Yield Farming in DeFi: How Does It Work?

In less than ten years, we’ve seen the novel crypto space reshape everything we know. Now, we are all on the verge of perceiving the rise of Decentralized Finance (or simply DeFi) and yield farming becoming mainstream with its applications in the crypto world. With the surge of $4 billion total value locked (TVL) in DeFi, this ecosystem’s development is nothing but viable. Of course, DeFi or crypto is volatile. But it also unlocks more opportunities for the public. 

The upshot? More DeFi projects are introduced to sustain and transform conventional financial products run on transparent protocols without intermediaries. That’s precisely how decentralized exchanges, insurance, lending, and borrowing give rise to the newer phenomenon — yield farming.

If you find yourself struggling to understand the fundamentals of yield farming, or to assimilate the relationship between DeFi and yield farming, here’s what you need. Read on to deciphers what yield farming is all about, including its mechanism, applications, profitability, and the underlying risks.

What Is Yield Farming?

Yield farming is a practice allowing yield farmers to earn rewards by staking ERC-20 tokens and stablecoins in exchange to support the DeFi ecosystem. Yield farming, also known as liquidity mining, involves depositing and lending crypto underlying a mining mechanism to liquidate the liquidity pool for lucrative rewards.

While yield farming is comparably similar to staking’s concept, there is an underline complexity associated with this mechanism. Contrary to crypto staking, yield farmers usually locomote their digital assets from one lending market to another in search of the highest yields. 

Typically, a yield farmer is required to lock their funds into a lending protocol. These protocols are such as Compound Finance or MakerDAO to liquidate the funding pools. In the process, the borrowers and lenders can earn some incentives. For example, when a yield farmer stakes 1,000 USDT in a Compound, the farmer will get a token in return for a cUSDT token. These tokens can then be pumped into an auto-market maker’s (AMM) liquidity pool that accepts cUSDT to leech off the transaction fees. In short, a yield farmer is earning incentives on Compound and the liquidity pool.

How Yield Farming Started?

The emergence of the DeFi Compound (COMP) and Aave is what gave rise to yield farming’s boom in the early summer of 2020. Soon after the COMP governance token issuance took off, the succeeding AMM partakers like the Balancer, Kyber, Tenders, and SushiSwap in yield farming further strengthened its growth and position. It was thereby making yield farming one of the most popular trends in the DeFi industry. While it’s possible to farm using cryptocurrencies like ETH and stablecoin like DAI, USDT is still a more acceptable token across the AMM platforms. 

Of course, there are plenty of reasons that contribute to the popularity of yield farming. But, the main attribution to yield farming popularity is that it offers a unique opportunity to earn a yield on loan. Regardless of your status, a yield farmer can find loopholes to stack yields and simultaneously earn multiple governance tokens.

How Does Yield Farming Work?

Yield farming is never a standalone mechanism. It usually involves extensive participation of the automated market makers (AMM) — the liquidity providers (LP) that add funds to the liquidity pool from time-to-time to uphold the ecosystem. The resemblance of the staking concept allows LP to earn rewards by facilitating the transactions in a blockchain network.

Hence, the LP and liquidity pool play an indispensable role in upkeeping the liquidation rate. After all, liquidity tends to attract more liquidity. 

The AMM’s concept is direct yet intricate at the same time. Liquidity providers who provide funds into the liquidity pool enable yield farmers to lend, borrow, and exchange tokens. Every transaction will incur a fee, and these fees are paid out to the liquidity providers in exchange for the service. Besides the yields, new tokens will be paid out according to the unique implementation of the protocol to encourage LP to keep funding the liquidity pool. 

It should be clear that DeFi is built based on Ethereum (ETH), and it is common that stablecoins are frequently deposited. In DeFi, stablecoins are pegged to USD. Hence, you’ll often see coins like DAI, USDT, USDC, and more in the DeFi ecosystem. However, according to the protocols, if you’re depositing USDT into Compound, instead of getting USDT, you’ll receive cUSDT.

Of course, there are no restrictions on how you circulate the coins for maximum yields. But, you’re bound to follow the protocols. That means your cUSDT is continually changing depending on the tokens that are pegged to the protocols. 

However, yield farming is still at its initial stage. So, it is rather complex to comprehend the operations for maximum yields. On top of that, yield farmers rarely disclose their strategies to the public, making it even harder for beginners to understand. 

Yield farming vs. Crypto Mining

Crypto mining is based on a consensus algorithm called Proof of Work (PoW), while yield farming relies on the decentralized ecosystem of “money legos” built on Ethereum. Compared to crypto mining, yield farming is an innovative way to earn rewards with cryptocurrency holdings using permissionless liquidity protocols.

While both yield farming and crypto mining involve mining pools, liquidity providers are the prominent elements that differentiate yield farming from crypto mining. 

Beyond the shared, decentralized peer-to-peer network, what further differentiates yield farming is its resemblance to the borrowing and lending plan involving governance tokens to yield rewards. On the contrary, crypto mining aids the introduction of new coins into the existing supply by block mining a block is to hash each transaction taken from the memory pool individually.

Ultimately, yield farmers and crypto miners shared the same goal to earn incentives by deploying unique strategies to maximize yields.

Yield Farming vs. Liquidity Mining

In simple understanding, liquidity mining is by giving liquidity to accrue tokens and obtaining governance rights, the token represents as an incentive. The curious amalgam of liquidity and mining’s concept gives rise to liquidity mining favoring the DeFi prospects.

While the dissection of liquidity involves the supply of coins or tokens, mining, on the other hand, takes account of the Proof-of-Work (POW) computation power to receive new tokens minted by the algorithm. For example, an avid investor can supply liquidation by staking in a liquidity pool like Uniswap to earn a dividend of 0.3% swap alongside newly minted tokens upon each block’s completion.

On the contrary, yield farming is a liquidity movement across DeFi platforms utilizing different mechanisms, including fund leveraging and liquidity mining, to maximize returns. At the same time, yield farmers maximize their gains by moving funds from time-to-time with different strategies. These strategies could range from yield farming roots to increase liquidity for Synthetic ETH tokens or using the 100% APR approach to supercharge earnings by leveraging loans to borrow tokens that yield Compound. 

Ultimately, both liquidity mining and yield farming indeed differ even though they are used interchangeably due to their nature to maximize returns by earning governance tokens. 

Yield Farming vs. Staking

Yield farming allows the token holders to generate passive income by locking their funds into a lending pool for some interests as a return. While crypto staking involves a validator who locks up their coins, they can be randomly selected by the Proof of stake (PoS) protocol at specific intervals to create a block. 

When yield farming and staking compared side-by-side, staking usually involves a more considerable amount of crypto to boost the chances of being selected as the next block validator. Depending on the coin maturation, it can take up to a couple of days before the staking rewards come by for collection. 

In contrast, yield farmers move the digital assets more actively from time-to-time to earn new governance tokens or smaller transaction fees. Unlike staking, yield farmers can deposit multiple coins into liquidity pools across several protocols. For example, yield farmers can deposit ETH to Compound to mint cETH, then consecutively deposit it into one to another protocol that mints third and fourth tokens.

Compared to staking, yield farming is more complex, and the chains can be hard to follow. And though yield farming has a higher return rate, it is also risker.

Is Yield Farming Profitable?

Anyone who invests would expect a return, and yield farming is no exception. As we discussed earlier, yield farmers earn rewards by lending in the liquidity pool, but it also sparks a discussion about whether yield farming is profitable. 

Yield farming’s returns are normally calculated yearly. That means you should expect an average return over the span of a year for more accurate prediction analysis. However, the profitability of yield farming is rather complicated as it highly depends on the capital you deploy, the strategies you use, and of course, to include the liquidation risks of your collaterals.

On the bright side, since yield farming is still at its early stage, those who decided to stake their cryptocurrencies into the protocols can expect significant returns. While the profitability is uncertain, some successful yield farming techniques are circulating in the crypto world with earnings as high as hundred-per-cent. With the continuous growth of active users in DeFi, the return-of-investments in the tokens with governance rights could be a massive hit in the upcoming years. 

How to Calculate the Yield Farming Returns?

It is hard to estimate the returns of yield farming even in a short term period. As many factors could contribute to these uncertainties, some of the reasons include the volatile fluctuations in yield farming and the relentless competition. Let’s put the demand and supply concept to justify the idea. So, if one of the yield farming strategies is overpopulated, naturally, the returns will dwindle.  

On the bright side, calculating the ROI of yield farming is still possible despite the limitations. Here’s an overview of the standard metrics:

Annual Percentage Rate (APR)

APR does not consider compounding, which means the calculation only involves the multiplication of the periodic interest rate with the number of periods within a year. The yearly return rate is imposed on borrowers but is paid to the capital investors. 

Annual Percentage Yield (APY)

APY distinguishes itself from APR, wherein the return rate based on APY is imposed on the capital borrowers and then paid to the capital providers rather than the investors. Whereas the compounding interest is taken into account to bring more returns to the investors.

Basically, the main difference between these two metrics is that APR does not take compounding into account, while APY describes the return rate with interest on interest.

What Are The Risks of Yield Farming?

Every investment possesses some threats, and yield farming is no different. Yield farming is indeed profitable at its early stage, but the profit does not come easy without extensive strategic planning. In most cases, the most profitable yield farming strategy involves a highly complex process. It also requires a boatload of capital to deploy different investment tactics out the mechanism for the best.

In fact, if you’re unaware of the risks it comes alongside, you’re likely to expose yourself to the following threats:

Higher Possibilities for Your Collateral to Being Liquidated

In order to take a loan, you’ll need to collateral some assets. Depending on the protocols, some borrowers are required to over-collateral. Mainly to ease in some room for position adjustments in the market whenever there’s a sudden market crash. While some lenders require little to no collaterals. That’s precisely why it’s essential to take the collateral ratio into account to avoid liquidation from happening. 

For example, you can only borrow an asset if you deposit according to the collateralization ratio of 400%. By right, when your collateral value is 1000 USD, you can only borrow 250 USD. So, it means the higher the collateral ratio, the lesser you can borrow. It’s best to steer away from liquidation by adding more collateral from the actual asset you intend to borrow.

Experience Asset Losses Over the Smart Contract Glitches

Yield farming relies on smart contracts to bind all two anonymous parties’ farming transactions without central enforcement. That means when there’s infiltration or error in the central data, many may fall victim to the system failure. That includes the leaks of financial information and the loss of funds. 

The Decrease in the Value of a Token in the Future

The farmed token might grow great in value, but it could plunge too. While the DeFi hype might put up for the growth as a result of the public interest, the future is uncertain. Ultimately, the value drops whenever the trend dies down or there is an oversupply token in the market.

Lacks Assurance as Defi Ecosystem Is a Highly Composable System

DeFi is built based on the idea of composability. Each of the building blocks deals with the inter-relationship based off the application for a specific goal. While this idea helps to eradicate a third-party involvement, thereby making the protocols seamless and permission-less. The down part is when a block experiences a malfunction; the entire ecosystem needs to put up for the losses too. 

Is Yield Farming Safe?

It’s a lie if you’re told that yield farming is entirely safe. Like everything else, investment takes time, effort, and extensive research to understand the concept. So, it’s always dangerous for those who fail to appreciate the ideology behind it.

However, all these can be prevented by reading and understanding the terms of a smart contract. Try to be less reliant on outsourcing third-party to interpret the contract and instead know the contract’s ins-and-outs to flag out a scam. However, do note that smart contracts are vulnerable to system bugs. That means, if the system fails, you might risk losing the staked funds or values of a token in the protocol.

While some crypto enthusiasts believe DeFi or yield farming possesses boundless growth, the volatility is still undeniable. And it’s being speculated to be just another crypto bubble. After all, you should weigh your financial position and your capability to make a decision from the most logical standpoint.

How to Farm Yield on Different Platforms?

It’s clear by now that farmers earn incentives by providing liquidity to a platform. So the interests and fees are varied depending on the capital growth and the strategies you deploy. The inevitable questions you may be asking what could be the protocol choices you can diversify your yield.

Here’s the answer:

Uniswap

As a decentralized exchange (DEX), Uniswap involves AMM to swap two trustless cryptocurrencies into a fund pool. In exchange, the liquidity provider earns a 0.3% fee when liquidity is provided for each swap. 

Compound Finance

The Compound’s (COMP) token is granted to users who utilize COMP to borrow and lend crypto assets. This approach is one of the most popular strategies as it boasts simplicity, and anyone with an ETH wallet can supply assets to the COMP liquidity pool. However, the challenge here is to determine the tokens’ expected value while allocating sufficient liquidity to maximize the returns. 

Staking Yields

The great thing about yield farming is you can stake yields to generate more profits. Let’s say an LP received a token minted algorithmically; then, re-staking it based on the other protocols, it’ll yield a third token.

Here’s are some of the platforms that support these protocols:

• Aave
  According to the algorithmic interest rates, lenders who deposited funds will get aTokens and immediately earn compounding interest.
• Balancer
  Balancer adopted similar protocols like Uniswap to allow LP to allocate funds to the pool. However, LP can disregard the fixed funds’ allocation on Uniswap by allocating custom funds. 
• Curve
  As stablecoin optimized swaps, Curve functions like Uniswap, except it allows traders to make higher-value swaps with lower slippage rates. For example, a Curve token can be staked on Synthetix to yield sETH with the underlying minted token then redistributed to another staker. 

What to Consider Before Yield Farming?

Inconsistent Gas Fee

Yield farming is built upon Ethereum. So, the computation effort needed to execute a transaction or smart contract execution on ETH is inevitable. And to do so, we would need Ethereum Gas. Ultimately, the more complicated a protocol is, the more gas is required to execute a transaction.

In short, gas is used to calculate the fees to pay within the network to perform a transaction. Let’s say you intend to interact with Synthetix; you’ll need more gas to transfer any of the SNX because the protocol is more intricate than the others.

Risk on Debt Pool when Staking

The debt pool represents the total value of the tokens you funded in the platform. Taking Synthetix as an example again, when you stake by minting sUSD, you’ve already claimed a portion of the debt. 

So, if the majority of SNX holders hold sETH while ETH soars, then the debt pool will increase proportionally. That means you need more funds to unlock the SNX again. Let’s say you minted 1000 sUSD, and the total circulation of Synths is at $1 million; your debt ratio is standing at 0.1%. You’ll be needing 1000 sUSD to unlock the SNX, while the unlock rate doubles as the prices of Synths doubles as well.

Misleading Annual Percentage Yield (APY)

Calculating your short-term profit with APY can be misleading and confusing at the same time. Since the yields are usually based on an expected return yearly, the APY percentages in the short-term are not sustainable. Looking at the farming reward harvesting hourly, daily, or weekly, APR’s actual calculation is doubtful.

What Does the Future Hold for Yield Farming? 

DeFi and yield farming have shaken the internet since the rollout of this project. With over a million active users in this ecosystem, it’s impossible to see what the future holds. Shall there be newer, more value-adding, and more cut-edging distribution of applications to revolutionize the liquidation of yield farming or DeFi in general? Or DeFi taking over the Bitcoin era? Only the future can tell what it worth.

Disclaimer

This article is intended for and only to be used for reference purposes only. No such information provided through Bybit constitutes advice or a recommendation that any investment or trading strategy is suitable for any specific person. These forecasts are based on industry trends, circumstances involving clients, and other factors, and they involve risks, variables, and uncertainties. There is no guarantee presented or implied as to the accuracy of specific forecasts, projections, or predictive statements contained herein. Users of this article agree that Bybit does not take responsibility for any of your investment decisions. Please seek professional advice before trading.