Yield farming refers to earning rewards in an asset other than the base one for blocking your funds in liquidity pools, e.g., on decentralized exchanges, in lending protocols or in crosschain bridges.
DeFi-staking and farming are very similar, because in both cases an investor's funds are blocked in some protocol, but farming is associated with obtaining some other asset that the investor can use at his discretion. For instance, the Compound Finance lending protocol offers its users COMP tokens as a reward, and Yearn Finance offers YFI tokens. In other words, you are engaged in yield farming if you “farm” some other asset as a reward in the process of blocking your assets.
What is yield farming?
Yield farming using the example of the Compound lending protocol has shown that it can be incredibly profitable. The COMP token showed an increase of about 1000% in the wake of the farming hype, despite the fact that it was conceived as a governance token and intended primarily for those who had to participate in project development, voting for certain decisions with their tokens.
However, as practice has shown, the majority were not at all interested in governance issues, but simply earned by providing liquidity on these favorable terms. Subsequently, the hype subsided, and the COMP price stabilized at 20 times below the spring 2021 maximum.
Is yield farming worth It
In the process of yield farming, you receive a certain asset in exchange for the provided liquidity. In general, you can use this asset in some other protocol, e.g., by staking it. If the exchange rate of the farmed asset increases significantly, you will be able to earn even more - the Compound example is more than eloquent, however, it should be remembered that Compound was a pioneer of yield farming, which is why it was so successful.
Is yield farming worth it? Nevertheless, even today yield farming offers an excellent opportunity to earn by providing liquidity to a particular pool. This is a kind of bank deposit that allows you to receive passive income. By engaging in yield farming in various projects, you can skillfully diversify risks and maintain high profitability.
With the help of a minimalist service called vfat.tools, you can see all the many yield farming projects, and by connecting a wallet to it, evaluate the TVL and the current profitability of each:
How does yield farming work?
One of the most common options for yield farming is to provide liquidity to decentralized exchanges. When we come to DEX to exchange one token for another, we work with the liquidity pool of this pair of tokens. This liquidity is provided by other users, i.e., farmers for rewards.
For instance, the Cake token is farmed this way on the PancakeSwap exchange. At the first stage, the so-called liquidity provider deposits a pair of tokens in a ratio of 1:1 (relative to USDT) and receives the LP tokens of this pair as a debt receipt for this from the exchange. At the second stage, LP tokens must be staked. At this moment, profit generation begins - and it can be easily tracked on the exchange's ROI calculator. If you find that some other project offers better returns, you can always withdraw and redirect some or all of the funds there.
The same happens with investing in lending protocols - in response, you get a “receipt” in the form of an alternative asset and rewards through farming. The profitability and interfaces of farming projects may differ significantly, but they all have one thing in common - you earn in other coins by providing the ones that you have.
Types of yield farming
You can earn money by yield farming on decentralized exchanges that work thanks to liquidity pools and so-called automatic market makers. It is profitable for exchanges to attract your funds, thus they offer the appropriate incentives. The Uniswap decentralized exchange was the first to propose the idea of an automatic market maker, where liquidity pools of trading pairs are required to ensure trading.
You can provide funds to lending protocols so that the users of these projects can take out loans. The Aave and Compound protocols are widely known.
You can provide liquidity to a project in which, according to the Whitepaper, an asset with a certain value is issued and distributed among the participants. For example, the Minto mining project is a tokenized mining farm, where 100 BTCMT tokens (Bitcoin Mining Token) are equated to a hashrate unit: 100 BTCMT = 1 TH/s. By staking BTCMT tokens on the Minto platform, the users receive daily mining rewards in Bitcoins in proportion to the hashrate that they indirectly own through BTCMT tokens. Thus, we can say that Minto users conduct yield farming of Bitcoin, providing liquidity to the Minto project through the purchase of its mining capacity hashrate.
Different projects implement the idea of raising funds in different ways, but the principle remains the same: users fill projects with liquidity, and projects pay out rewards for it. If the rewards are paid out in an asset other than the one provided, this is referred to as the yield farming of this asset.
Risks of yield farming
Most yield farming risks are somehow related to exchange rate fluctuations of both basic and farming assets. When the market is falling on all fronts, even high-rate yield farming will not be able to break even.
On decentralized exchanges, there is a risk of impermanent losses associated with the fact that assets are deposited into the pool in pairs of equal value. As soon as the balance is broken, there is a loss in either asset.
It is also necessary to remember that any action in DeFi is an interaction with the respective smart contract, for which you have to pay a fee. Sometimes the fees for providing funds or any other operations are very large - when familiarizing yourself with the platform and especially when depositing liquidity, be sure to keep track of information about commissions. Abandon your intentions if the commissions are too large - there are many projects with low commissions.
Any platform can suffer as a result of hacking, smart contract errors, etc. Trust platforms with only audited smart contracts. At the same time, no one is immune from losses in the crypto industry, regardless of the segment, because it’s a young industry where you work at your own risk.
The regulator represented by the SEC is dissatisfied with the DeFi development, so the pressure on this segment will only increase. Regulatory initiatives may negatively affect the profitability of yield farming projects.
Is yield farming profitable?
Yield farming is a very profitable occupation if you manage risks competently and do not invest all your funds in any one project. Despite the fact that yield farming is a passive investment, some projects offer high interest rates and allow you to earn even when the market is drifting sideways.
Yield farming is good if you do not want to engage in mining and are not ready to actively trade on an exchange, nevertheless, the best yield farming strategy is a combination of different types of activities according to the market period and the opportunities that open up. Sometimes farming can be much more attractive than trading, and vice versa. It all depends on the state of the market and your approach to it.
Is yield farming worth it. FAQ
Is yield farming a good investment?
Investing in yield farming is a passive income generation strategy comparable to a bank deposit. Yield farming allows you to earn on assets other than the basic ones when providing liquidity to a particular project. This is undoubtedly a great investment if you skillfully combine staking, farming and trading, limiting risks with passive strategies and increasing profits by active trading when the market allows it. However, even if you use only yield farming, you can easily earn at a double-digit rate.
What is the downside of yield farming?
Yield farming may seem more difficult to understand than conventional staking, besides, it contains more risks, e.g., the risk of impermanent losses. Regulator intervention may also negatively affect the entire DeFi segment. Nevertheless, the whole farming history, starting with the Compound Finance project, demonstrates the huge attractiveness of this sphere among investors.
Is yield farming riskier than staking?
In formal terms, since yield farming has more variable components than conventional staking, it is certainly more risky. In other words, since you earn on some other assets, you risk a loss in the value of both the provided and earned assets. However, it all depends on the project you are investing in, because each project comprises a team, an idea, the quality of the work done, etc. By skillfully limiting risks, you will never lose much.
