Understanding How Yield Farming Works (Beginner’s Guide)

Yield farming is a concept that has gained significant traction in the cryptocurrency domain, but what exactly does it entail, and how beneficial is it? This comprehensive guide delves into the intricacies of yield farming. We’ll examine its mechanisms and evaluate its potential rewards and risks in 2024.

What is yield farming?

Yield farming is the process of depositing your cryptocurrencies into a liquidity pool and then taking the LP tokens to deposit or stake on another platform. The aim is to earn more crypto as passive income. Essentially, you’re adding liquidity to multiple platforms and earning compounded rewards in the form of interest for doing so.

The process is similar to holding traditional fiat in a savings account. Money held in a savings account is added to the bank’s balance sheet. Banks utilize those deposits to make investments. Yield farming is the same idea, except you’re contributing to a liquidity pool rather than a bank.

How do you yield farm?

The process of yield farming goes as follows:

1. Deposit your cryptocurrency into a liquidity pool (e.g., DEX, lending platform, liquid staking).
2. You will receive tokens (LP or LST tokens) representing your share of the liquidity pool.
3. Take those tokens and stake/deposit them into another liquidity pool or yield-baring smart contract.

When you engage in yield farming, you earn rewards over time. The amount you receive as payouts depends on the platform you choose, with each offering different rates and terms.

This method compounds the rewards you would have earned by only staking on a single platform. Additionally, the success of yield farming often hinges on market conditions and the performance of the underlying assets.

It’s important to consider these factors, along with platform-specific risks and rewards, to make informed decisions. This approach optimizes your earnings and also helps in managing the inherent risks associated with yield farming.

How to start yield farming

To start yield farming, you need to deposit into a liquidity pool on platforms like Aave, Uniswap, Compound, or Curve Finance. You’ll also need to hold assets, generally Ethereum or ERC-20 tokens, in your connected wallet. A popular ERC-20 wallet to use is MetaMask in this instance.

Then, you’ll pick the liquidity pool of whichever asset you wish to lend and input the desired amount. The platform will state any fees as well as projected earnings. Once you’ve contributed to the liquidity pool, it’s time to start earning.

Rewards will be paid out, and they vary depending on the lending platform and asset you choose. Also, keep in mind that you’ll need to dedicate a significant amount of liquidity to see any meaningful returns.

Finally, deposit the LP tokens you receive on another platform. You can redo this process as many times as you like to compound rewards but keep in mind that this increases the risk. This process is known as rehypothecation, which you should learn about to understand the risks associated with yield farming.

Yield farming vs staking

Yield farming and staking are very similar, but each has subtle nuances. Staking is the act of storing or locking up your assets into a smart contract. There are generally three different types of staking:

• Blockchain: Staking coins allows you to validate transactions and provide security to a blockchain network. In this scenario, stakers are called validators.
• Decentralized application (DApp): On DApps, staking simply involves locking cryptocurrency into a smart contract to perform some task or fulfill a function, after which you are rewarded with some digital asset (e.g., token/NFTs).
• Protocol: Protocol staking is similar to DApp staking. The best example of this is Chainlink. Those who stake on Chainlink do not necessarily use a DApp, as Chainlink is not a DApp but a protocol. You still earn rewards in exchange for depositing crypto into a smart contract.

Is farming crypto worth it?

“As cryptocurrency gains wider acceptance, yield farming will enter the mainstream. Like traditional banking practices, this simple concept is essentially a digitalized form of lending with interest, providing a means for investors to generate profit.”

Daniel R. Hill, president of Hill Wealth Strategies: LinkedIn

Many would argue that farming cryptocurrency is very worthwhile, considering you’re earning interest on cryptocurrencies that were just sitting in your wallet in the first place. Depending on how much you lend or deposit, yield farming can be lucrative.

Let’s imagine a scenario where Bob wants to yield farm. Bob deposits 100 ETH into a decentralized exchange (DEX) liquidity pool. He receives liquidity provider tokens (LP tokens) representing his share of the pool. If Bob’s deposit is 50% of the pool, he will receive 50% of the fees when traders swap in the pool and pay a fee.

He then takes his LP tokens to a borrowing and lending platform and deposits them into another liquidity pool for a loan. They then take that loan for crypto and deposit it into another DEX to earn more fees.

Hypothetically, Bob has just doubled his rewards using a single amount of liquidity, 100 ETH. If Alice swaps some crypto using either DEX, she pays a fee. This fee will go to Bob.

Risks of yield farming

Yield farming is an extremely complex process and there are many factors to consider to remain safe. In other words, the risks are not very simple to understand.

Example 1

The most obvious risk is smart contract risk. This means that some smart contract(s) within the yield farming strategy are not properly audited, misbehave, or break, leading to the loss of funds via burning (funds are stuck at an address) or an exploit.

Example 2

Another risk is that you deposit funds, the smart contracts work, yet you still lose funds due to some exploit. In this scenario, the culprit likely has utilized some sort of price manipulation strategy or flash loan. This risk affects the liquidity providers (LP) and the platform.

For example, you deposit cryptocurrency into a yield farming pool to earn yield. Someone manipulates the price of the assets in the pool through flash loans, becomes an LP, and withdraws a larger share of the pool than they actually own, slowly draining the pool. An example of this type of exploit is Harvest Finance.

Example 3

It is also important to note the risks of businesses built using yield farming strategies. In this scenario, retail users and institutional investors provide funds to a business that engages in yield farming strategies.

If the business does not implement proper hedging strategies or adequate withdrawal periods, this could lead to a bank run and the eventual bankruptcy of the business. Your assets will become stuck in legal limbo, and if you receive a payout, it will be in-kind, at par value, or at a haircut.

Celsius is a popular example of this scenario. Many retail users and businesses deposited crypto onto Celsius and when they could not get back their funds, they could not pay off the promises that they made to their own customers. This led to a chain reaction of bankruptcies and effectively tanked the price of multiple assets in DeFi.

Example 4

The last example we will explore is the risks associated with rehypothecation, which is notorious in traditional finance. In the DeFi context, rehypothecation occurs when users provide collateral, such as LP (liquidity provider) tokens, which the platform then uses to generate yield, borrow additional assets, or provide liquidity elsewhere.

This recursive use of collateral increases risk exposure because if one link in the chain fails, it can trigger liquidations, insolvencies, or even platform-wide crashes. You can learn about this by analyzing the Anchor Protocol on Terra.

For example, a user can deposit tokens into a DEX or borrowing and lending platform and receive LP tokens. They can then take these LP tokens to another platform and deposit them as collateral for a loan. They can repeat this process as many times as possible.

If the price of the asset falls, it will liquidate its position (i.e. sell off the user’s collateral). This means that the LP who provided the crypto loan to the user will lose profit, the borrower will lose their collateral, and any platform that held the LP tokens may sell them off, and if they do, may not receive the original asset deposited, leading to a liquidation crisis.

Summary of yield farming risks

Many DeFi platforms are highly interdependent, with liquidity and collateral flowing between different protocols. The recursive use of LP tokens or other derivative assets creates complex, fragile chains.

If a single link in this chain fails — whether it’s a borrower defaulting, an asset being liquidated, or collateral becoming illiquid—it can trigger a chain reaction of defaults across the entire system. In summary, yield farming can create user risks, platform/application risks, and systemic/market risks.

Best platforms for yield farming

There are various platforms for yield farming. Let’s get into a few.

1. PancakeSwap

Operating as a DEX, PancakeSwap is built on the Binance Smart Chain. It functions similarly to other automated market maker platforms, enabling users to engage in direct cryptocurrency trading from their digital wallets without relying on intermediaries.

Through the liquidity pool model, PancakeSwap allows users to contribute their tokens to different liquidity pools, which in turn facilitates trading activities. By staking LP Tokens, users can use Yield Farms to earn CAKE while supporting PancakeSwap.

Liquidity providers earn fees proportional to their share of the total pool on trades executed within their respective pools. This mechanism incentivizes users to contribute liquidity to the platform and participate in its ecosystem.

Trading fees on PancakeSwap can be as low as 0.2% per trade, making it a more affordable option for frequent traders looking to cut costs.

2. Bake (ex. Cake DeFi)

CakeDeFi is a user-friendly platform that caters to all your DeFi requirements. It is a fintech company based in Singapore that brings together multiple DeFi applications and services into one platform.

This yield farming app offers staking, borrowing, yield mining, and YieldVault as its key products. YieldVault allows investors to earn high returns on their crypto assets by utilizing DeFiChain vaults and leveraging negative interest rates.

Staking, borrowing, and yield mining function exactly as their names imply, providing users with additional ways to maximize their earnings. CakeDeFi also offers a staking service tailored for intermediate-level investors.

Liquidity mining, in simple terms, allows crypto investors to earn rewards by providing liquidity to a decentralized exchange. For those who want to maintain ownership of their crypto assets but need funds to support their cash flow, Cake DeFi’s “Borrow” service enables them to use their assets as collateral and receive the necessary funds.

3. Aave

Aave is a non-custodial liquidity platform for lending and borrowing cryptocurrencies. It supports various stablecoins and other assets, such as DAI, USDT, BAT, and yearn.finance.

The website’s main page provides an overview of supported assets. Here, you can see the market size, total amounts borrowed, and yearly interest paid on depositing assets as well as borrowing them. Also, you can see these values in USD or their native amounts, which is an ideal choice for investing experts.

4. Compound

At first glance, the popular lending platform Compound is very similar to Aave. This platform offers lending and borrowing for many of the same assets. Compound also provides a ton of information, such as supply annual interest rates, total supply on the liquidity pool, and more.

What makes Compound stand out, however, is its implementation on other cryptocurrency platforms. For example, you can earn the platform’s COMP token via assets stored in your Coinbase or Ledger wallets. This saves you time and money as you don’t need to pay transaction fees to move assets into the Compound Wallet.

5. Uniswap

Uniswap was one of the first borrowing and lending platforms to take off during the big DeFi boom. The exchange supports over 200 integrations with decentralized finance platforms such as Compound, Aave, and even the centralized platform Coinbase.

Apart from Uniswap’s liquidity pool, you can enjoy many benefits. The platform offers governance based on its UNI token, swaps for all types of cryptos, and various chart information that both lenders and borrowers can use.

6. Balancer

As a popular DEX, Balancer is an interesting platform because it enables anyone to trade Ether against ERC-20 tokens in a liquidity pool they create. A created pool contributes to the overall balancer liquidity and rewards you in the platform’s BAL token.

This method is also called an Automated Market Maker (AMM). Basically, liquidity will move around in a pool of two assets as users borrow, lend, and withdraw assets from it. This activity, of course, consistently changes the price of assets within said pool. To counteract this, Balancer automatically converts assets through pools that create the best user value.

7. Sushiswap

Finally, we have Sushiswap. This DEX platform is actually a hard fork of Uniswap, meaning it’s also an AMM. The protocol supports various assets not listed on other providers, making it quite appealing to experienced providers and borrowers.

By providing liquidity, lenders yield SUSHI as a reward. They can then take those rewards and place them in the SushiBar for staking, which earns them xSUSHI to profit even more. xSUSHI is an asset minted when investors buy SUSHI, utilizing transaction fees to do so.

Mastering the art of yield farming

Now that you’re informed about yield farming and the optimal platforms for it, you’re well-equipped to navigate this complex, sometimes daunting, but potentially lucrative domain. Understanding the risks and rewards, keeping abreast of market trends, and choosing the right platform are crucial steps in your yield farming journey. By doing so, you can maximize your opportunities for profit while managing potential risks in this dynamic area of finance.

Frequently asked questions