The world of Decentralized Finance, a movement that seeks to create an open, permissionless, and third-party free financial ecosystem, has birthed many new concepts. One such concept is Yield farming.

Having emerged in the summer of 2020, yield farming is a strategy crypto investors use to earn passive income on their otherwise idle crypto assets. This strategy quickly amassed popularity after its emergence and became one of the major reasons for the growth of the DeFi sector. Today, yield farming contributes more than $5 billion to the $40 billion of Total Value Locked (TVL) crypto assets in the DeFi sector.

In this article, we explore the intricacies of yield farming, the differences between yield farming and other earning strategies, the profits yield farmers stand to gain, the risks involved, and the best platforms and protocols for yield farming.

What Is Yield Farming?

Yield farming is a strategy crypto investors use to earn additional income on their cryptocurrency holdings. The strategy is named yield farming because it mimics the process of farming: planting and reaping. In this case, however, investors lock up their assets in DeFi protocols and gain rewards.

Yield farming involves providing liquidity in the form of cryptocurrency holdings to liquidity pools, a collection of investors’ cryptocurrency assets that are backed by a smart contract. The purpose of providing this liquidity is so other users can lend, borrow or trade with the assets. In exchange for liquidity provided, investors receive rewards, usually in the form of interest on their deposits.

How Does Yield Farming Work?

Yield farming is based on two main factors, Liquidity Providers and liquidity pools. Investors who deposit their crypto assets into liquidity pools are known as Liquidity providers. Additionally, liquidity pools are based on smart contracts, and they serve to power DeFi protocols on decentralized exchanges (DEXs), peer to peer marketplaces where traders can borrow, trade or lend assets without the need for an intermediary.

The liquidity available on these DeFi protocols allows other users to lend, borrow or trade these assets. Every time a user lends or trades assets from that pool, they pay a fee. All fees are then distributed amongst liquidity providers according to the percentage of assets held in the liquidity pool. These processes make up a smart contract model called the Automated Market Maker (AMM).

In some cases, yield farming pro tools offer other types of incentives, including governance tokens and interests from lenders. All these yields are calculated annually using the Annual Percentage Yield (APY).

Is Yield Farming Profitable?

The high risks in yield farms parallel the profits investors stand to gain. However, the profits one can earn yield farming depend entirely on how much time and assets one can dedicate to the strategy.

An investor with extensive knowledge of DeFi platforms and protocols has the potential to double or even triple an investor’s initial deposit. Finding liquidity pools that offer APY in the hundreds or thousand percentage points is relatively easy with a little research and attention to detail.

Ultimately, the only real way to get real profit from these pools is by lending lots of funds to the protocol and familiarizing oneself with the complex strategies involved in yield farming.

How to Calculate Returns in Yield Farming

Returns in Yield farming are generally calculated annually. There are two standards of measurement used to calculate returns in yield farming: Annual Percentage Rate (APR) and Annual Percentage Yield (APY).

APR, also known as simple interest, is the rate of returns calculated annually and expressed in percentages. In contrast, APY is a method of calculating interest earned on cryptocurrency while considering compounding interest. Compounding interest results from interest gained on both the initial deposit and interest accrued on that deposit.

The difference between both methods of calculating yields is that APY considers compounding interest while APR does not. However, sometimes both terms are used in place of one another.

Staking vs Yield Farming vs Liquidity Mining

Within the DeFi network, Staking, Yield farming, and liquidity mining are the most popular terms and strategies within the decentralized finance network. All three terms are interconnected, but they hold certain differences.

First, staking is the most comprehensive strategy. It involves providing collateral in the form of crypto assets to blockchain networks that leverage the Proof of Stake (PoS) algorithm. The primary purpose of staking crypto is to validate a blockchain network and then gain rewards in the form of tokens which are distributed on-chain every time this validation happens. Staking is done using the PoS mechanism, and it works on centralized networks like Nexo and Coinbase.

Secondly, yield farming is the more popular strategy, and it involves providing liquidity in the form of idle crypto assets to liquidity pools, allowing other users to borrow those assets. Yield farming is done on decentralized finance applications (dApp), and investors store their crypto in smart contract-based liquidity pools such as ETH.

Finally, Liquidity Mining is a DeFi earning strategy that involves depositing crypto assets into DeFi protocols for trading. In exchange for the liquidity provided, liquidity miners receive the protocol’s native tokens. The strategy is based on decentralized mechanisms: Liquidity providers (LPs) and smart contracts.

The key difference between all three is their inner workings, the rewards received, and the mechanism investors use to apply the strategy. One thing to note is that while all three terms are strategies used in the DeFi network to earn income on crypto assets, they are subsets of each other. Ergo, yield farming is a subset of staking, and liquidity mining is, in turn, a subset of yield farming.

Top Yield Farming Platforms

Experienced yield farmers know that the best way to maximize returns is to use various DeFi protocols. Some protocols are more popular than others, and these top protocols include:

• AAVE: With over $9 billion in total value locked across 7 networks and 13 markets, AAVE is one of the most popular DeFi lending and borrowing protocols. The platform offers liquidity providers a percentage of the interest rate on loans and a percentage of the fees charged on flash loans.

• Curve: Another large DeFi platform, curve finance, is a decentralized exchange protocol focusing mainly on stablecoins. The protocol has over $5 billion in Total Value Locked assets and over 30% of the crypto volume share. APY’s on the curve platform range from below 1% to 32%. The platform is designed to optimize the swapping of stablecoins.

• Uniswap: This decentralized exchange platform supports the exchange of trustless tokens. To earn on this platform, liquidity providers are expected to stake equal proportions of assets on both sides of the pool. Uniswap has its own governance token and owes its popularity to the frictionless nature of the protocol.

• Compound: This is an open-source protocol that is open to users for lending and borrowing assets. Any crypto holder with an ethereum wallet can access the compound protocol, provide liquidity and earn a yield on their assets. In addition, Compound Finance also has its own token COMP.

What Are the Risks Involved in Yield Farming?

Like most cryptocurrency investments, yield farming is susceptible to various risks due mainly to its volatility and other factors involved in the investment process. For starters, most yield farming is performed on the ethereum network and is thus subject to high gas fees. In addition, some of the risks specific to yield farming include:

• Smart contracts risk: Liquidity pools in Yield farming are based on smart contracts, paperless digital codes with the terms of the agreement between parties. However, the nature of the DeFi sector, which supports the elimination of third-party systems, often results in smart contract codes being written by small developer teams with limited budgets. Smart contracts are therefore susceptible to bugs and attacks.

• Rug Pulls: This is an exit scam that occurs when developers call for funding to undertake a project and then abandon the project and abscond with all the funds. In the second half of 2020, rug pulls were responsible for 99% of fraudulent activities in the yield farming scene.

• Impermanent loss: The volatile nature of cryptocurrency often results in dramatic rises and falls in the value of a cryptocurrency. This volatility could result in sudden gains or losses that, in turn, might turn out to be unfavorable if the assets are withdrawn while the market value is low.

Conclusion

Yield farming is a profitable earning strategy within the DeFi sector that allows investors to earn returns on their cryptocurrency holdings. It has the potential to yield returns in high percentages, but it is also complex and susceptible to many risks.