from time to time. Hackers want to steal your money. They find new ways to exploit all the loopholes, bugs, and vulnerabilities to steal your funds.
2. Token Coin Rewards
New token coins are being introduced by multiple platforms as rewards, but these coins need a few years to generate returns. But there is a big possibility that they will never gain value. Even if they gain value, there are very high chances for them to lose it in a short time. Many early investors stack up on a lot of reward tokens, which they sell later impacting the price of reward tokens. Hence, it is subjected to supply and demand fluctuations as well.
Further, there are many fake projects which make promises in the beginning but don’t deliver them. This is an unpredictable risk however, it can be mitigated with proper research.
3. Regulatory actions
Lastly, all the Governments have not yet approved the issuance of reward tokens & their operations. Their decision is going to have a big impact on the reward token usage and value.
4. Computer bug risk
Another big risk regarding yield farming is the computer bug risk. There are chances of human error, the developer might miss out on something. A small mistake can lead to a lot of issues in the final build. Although the blockchain infrastructure has become efficient over time, there are no major issues faced yet. But there is a big possibility!
Smart Contracts
One more thing related to the computer bug scenario, here is that all your funds are held together using smart contracts. Smart contracts are bound by software code. The systems need a lot of optimizations to enhance security on a regular basis. Hackers can exploit loosely coded smart contracts to steal assets.
Although the majority of the yield farming platforms pay attention to these risks and take the appropriate steps to handle them!
We have already explained the basic concept of depositing crypto assets into a smart contract. The implementation of the entire concept varies from one platform to another. Therefore, you need to do your risk assessment, so that you can have control over your investments.
8. Best Yield Farming Platforms & Protocols
There are multiple yield farming platforms and cryptocurrency farming strategies can change by the hour. You can decide which platform you want to choose; each one has its risks and regulations. It is highly recommended that you go through all the decentralized liquidity protocols.
We have also attached the links for Exchanges where you can buy these coins from.
Please note: Kindly undertake your own research before investing your money in any of the platforms. This list is for educational purposes.
Compound Finance
Compound is for all Ethereum holders, where you borrow and lend assets to others. Add your Ethereum assets to its liquidity pool and your APY* will start compounding. As mentioned earlier in the article. It is the first cryptocurrency that popularized Yield Farming.
Compound was the first one to introduce rewards not only to lenders but borrowers too.
*Please note: – APY rate changes based on the supply and demand of Ethereum.
Aave
Aave is a decentralized platform that generates Tokens against cryptocurrencies. You start earning and compounding as soon you add your funds. The platform also supports advanced functions such as flash loans.
Flash loans allow you to borrow money instantly without providing any collateral, provided that you return the amount within one transaction block.
Alpaca Finance
Alpaca is a relatively new Cryptocurrency but it has opened a huge box of products that users can invest in. It is based on Binance Smart Chain and offers Farming, Staking and Lending. It has other features like Stronk, Graze and Alpies (NFTs).
Harvest Finance
Harvest Finance is a new platform. It offers yield farming for loads of Ethereum Mainnet, Binance Smart Chain and Polygon based coins. You can farm, boost, borrow and work with Harvest Finance. Its main token FARM is an ERC20 token.
Synthetix
Synthetix generates a locked-up value of Synthetix Network Token & Ethereum. The platform generates mint synthetic assets, which a price feed. It allows users to add any financial assets to the Synthetix platform. In the future, it is expected to add more assets (other than crypto) for yield farming as well. Synthetix has great potential to utilize yield farming strategies.
MakerDAO
Maker works on the concept of DAI, which is a decentralized currency secured with the value of USD. Once you sign up with the platform, you can lock your crypto assets in the Maker Vault. DAI is generated as a return against the crypto assets. The interest/return is decided by the MKR token holders & referred to as a stability fee.
Uniswap
Uniswap works on the function of decentralized token swaps. The Lenders deposit money, where they hold it against two tokens to create a market. It supports trading against the liquidity pool, and the lenders earn fees based on their trade in the pool.
Curve Finance
Curve finance is a coin swap platform with main focus on the stable coins. The main focus here is to create high-value stable coins protected against slippage. There is an abundance of stable coins, and the curve liquidity pools are the key part of the infrastructure. It minimizes slippage occurrences using the stable coin.
Balancer
Balancer differentiates from other platforms as it allows to get custom token allocations in the liquidity pool. It creates custom balancer pools as required in Uniswap. Liquidity pools earn fees for their trades within the liquidity pool. Due to its high flexibility, balancer has gained recognition among yield framers.
Summing up!
Yield farming is a powerful and profitable strategy to generate strong APY against crypto assets. Just like any other investment, there is a risk and gain opportunity. There are multiple yield farming platforms with different rules and regulations.
If you are new to this, then you can check out a decentralized aggregator for yield farming. One of the most popular aggregators is Yearn.finance, which optimizes token lending by finding profitable lending services. It automatically chooses the right lending platform for your investments. All your funds will balance in tokens to maximize your profit.
Again, please do your own research before you start yield farming. Best of luck!
