What is Yield Farming and How Does It Work?

Lead Image by Alesia Kozik

Yield farming is the new high-risk, high-reward strategy that's taken the DeFi world by storm. This investment strategy has exploded in popularity, with $74.6 billion worth of staked assets in DeFi protocols in January 2023, according to Cointelegraph.

Since December 2022, the total value locked in DeFi protocols has grown byover 26%. But what is yield farming, exactly? In this article, you will get the scoop on this popular investment method and will explore potential gains and pitfalls. Let's dive into the exciting world of yield farming!

What is Yield Farming?

Yield farming essentially refers to earning more cryptocurrencies through the assets that a yield farmer already has by lending them to a borrower through smart contracts. It’s a high-risk activity that generates high rewards, and is carried out using different strategies to maintain impressive return rates.

For example, imagine having or borrowing some money from someone and then lending it to someone else at a higher interest rate. Then, repeating this process several times with different people and multiple sources of funds. This is how yield farming works!

Lending your cryptocurrency adds to the liquidity pool that also generates rewards. These rewards are generated by the fees charged by the DeFi platforms or a different source.

Sometimes, when the individual adds to the liquidity pools, rewards are given in the form of tokens. Now, that individual can re-invest these tokens to a different liquidity pool to earn more rewards, and so on.

How does Yield Farming work?

Now that it is clear what yield farming is, you can start practicing it to generate returns. How does it work, though?

First, you will have to register on any DeFi platform like Compound, Uniswap, Binance Smart Chain, etc., and start acquiring cryptocurrencies that work on that particular platform. These can be Ethereum (ETH), Bitcoin (BTC), or any other stablecoins such as USDT, USDC, etc.

Next, you will have to download a decentralized wallet to store these cryptocurrencies such as Trustwallet, Metamask, Wallet Connect, etc. Now, register when prompted for details and keep the private key and seed secure used for the wallet in a safe place.

Next, transfer funds to your wallet and then go to the dApp section of the wallet to start your yield farming journey.

Now, you will be able to lend your crypto to the borrowers and earn interest on the loan. These interest rates might be fixed or may vary depending on the platform you are using.

Sometimes, for lending, the platform also rewards you with its native token, for instance, Compound, that you can again use to lend and keep the cycle going to earn high returns.

While borrowing though, the borrower will have to deposit an amount that is in proportion to the amount that is to be borrowed as collateral before the transaction happens to safeguard the funds of the lender.

This entire system is done through smart contracts. They enable these transactions to be trustless, decentralized, and seamless. The value of the funds in the smart contract can fluctuate depending on the market price.

Hence, if it turns out that the collateralized amount pledged by the borrower is less than the amount that was lent, the smart contract will get triggered. Post that, the borrower’s account will get liquidated to pay interest to the lender. Consequently, the lender is never at a loss even if the borrower defaults on the loan.

For instance, let’s say the borrower takes out a $100 loan from the lender and pledges an article worth $80 as collateral. Now, if the price of the article drops to $70 as per the market, the smart contract will be triggered. The borrower’s article would be sold to pay interest to the lender.

How to calculate Yield Farming returns?

Yield farming is a competitive space, and consequently, the incentives earned change pretty rapidly. As soon as a farming strategy starts working, other yield farmers take note of it and start profiting off it, making it less profitable within a short period. However, the returns yielded can be calculated via two methods:

1. Annual Percentage Rate or APR

   When an investor re-invests the gains accrued over a span to gain more, the annual returns are calculated on that, using the Annual Percentage Rate or APR. Compounding is not taken into account for this metric.

   
   

2. Annual Percentage Yield or APY

   Here also, the returns are calculated over a period but compounding is taken into account when annual returns are being calculated.

   
   

However, as yield farming generally involves short-term gains, there are other ways as well to calculate returns for a short period rather than every year. Also, these return calculations have been automated now by several platforms to make things easier for the farmers. Platforms such as Zapper, Aave, Harvest Finance, Yearn.finance, etc.

Risks of Yield Farming

As lucrative yield farming can get, it also comes with risks that can make you bear huge losses, especially in times of financial turbulence in the crypto ecosystem. The losses can be impermanent, and the investors may see the prices of their crypto assets slipping drastically low.

Also, the regulation part of the crypto space is still clouded with uncertainty. Some of the risks associated to yield farming are mentioned below:

Rug Pulls

Yield farmers are particularly vulnerable to these kinds of exit scams because they’re often lured in to invest in new and untested projects being built by developers. The projects are incentivized by high APY when compared to the standard 10%-15% returns that investments generally lead to. The amount of APY depends on the project, protocols, etc though.

Also, the farmers may not have access to all the information they require to make informed investment decisions. Moreover, smart contracts may have loopholes that the investors may be unaware of. Hence, the developer, after collecting the desired amount of funds, may disappear, leaving the investors looking at a financial loss.

A good example would be the OneCoin rug pull that happened in 2017. It was a cryptocurrency ponzi scheme in which the founder disappeared after raising $4 billion.

Volatility

Volatility can be a major concern for yield farmers, especially during bear or bull runs in the crypto environment. The value of the tokens can rise or fall drastically due to instability.

Yield farmers can face impermanent losses due to this, as the tokens are locked up. As such, the changing prices of the tokens in the liquidity pools consequently change the ratio of the tokens in the pool to stabilize their total value.

Smart Contract Hacks

DeFi is comparatively a new space, and continuous improvements are being made to advance it. Hence, its components are vulnerable to bugs and hacks.

One of these components is a smart contract that is used for secure transactions but is prone to hacks that can lead to losses for investors. Yield farmers often use multiple protocols and smart contracts to maximize their returns, which increases their exposure to potential smart contract hacks.

A single vulnerability in any of the smart contracts used by the yield farmer could lead to a loss of funds across all the protocols they are invested in.

For instance, a very popular decentralized exchange called SushiSwap suffered a loss worth $3.3 million because of a bug in their smart contract called RouteProcess02. Luckily, only those individuals were affected by this that had swapped during the last four days leading to this event.

One crypto advocate called Sifu was majorly impacted by this, as the user lost 1800 ETH. Although the exchange recovered the majority of the funds, this event showed how vulnerable a position user can get into.

Although technological advancements are in line such as third-party audits and vetting the basic code. They make smart contracts more secure, but yield farmers should be careful.

Farm your yields or let them wilt away?

Though yield farming protocols offer lucrative returns, they’re not guaranteed.

Although it is a high-risk activity that produces enticing gains within the short term, it also comes with multiple risks such as volatility, regulatory risks, smart contract hacks, rug pulls, impermanent losses, etc.

Hence, yield farmers need to conduct thorough research and due diligence before diving into investing in any DeFi project!

The yield farming space is continually evolving and brimming with new trends and innovations. For instance, Spiral DAO's novel yield farming model, which uses a two-token structure to optimize market position tells us what might be in store for the future.

Also, the expansion of DeFi beyond the Ethereum ecosystem is offering more yield farming opportunities, as Binance Smart Chain and Solana gain popularity. This space may also experience regulatory scrutiny as regulators seek to protect the space to prevent illicit activities.

Overall, the future of yield farming may be shaped by a lot of innovations, regulatory developments, competition, and much more in the coming years!