Yield farming is a very popular concept within the DeFi space. It is a method that allows cryptocurrencies owners to earn money without actually having to do anything for it. You can therefore compare it with obtaining interest on money in a savings account (a few years ago).
Many people do not know yet what yield farming is, or how it works. Let alone that they know how to do it themselves, in order to make money with cryptocurrencies that they use somewhere. This article is a guide for anyone who wants to know everything about yield farming. You will learn what yield farming is, how it works and how you can get started! But first watch this video below.
- 1 What is yield farming?
- 2 What is crypto farming?
- 3 Is farming for everyone?
- 4 What is Total Currency Locked (TVL)?
- 5 What types of yield farming are there?
- 6 The best-known protocols for yield farming
- 7 The risk of yield farming
- 8 Conclusion
What is yield farming?
Yield farming is a way of using different strategies to optimize the returns of cryptocurrencies. It is a process by which users provide liquidity to DeFi protocols, and are rewarded with a return, in the form of tokens.
The phenomenon of yield farming is explained by the growing interest in DeFi, and the massive influx of liquidity into money markets such as Compound. The original idea of the protocol was very simple: to connect lenders and borrowers. Now that goes a lot further than just that.
The platforms use a liquidity pooling system that allows lenders to offer assets to the market and borrow users from the market. So compare it a bit with a bank and people who want to borrow money from the bank to buy a house, for example. The house serves as collateral if the borrower is no longer able to pay off his loan.
In addition to the interest rate and commission charged for each transaction, the liquidity providers are paid in tokens. Tokens are valued by the market and can be sold or held. The returns are often so high that they provide an incentive for users to provide liquidity to provide the funding of a new decentralized funding protocol.
It is this double reward that gave rise to the term ‘yield farming’. The trend of yield farming has been democratized by the creation of new DeFi protocols and the evolution of different strategies. Now people are trying to take advantage of the capabilities of the various DeFi applications, with the aim of getting rewards.
What is crypto farming?
In cryptocurrencies, farming involves depositing units of a virtual currency into a pool of liquidity on a DeFi protocol to earn rewards. Borrowers are rewarded in the form of special tokens, also known as governance tokens. These tokens entitle their holders to participate in protocol decisions through voting.
The most famous platforms that have offered a native token to liquidity providers are Compound with its COMP token, and Balancer with its BAL token. The returns are often very attractive to liquidity providers, as DeFi protocols require resources to grow.
The concept behind farming is fueled by Liquidity Mining’s incentive strategy. Users, called the ‘farmers’, then find smart ways to farm these tokens, by borrowing less used tokens and lending them to the platform. By mining these tokens, a better return can be achieved than just the return from interest. To maximize efficiency, users repeat this process on other DeFi applications.
Is farming for everyone?
Any crypto owner who owns a wallet like MetaMask or Ledger could be able to farm. This is a sensible strategy for making your cryptocurrencies work for you, as long as the proceeds cover at least the necessary transaction costs.
Don’t make hasty decisions, but put in some time to get all the necessary assurances that a project is healthy and therefore safe. Strategies that are currently the most risky do not make sense and therefore may not actually be sustainable for the long term.
Finally, a small exposure of the wallet to the strongest projects with a product with strong indicators (fixed value in contracts or number of users) is more interesting than too high returns offered by a dubious project.
What is Total Currency Locked (TVL)?
With yield farming you will often hear about Total Value Locked (TVL). This reflects how much crypto is locked into DeFi yield farming protocols. In this way you can see how much value there is in a protocol.
When a protocol has a low TVL, it can mean that there is a high return to be achieved, but there is also a high risk of losing effort. The project is then a lot less stable. A high TVL, on the other hand, has a lower return, which is because the risk that users run is much lower.
So you will have to weigh up for yourself: would you rather be able to get more interest and run a higher risk, or would you rather have more certainty and a lower interest rate?
What types of yield farming are there?
The term yield farming can be interpreted as different activities, with low or high annual interest rates, depending on the risk of the project. Let’s take a look at some of these activities, from the least to the most risky.
Earn interest by lending money
The first and most accessible activity for everyone is depositing cryptocurrencies on platforms such as Compound or Aave. In exchange for this deposit, you receive an interest that fluctuates according to supply and demand. This means the amount that is available to borrow. In general, the interest rates that you can obtain on these platforms fluctuate between 0.1% and 40%.
The higher rates are the result of loans that give access to more attractive rates. Prices can collapse in a few days, but this is one of the least risky activities in yield farming, and therefore also suitable for people who want to start with this.
When calculating the return, depositors and borrowers on Compound always receive COMP tokens. These are valued by the market and can be sold or held to participate in voting as it also serves as a governance token.
Of course you can make even more money with yield farming by saving the tokens you earn. When you keep these, the value could increase in the future, after which you can sell the tokens for a higher price. You often receive a lower interest rate with yield farming when the price is high, because the token is then very popular. This is something to keep in mind when doing yield farming.
The second possibility for yield farming was invented by Yearn, and it concerns vaults. Vaults involve depositing cryptocurrencies into smart contracts that act as an “automated hedge fund” that will apply a strategy. In this case, that’s the strategy that has yielded the best return so far. The vault can change its strategy if a better return is found.
You can deposit stablecoins or other assets backed by the platform. The returns are interesting and the result of the automatic sale of governance tokens obtained by the strategy.
Returns are earned based on the assets deposited in the vault. The risk is in the code of the vault, or the strategy may be based on a CDP. A CPD is a debt contract shared by all depositors.
Providing tokens to liquidity pools
The third option is to use cryptocurrencies in liquidity pools on, for example, various DeFi platforms such as Uniswap or Balancer. The liquidity provider (the one who provides liquidity to a platform) receives fees on the exchanges that pass through these pools. However, beware of the risk of temporary losses similar to the way decentralized trading platforms are constructed. This is also known as impermanent loss, and is a common problem within DeFi.
Excessive price differences between assets lead to the loss of part of the capital. Therefore, the potential fluctuations of the assets must be calculated in advance to get an idea of the risk involved.
The fourth option is to discontinue a stablecoin or governance token (such as USDT, YFI, or COMP) in order to obtain new tokens in return. If the contract is checked, the activity itself is not very dangerous. For example, YAM or Harvest.finance in this case are in front of the community after a few hours or days to provide feedback on the contracts.
Many projects try to ride the wave, risking losing their capital if the project is fraudulent or not covering the transaction costs if the token is not purchased on decentralized exchange platforms, as the listing is technically simple to do.
Farmers are keen on these projects and are looking for interest rates of these tokens with no intrinsic value of 1,000 to 30,000%. In many ways, the rates are misleading and will fall as the volume on the contracts grows.
In a sea of worthless projects, a small number of projects will be worth considering, especially if they don’t lead to a product. That YAM is the first badge and project in this vein may make sense to some. It is important to have some knowledge about crypto before embarking on these types of projects, because only then can you determine whether a project is worth investing in.
Tokens increasing in value
The fifth possibility is close to the fourth, but carries a greater risk as the token that is put into play is no longer a token, but a token that represents part of the money deposited on services like Uniswap or Balancer . Don’t worry if you don’t understand what we’re talking about yet.
First, you add trades to the process, which involves costs, but also and above all a risk of losing your capital. This is mainly because the market is highly volatile and thus unstable. Uniswap offers, in addition to the airdrop of UNI coins to historical users, the possibility to get UNIs back in this way. Hence a massive influx of liquidity.
It should be noted that approximately $30,000 is needed to cover just the costs incurred each day to remove the obtained UNIs. Uniswap is the most interesting and solid project of this possibility, but it is not recommended for everyone.
The best-known protocols for yield farming
There are many different DeFi protocols and applications that you could use for yield farming. Below we will tell you what the best-known and most used protocols are. Of course we would like to advise you to do good research into these applications yourself before starting yield farming.
Aave is a protocol that provides a platform for borrowing and lending cryptocurrencies. People who lend their cryptocurrencies are called lenders, and they receive an interest on the amount they lend to other users, the borrowers.
As a borrower, you would like to borrow crypto and then invest it. However, you must first deposit collateral on the Aave platform. This is a security for the lender, so that it is certain that the user who wants to borrow money is creditworthy.
By lending money through Aave’s platform, you can earn interest on the cryptocurrencies that you would not otherwise use.
Balancer’s protocol provides liquidity for various DeFi applications. It does this by properly placing tokens in the pool. This ensures that the provision of liquidity is much more efficient.
For many crypto users, Balancer is one of the most important methods for yield farming. That’s why it’s definitely worth learning more about this protocol, and then maybe incorporating it into your yield farming strategy.
Curve Finance is a protocol for decentralized exchanges, for swapping tokens. This is not just about any token, but in particular stable coins. These are coins that always have the same value, often linked to a fiat currency such as the euro or US dollar.
An advantage of Curve is that users experience a fairly low slippage. This is the difference in price between the swap. In some cases, the slippage can be very high, which is perceived as the biggest disadvantage of an Automated Market Maker (AMM).
Many users opt for yield farming with the Curve Finance platform. In general, the risk is slightly lower than with other protocols, because liquidity is provided here with stablecoins.
Like Aave, Compound Finance is a platform where people can borrow and lend crypto. To make the platform usable, both lenders and borrowers are needed. The borrowers pay costs to be able to borrow money, which count as the income of the lenders.
In order to use Compound, you will need an Ethereum wallet. It is then possible to deposit tokens into the liquidity pool, after which you receive interest on the tokens that you have made available to the platform.
Chances are you’ve heard of Maker or MakerDAO. This protocol has its own stablecoin, called DAI. The MakerDAO protocol ensures that the value of this coin is always the same. They do need people who want to use tokens to keep the value the same.
You can bet different types of tokens like it is ETH, BAT, USDC or WBTC. This means that there are quite a lot of options for yield farming.
By depositing tokens in Maker’s protocol, you can receive a nice interest. This interest is quite high, compared to the interest you can earn on the other protocols we have mentioned here. That’s why Maker is definitely worth delving deeper into, and perhaps using it for yield farming.
Uniswap is a DEX where users can swap tokens against other tokens. This is done by means of a liquidity pool. A liquidity pool is a collection of coins held in a smart contract. As a user, you could deposit your tokens in this smart contract, after which the blockchain will keep track that you have deposited tokens in the liquidity pool.
Users can swap their tokens against tokens from the pool. All users who submitted tokens to the pool will receive an interest. This interest is paid from the fees users pay once they swap tokens.
So you can do yield farming on the Uniswap platform, by providing liquidity to the DEX.
Synthetix is a protocol for staking the SNX token or ETH, in order to subsequently mint synthetic tokens. Anything could be a synthetic token, as long as it’s tied to a product.
For example, someone can create a synthetic token for oil, which would mean that the token always has the same price as the oil price. You can then stake your tokens and ensure that the price always matches that of the oil price. If you do it wrong, there is the possibility that you will lose all your tokens that you have wagered.
Synthetix is a platform that is being used by more and more crypto traders to do yield farming, and that is why it should certainly not be missing from this list. The interest you can earn with Synthetix is quite high, compared to the other protocols we have mentioned here.
One crypto protocol that has gained a lot of fame in recent years is Yearn.finance. It is an aggregator for loan platforms such as Aave and Compound, which we also discussed above.
Yearn.finance itself is not a platform where you can borrow and lend tokens. It is just an aggregator which means it optimizes these types of platforms. When you do yield farming, this protocol is a must to arrive at the best strategy, and thus also earn the most money.
The risk of yield farming
We cannot publish this article without informing you about the risks of yield farming. It is important to mention that there is a big risk with yield farming, which could cause you to lose a lot of money if you are not careful.
Many people think that yield farming is easy. It may seem that way at first glance, but in fact it is not. It is not easy to earn a stable income through yield farming. This is because you need quite a bit of knowledge about how DeFi applications and protocols work.
Yield farming is mainly effective for people who can invest a large part of capital. This does not mean that you cannot start with a small amount. There is no minimum amount required to get started. Only you will notice that you will not make big strides with a fairly small amount of cryptocurrencies. From there we mainly see large whales stepping into yield farming.
There is also the risk that smart contracts entail. Yield farming is purely and solely based on smart contracts. There have been a number of issues with Ethereum smart contracts in the past. For example, various hacks were found in this, so that a lot of money could be stolen.
This means that you are completely dependent on the operation of the smart contracts. Should there be a vulnerability in one of these smart contracts, you have the chance to lose all your money. This does not only happen with small DeFi protocols, by the way. Today, even in large projects, vulnerabilities are still found that can cause users to lose a lot of money.
The latter risk stems from what is perceived as a major advantage. Yield farming is done using blockchain technology, which is a decentralized technique. It consists of a network that is continuously producing blocks. This ensures that the network is not dependent on a central party. However, it can also go wrong here. When something goes wrong in block production, the entire network could suffer. This means that users can lose their money if something goes wrong in block production. They will then lose this money for good, and they cannot get it back afterwards.
Yield farming is a very popular way to make money with cryptocurrencies that you would normally keep in a wallet, without even touching them. You can lend your cryptocurrencies to other people, through a liquidity pool or through a platform to do this directly. The possibilities are, as you have read in this article, almost unlimited.
You now also know what you can do to start yield farming yourself. By following the steps in this guide, you can make money with yield farming. Of course it is important to consider the risks associated with yield farming. You can always lose the money you bet. Therefore, make sure that you do not farm with money that you could not afford to lose.
We wish you every success with yield farming.
Thanh Lanh Tran(1989) is Chief Editor from BitcoinUSD.com