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What is Yield Farming?

What is Yield Farming?

Introduction

Over the last few years, decentralised finance (DeFi) has been growing exponentially. DeFi offers the same products as traditional finance, but without requiring middlemen who make a profit (usually out of your pocket) from your financial transactions.

DeFi is trustless (meaning you don’t need to trust anyone) as instead of banks, insurance agencies and loan companies handling the process, all transactions are recorded on a blockchain. This makes it incredibly hard for someone to alter transactions after the fact.

Yield farming is just one of the new wave of passive income strategies born out of the DeFi revolution. It allows crypto holders to earn extra (usually compounding) income just for holding their crypto.

Sound amazing right? 

Well, yes but let’s have a deeper look behind the curtain!

Yield Farming Factoids:

  • Yield farming allows token holders to increase their rewards from holding crypto.

  • Yield farmers provide liquidity on decentralised exchanges (DEXs) and earn rewards in cryptocurrencies.

  • Most blockchains have DeFi products that offer yield farming

  • Yield farming can be risky due to Impermanent loss (from price volatility), rug pulls and smart contract hacks.

What is Yield Farming?

To start with we need to understand a little more about how Automated Market Maker (AMM), Decentralised Exchanges (DEXs) work.

Brief Introduction to AMM DEXs

Automated market maker (AMM) DEXs have been around since 2018 and are designed to solve the low liquidity problem found on order book DEXs. 

To prevent low liquidity on AMM DEXs, they use liquidity pools instead of matching buy orders with sell orders (as order book DEXs do).

What are Liquidity Provider (LP) Tokens

Liquidity provider tokens are issued to liquidity providers on a decentralised exchange (DEX) that runs on an automated market maker (AMM) protocol.

When a user provides their crypto tokens to a liquidity pool, they receive LP tokens in exchange. This is called “providing liquidity” and users who hold LP tokens earn a small amount from each transaction within that liquidity pool (this is NOT yield farming).

While the liquidity provider fee (mentioned above) is a passive income source for the provider, it doesn’t pay huge amounts (unless you deposit a huge amount into a heavily traded pool…because you own a larger percentage of the LP tokens associated with the pool).

How Does Yield Farming Work?

Because the LP tokens can be easily redeemed for the crypto of the pool they came from, and thus have intrinsic value, many DeFi protocols have started allowing users to yield farm using their LP tokens. 

True yield farming involves taking your LP tokens and putting them into another pool to earn further rewards. These rewards are often paid out a higher APY in a different (newer or more volatile) crypto token than those originally deposited.

In effect, the initial liquidity provided to the pool is working twice as hard earning the provider more passive income.

Is Yield Farming Profitable?

I’ll preface this section by saying, with increased profits come increased risks and you should always research any DeFi protocols you are considering using.

Ok, now that is out of the way. Yes, Yield farming can be profitable.

However, one yield farming pool may be so profitable that more and more users jump into it. The more users using it the less profitable it will become. 

Confused? That’s understandable, yield farming is much more complex than just staking your tokens.

 

Is Yield Farming the same as Staking?

Both yield farming and staking are passive income strategies users can benefit from on DeFi platforms. The terms are often used interchangeably. 

However, while both strategies are very similar, they have their nuances.

Staking

On many blockchains users may “stake” their tokens, this usually (but not on Cardano) involves locking your tokens up on a platform and earning an Annual Percentage Yield (APY) (APY is usually auto-compounded (meaning your staking rewards earn further rewards)).

Staking can earn you rewards anywhere between 4-15% APY on average. This amount is fairly stable, rarely changing much.

Staking is a much simpler process but pays less and can involve you not having access to your tokens during the lock-up period (Cardano does NOT require you to lock your tokens).

Yield Farming

Yield Farming on the other hand can earn much higher rewards (anywhere between 1-1000%) but this can fluctuate worldly depending on the tokens in the liquidity pool. 

Tokens used for yield farming are not locked but the process of yield farming is not as straightforward as staking. This complexity may stop new users from diving into yield farming.

Remember, as always, education is king!

What are the Risks of Yield Farming?

As I mentioned earlier, increased reward comes hand in hand with increased risks.

Impermanent (Divergence) Loss

Impermanent loss occurs when the price of the tokens provided in the pool initially changes, this means that it is both unavoidable and we can’t predict to what extent it will occur (hence the greater risk).

Let’s say for example that you deposited your liquidity in the ratio of 1 token A to 100 token B (1:100) and let’s say that the price of each token when you deposited them was; token A = $100 and token B = $1, you’d deposit 1 token A and 100 token B.

If the price of token A goes up to $1000, suddenly the ratio of the two assets has to change. This is because traders looking for an arbitrage will flood the pool with lots of token B and remove the corresponding amount of token A. In effect they are buying token A for $100, which they can then sell on other exchanges for its new price of $1000).

So the ratio changes and your initial liquidity is worth less. However, it is called impermanent loss because the loss is only realised if you remove your liquidity. 

If you never remove your liquidity or the price of both assets changes back to where it was initially, the effects will be reversed.

Smart Contract Risks

When yield farming with your LP tokens, you are placing your trust in the DeFi protocol and its underlying smart contracts. In the event of a hack or security breach, you could lose all of your LP tokens, and by extension, the initial crypto you put into a liquidity pool.



Final Thoughts.

Yield farming is another string to the bow of DeFi, it allows users to increase the profits they can make by holding their crypto tokens without having to line the pockets of greedy banks and middlemen!

Please remember to educate yourself on the risks involved and only ever invest money that you are ok losing, do not overextend yourself. Be sensible and you reduce your risks (and usually increase your rewards).

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