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What is yield farming?

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PDAX

September 15, 2022

7 min read

IntermediateDeFi

TL;DR

Yield farming is a crypto investment strategy designed to earn passive income through various decentralized finance (DeFi) protocols such as lending and providing liquidity, often “stacking” different protocols together to maximize returns.

What is yield farming?

More often, people think getting into cryptocurrency means one has to either engage in active trading or to just sit on one’s tokens until enough time passes to reap a considerable profit. Though both strategies may work out fine, some traders explore other approaches and tactics for earning additional income on one’s crypto investments called “yield farming”.

Yield farming, as the term suggests, refers to methods for ”farming” or generating yield on one’s token holdings. It is a blanket term used to refer to a number of decentralized finance (DeFi) protocols that can be used to generate maximum profits within a relatively short amount of time. 

At its simplest, yield farming could mean lending your crypto on DeFi platforms to earn an annual interest in the form of new tokens–on top of the value that each individual token gained on the market. At its most complex, yield farmers with large risk appetites figure out ways to leverage or “stack” together different DeFi instruments and even different protocols on different networks. 

And since DeFi protocols are built on the blockchain, this means that anyone is free to participate in yield farming, providing financial opportunities that would otherwise be inaccessible for most people, especially the unbanked. 

DeFi protocols also make use of smart contracts, which means that transactions are automated and “trustless”, requiring no direct contact or exchange of personal information between transacting parties.  

How does yield farming work?

Yield farming involves locking up your tokens on a specific platform to earn rewards–often for a fixed period of time. Similar to time deposits in a bank, once locked up, you won’t be able to access your crypto until the given time has passed, and during that time, your assets may earn you passive income.  

Depending on what your tokens will be used for, there are many protocols that fall under yield farming:

Lending and borrowing

Crypto owners can also choose to lend their assets to borrowers at a set interest rate through DeFi lending platforms. In the same way that a traditional loan functions, crypto owners could then stand to profit from interest that is paid on the loan over a set period of time as programmed into the DeFi protocol’s smart contract. The difference is that DeFi lending generally earns higher yields than bank deposits (with most DeFi platforms offering anywhere between 4 to 8% APY compared to the average 0.25% with Philippine banks), since there is no middleman or third party institution between the lender and borrower–only a set of algorithms embedded in a smart contract.  

Crypto investors could also borrow crypto assets for the purpose of participating in other yield farming ventures, such as depositing them on other DeFi platforms with the expectation of earning higher returns–or what is called as “leveraging” a loan. Borrowers will then use their profits to pay back their borrowed tokens while keeping the remainder for themselves. 

Popular DeFi platforms for borrowing and lending include Compound (COMP) and Aave (AAVE) where users can borrow Ethereum-based tokens (ERC-20) upon providing another cryptocurrency as collateral. 

Liquidity 

In cryptocurrency, liquidity refers to the ease by which one token  can be exchanged for another token, which means that cryptocurrency exchanges and other DeFi platforms must always have an available supply of tokens to facilitate token conversions. 

In yield farming, one can help supply tokens by depositing their cryptocurrencies in liquidity pools (LP). This will allow you to earn passive income through the fees charged on each transaction everytime someone makes use of the token supply in the pool to convert one asset into another. 

Liquidity providers are paid based on the percentage of their contributions to the liquidity pool. The higher the amount that they put into the pool relative to other contributors, the higher the returns on their investment will be. Most liquidity pools require two different assets which are equal in value when making a deposit, to make sure there is an equal amount of each token for traders to use in the pool. Currently, two well-known liquidity pools are on the decentralized exchanges (DEXs) of Uniswap (UNI) and Sushi (SUSHI), which both offer liquidity on ERC-20 tokens, especially those which are not readily available on most centralized exchanges. 

Leverage stacking

When depositing tokens in a DeFi protocol, users will receive another set of tokens to represent the amount which they have locked up. These tokens are called “interest bearing tokens” (ibTKNs) and may be used further in yield farming. 

In leverage stacking, ibTKNS from one financial instrument may be redeposited in another protocol in order to maximize gains. In fact, there are ways wherein two or three protocols (or sometimes more) can be stacked on top of one another to fully maximize returns. 

In Sushi for example, users can supply tokens to the Sushi Liquidity Pool (SLP) to receive SLP tokens to represent their share. These SLP tokens in turn can be redeposited on other financial products within the Sushi platform itself to stack more revenue potential.  

Yield farming vs. staking

Since your tokens are locked up, yield farming is often compared to “staking” and many users actually find it convenient to also use the term to refer to depositing tokens in yield farming. 

However, the term “staking” is derived from the Proof-of-Stake (PoS) consensus model that most blockchains use to secure their network. In PoS, a user can lock up one’s tokens to set up or support  a “node” for validating network transactions. Validators essentially provide the computing power for the blockchain, but to ensure that they act independently and according to protocol, they must first provide a collateral or “stake”. 

Though staking itself is a form of passive income, the technical difference is that staking is used for the maintenance and upkeep of a blockchain while yield farming is intended solely to generate more income or returns on crypto investments.

What are the risks in yield farming?

While yield farming does sound attractive on many levels, investors should be aware of the possible risks. At the end of the day, any kind of investment opportunity will never be able to fully guarantee positive returns at all times. 

One of the biggest risks of yield farming is volatility. As cryptocurrencies tend to fluctuate in value, yield farmers often run the risk of having their assets locked during critical times like when there is a sudden market downtrend which could cause one to default on one’s loans when a particular token drops in value.

Another risk particular to liquidity providers is impermanent loss, which happens when one token’s price falls or rises significantly relative to the token you paired it with during the time of your deposit. When that happens, the pool compensates for the now uneven supply in the pool which would mean that your contribution might be worth less than when you deposited it.   

Aside from market movements, there are also risks involving cryptocurrency scams such as “rug pulls”–or when developers suddenly decide to pull out on a project, leaving their investors high and dry. As such, everyone should do the necessary research and background checks before deciding to put your money in any protocol. 

Conclusion

At the end of the day, yield farming through DeFi instruments can be a highly rewarding venture, both personally and financially. While there are certain risks involved in the process, there are many who have managed to yield significant returns from well-placed and well-executed investments.

As it is with all investments decisions, always exercise caution and better judgment before committing to any kind of yield farming opportunity and rely on a strategy instead of on emotions when making calls. And when it comes to yield farming, it also helps for the crypto investor to constantly update oneself on the movement of the market and the different nuances of every investment platform.

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DISCLAIMER: The statements in this article do not constitute financial advice. PDAX does not guarantee the technical and financial integrity of the digital asset and its ecosystem. Any and all trading involving the digital asset is subject to the user’s risk and discretion and must be done after adequate and in-depth research and analysis.

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