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What is Yield Farming? | A Guide on Making Money in DeFi

What is Yield Farming? | A Guide on Making Money in DeFi Defi 101

DeFi brings curiosity about what is yield farming all about. Alongside its decentralized applications (DApps) and protocols, DeFi’s growth is driven largely by the emergence of money-making opportunities that promise massive profits.

With investors flocking to earn more, yield farmers started to grow in number. With this new form of strategy, the DeFi market continues to grow further; even reaching $13 billion total value locked (TVL) in November 2020. This is over a 2,000% increase from its value of the past year.

Commonly compared to the concept of staking, yield farming allows people to earn fixed or variable interest by investing crypto in various DeFi markets. As one of the hottest trends in crypto, investors must understand what is yield farming and how it works.

What is yield farming?

To put it simply, yield farming refers to the process of locking cryptocurrency assets into platforms that provide lending and borrowing services. Often, liquidity pools hold these funds to provide liquidity on networks.

Token holders and investors, aka yield farmers, generate passive income in DeFi through this strategy. What is more, aside from the interest rates that range between 0.25% to over 150%, they also receive a part of the platforms’ tokens as incentives.

Instead of simply staking coins, tokens, or stablecoins in crypto wallets, putting the assets in a decentralized finance fund attracts more profitable yet high-risk opportunities. Also, by providing liquidity, yield farming is associated with the term “liquidity mining”.

Taking this into consideration, yield farming involves lending cryptocurrency, providing liquidity, and earning rewards. It turns out to be one of the popular DeFi investment strategies in 2020 that mainly utilizes the Ethereum blockchain.

How does yield farming work?

In a traditional setup, a user typically receives annual interest for keeping money deposited in a bank. On the other hand, in a decentralized approach, “farming” refers to reaping high annualized percentage gains while providing liquidity for various DeFi projects.

It is a more profitable alternative to staking coins. Investors have been hooked with the idea of “greater gains” which is equivalent to “higher risks”.

Yield farming is not possible without liquid providers (LPs). They are responsible for staking funds in liquidity pools. Also known as market makers, they supply what buyers and sellers want to trade.

By putting up these money pools, buyers and sellers can transact conveniently. To explain, the pool is a smart contract that executes a buyer-seller agreement. This powers decentralized platforms.

What jump-started the yield farming hype is Compound. During the summer of 2020, it started to issue its governance token COMP to lenders and borrowers who use its DApp. Since then, several projects have followed suit.

The most common yield farming method is using a DeFi application and earning the project token in return.

As a matter of fact, the most successful yield farmers maximize their returns by deploying more complicated investment strategies. These strategies usually involve staking stablecoins and ERC20 tokens such as Dai, Tether (USDT), USD Coin (USDC), and Ether (ETH).

Investors deploy yield farming strategies in different DeFi protocols to maximize returns:

  • Decentralized lending: Firstly, these require lendings assets to be deposited on pools in exchange for lending interest and additional tokens.
  • Decentralized liquidity pools: Secondly, these involve contributing assets to pools and earn transaction fees.
  • Derivatives protocols: Thirdly, these involve minting assets or contributing liquidities to a pool and also earning transaction fees in return.
  • Yield optimization vaults: Lastly, these involve selling yield farming rewards at appropriate timing to maximize capital returns.

In summary, a yield farmer allocates capital to get rewards from protocols. They get rewards in a variety of forms such as fees, interests, or incentives.

How is yield calculated?

Typically, investors compute their yield farming gains on an annual basis. In this manner, an annual approach will allow you to track the performance of your portfolio and make adjustments where necessary.

Annual Percentage Rate (APR)

Annual Percentage Rate (APR) refers to the yearly rate of return imposed on borrowers. Regardless, capital investors receive this payment.

In other words, protocols offer APR for deposited funds. It determines how much income can be expected in a year, excluding any possible changes. But in reality, the APR in DeFi is highly volatile.

Generally speaking, APR is determined by the ratio between the funds lent to the pool and the funds borrowed (the pool’s utilization). Hence, if a high percentage of the pool is borrowed, the interest will also go up. As a result, lenders receive incentives for liquidity contribution while borrowers refrain from taking loans at high rates.

Annual Percentage Yield (APY)

Annual Percentage Yield (APY) is an annual rate of return charged on capital borrowers and subsequently paid to the capital providers. Conversely, APY allows the compounding of interest to bring in more returns to the investor.

Unlike simple interest, compounding interest is calculated at regular intervals and the amount is immediately added to the balance. Therefore, going forward, the account balance gets a little bigger, so the interest paid on the balance gets bigger as well.

It is important to note that calculating your short-term profit with APY can be misleading and confusing. Since the yields are usually based annually, the APY percentages in the short-term are not sustainable.

Thus, the aggregate yield for a farmer is, therefore, more lucrative. Multiple revenue streams cause this. Other sources of yield include liquidity rewards for contribution and additional DeFi tokens.

Risks and benefits of yield farming

Risks of Yield Farming

  • Smart contract Locking funds in vaults using smart contracts is undeniably risky. Smart contract misuse deals with abusing the logic of the contract to generate high returns. Moreover, vulnerabilities and bugs are inevitable to happen.
  • Token price volatility. As investors seek out the DeFi projects with highest yields, many newcomers are rushing to buy and sell. There have also been various cases that farmed tokens decreased in value. This is mainly due to DeFi hacks or unrealistic gains.
  • Complexity and huge money investment. Yield farming is not ideal for newbie investors. Often than not, a lot of money is involved. Therefore, advanced users and whales are typically the ones taking the risk.
  • Capital losses. Yield farming involves surrendering funds to a smart contract. If a DeFi protocol encounters a system error, contract codes will be affected. As a result, invested funds will get lost.
  • Unsustainable in the long-run. Higher yields are not likely to sustain forever. Furthermore, as yield farming gains more widespread adoption within the cryptocurrency world, yields will likely decline. Smaller yields will not attract many investors.

Benefits of Yield Farming

  • Profits and gains. Apparently, the main benefit of yield farming is earning significant profits and gains. Yield farmers who are early to adopt a new project can benefit from token rewards that may quickly increase in value.
  • Prevent digital assets from losing value. With yield farming, digital assets can earn a rate of return without doing tedious trading. In this way, yield farming is similar to putting money in a savings account. Just make sure that the account (protocol) is safe.
  • Provides more borrowing and lending options. Through decentralized lending pools, yield farming connects investors who need money through digital assets. They can conveniently access this investment tool without submitting any documents.
  • Interoperability. The entire DeFi sector is built around interoperability, making the market extremely versatile. Some platforms take your staked crypto and allow it to be converted from platform to platform automatically.

How to start yield farming?

Now that we know what is yield farming and how it works, we are now ready to learn how to start yield farming. To do so, you have to pay to play. In this case, paying doesn’t mean a few hundred dollars. As we mentioned before, higher yields are favorable for whales or big investors. Investing a smaller amount may not be profitable due to fees.

In other words, larger investments can cover the fees from the return rates and secure a position for profits. Additionally, creating incentives to participate in governing and improving networks is a great tactic. This is deployed by DeFi yield farming protocols.

Making money in DeFi has a variety of methods. It can be as simple as lending cryptocurrencies on Compound or something more complex like liquidation auctions on Maker. Thus, users must have the ability to farm yield on their preferred DeFi tokens.

DeFi insights provider DeFi Rate lists down tutorials on DeFi yield farming. These include Curve and Balancer liquidity mining as well as Compound and Curve Bitcoin yield farming.

To start plowing in the fields of yield farming, you have to pay to play.

The basic way to invest in liquidity pools (LP) is to buy two tokens of the same base (TRX or ETH) and pair them in a ratio of 50/50. After pairing them, lock your tokens by investing them in the pool and mine the proportional amount of tokens.

Before you buy and convert crypto, keep in mind that gas price will affect your currency. ETH has immensely increased its gas price and any small investment will be useless. Another important thing to note here is the retracement risk. After you lock up your crypto, they will have to maintain the same ratio. Be careful to avoid any fluctuations that will cause profit loss.

Low-Risk Yield Farming Strategies

Low-risk yield farming strategies are those that are part of fully-audited and reputable protocols. They are less lucrative in terms of net returns but offer safer and more stable yields in time.

These include the following:

  • Curve.fi — earn yield on stablecoins and farm the CRV token
  • Compound — users deposit either stablecoins or other assets such as WBTC or ETH and accumulate COMP tokens
  • Balancer — deposit tokens into different Balancer pools and earn both swap fees and the BAL token

High-Risk Yield Farming Strategies

High-risk yield farming strategies are brand new and untested protocols that temporarily last. Hence, these are more unpredictable and risky.

These include the following:

  • Yam.finance — stake a range of tokens or supply liquidity to a Uniswap pool to farm the YAM governance token
  • Yearn.finance — farm YFI tokens by depositing stablecoins into Curve or Balancer and stake the liquidity provider tokens on Yearn.

Top Yield Farming Coins by Market Capitalization

The current stars of the DeFi yield farming scene are Aave, Uniswap, Yearn.finance, Synthetic Network, and Compound. In line with this, they are ranked as the top yield farming coins by market capitalization.

Source: Coingecko
Source: Coingecko

Aave (AAVE)

Aave is an open-source and non-custodial protocol that enables the creation of money markets. Thus, users can earn interest on deposits and borrow assets.

As of November 2020, the Aave protocol market size is $1.8 billion. Users can deposit and borrow DAI, USD Coin (USDC), TrueUSD (TUSD), USDT Coin (USDT), and Binance USD (BUSD), among others.

It supports flash loans, the first uncollateralized loan option in DeFi. It enables users to borrow instantly and easily without any collateral. Among its use cases are arbitrage, collateral swapping, and self-liquidation.

Uniswap (UNI)

Uniswap is a decentralized protocol that allows seamless Ethereum token swaps. As of November 2020, it has over 23,000 pools and token pairs, as well as $1.8 billion in total liquidity.

Uniswap opens an accessible financial marketplace to developers, liquidity providers, and traders. Specifically, each Uniswap smart contract, or pair, manages a liquidity pool made up of reserves of two ERC-20 tokens.

In detail, anyone can become a liquidity provider for a pool. This can be done by depositing an equivalent value of each underlying token. In return, investors receive pool tokens. Moreover, Uniswap flash swaps are useful as it allows the withdrawal of full reserves of any ERC20 token on the decentralized exchange.

Yearn.finance (YFI)

Yearn.finance performs profit switching for lending providers. In line with this, it moves funds between dydx, Aave, and Compound autonomously.

Notably, YFI has made several milestones in 2020. These include surpassing the Bitcoin ATH price as YFI price surpass $30,000. Moreover, it reaches $40,000 upon listing on Coinbase.

Its core products include vaults that are capital pools that automatically generate yield based on opportunities present in the market. In addition, its Zap tool enables users to swap into and out of several liquidity pools available on Curve.Finance.

Synthetix Network Token (SNX)

Synthetix Network is a derivatives liquidity protocol. Everyone can gain on-chain exposure to a wide range of assets. Hence, it serves as the backbone for derivatives trading in DeFi.

As of November 2020, TVL in Synthetix is over $800 million. Furthermore, the current APY for lending SNX on AAVE is 2.33%.

Based on a system of collateral, staking, and inflation, Synthetix uses a multi-token infrastructure. To explain, users lock up SNX to create synthetic USD (sUSD). As a result, the sUSD acts as debt while SNX acts as the collateral.

Compound (COMP)

Compound is an algorithmic and autonomous interest rate protocol built for developers. It aims to unlock a universe of applications for an open finance world.

As of November 2020, the Compound protocol has $3 billion worth of assets earning across 11 markets. In particular, over $13 million of COMP earns 2.44% interest while more than $400 million of USDC earns 5.59% interest.

The Compound protocol has been reviewed, audited, and verified by Trail of Bits, OpenZeppelin, and Certora using Certora ASA (Accurate Static Analysis).

Read Also: Top 10 DeFi Tokens by Market Capitalization

Conclusion: Making Money in DeFi

To sum up what is yield farming all about, it is the process of locking cryptocurrency assets into platforms that provide lending and borrowing services. Moreover, it provides liquidity and can allow investors to receive tokens as incentives.

Before you start yield farming, you must understand the risks and benefits of yield farming and how does it work. Depending on the yields calculated, you may get high yields within a short period of time. Yet, this does not save you from smart contract risks or price volatility.

Yield farming may be an effective source of passive income. Just make sure to do your own research first and invest money that you can afford to lose. Let the money-making begin!

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An aspiring journalist who spills her ideas in cryptocurrency and blockchain-related matters. With her background in Communication and Journalism, she is more inclined to write about reality than fiction.