12/21/2020

What is Yield Farming?

If you’ve read about decentralized finance (DeFi), it’s likely you’ve encountered the curious term “yield farming.”  As it turns out, yield farming does have a lot in common with growing crops. Both require dedication, rotation and care. Liquidity providers (LPs), like farmers, want to find the richest soil and the most profitable fruit, and that’s no easy task.

DeFi constantly pushes toward unexplored areas, finding workable solutions to current problems. These protocols only work if they’re able to keep money circulating in their smart contracts, which means that, to get the best return, LPs need to constantly move their crypto assets around. Providing liquidity can be taxing and time-consuming for the user since DeFi moves at a breakneck speed and interest rates can fluctuate wildly.

Liquidity mining explained

Yield farming, or liquidity mining, is the concept of using DeFi platforms to generate interest and rewards. It often involves using the Ethereum blockchain to make money on trading fees, token generation, and interest. Just like Bitcoin miners, liquidity miners are rewarded for their involvement and perpetuation of the ecosystem. In this case, miners aren’t providing computer power, but capital.

Yield farmers can maximize their returns with a few tools: lending and borrowing platforms, liquidity pools, and by staking (or 'locking-in') their tokens. These tools can often be used in tandem to earn more yield and rewards. DeFi protocols require a lot of financial capital to work properly and must compete with each other to bring in enough liquidity to function. After all, it’s not cheap to kickstart a bank. The health of these projects is often measured in total value locked (TVL), or the amount of capital locked in their smart contracts.

Liquidity providers are usually rewarded based on how much of a pool they control. Although LPs can get paid well, there’s an ever-present risk of losing funds to liquidation, price movement, or smart contract exploits. By participating in this new money market, users can earn a significantly higher annual percentage yield (APY) than any bank can offer, but they must navigate the dangers of an unregulated and immature market.

A moving target

DeFi enthusiasts first started talking about yield farming with the emergence of platforms like Compound. Since Compound rewarded borrowers and lenders with its native token, COMP, users found clever ways to “farm” COMP by borrowing a lesser-used token and then lending it back to Compound. Farming COMP often provided better returns than simply accepting the interest rate, even if some capital was lost on the initial investment. The strategy worked pretty well on other applications like Aave, Curve and Balancer, leading to the creative use of multiple DeFi platforms to maximize yield.

Liquidity mining has become a central pillar of decentralized finance. It’s essentially the process of taking different pieces of the DeFi puzzle and rearranging them in new ways to find the optimal yield. The best rate, however, is a moving target that becomes increasingly difficult to track as DeFi develops, requiring investors to jump from pool to pool in pursuit of the highest APY. This creates exciting, albeit sometimes risky, opportunities for the end-user.

Farming tools

Yield farming can involve the use of one or several DeFi cornerstones like borrowing and lending platforms, decentralized exchanges (DEXs) and liquidity pools, staking, and so-called “second-layer” farms that utilize the bigger protocols. Each has a slightly different method of rewarding crypto holders for locking their assets, and each tool fulfills a distinct role within the broader DeFi ecosystem.

Well-known projects like Compound, Aave and Uniswap are safe gateways to yield farming. Newer, second-layer projects can generate even better returns, but with increased risks, as they may not be fully tested or audited. The chase for the best APY has also led to the emergence of some fairly worthless products that pull yield farmers in with attractive rewards, but token hyperinflation means little return and the risk of incurring a big loss. Therefore, it’s important to understand the positives and negatives of each tool, what they do, and which ones you’re comfortable using.


Lending and borrowing platforms

As we covered in our last blog post, lending and borrowing platforms let users earn interest on crypto deposits like Ether (ETH), which act as collateral for borrowing. Lending projects offer a straightforward path to liquidity incentives, which includes a typical base APY rate of 2-3%. In addition to interest, lenders and borrowers generate governance tokens such as COMP and LEND that can be sold on the open market. Although they’re not as profitable as they used to be, yield farming with lending platforms is one of the safest and most reliable methods to earn rewards. Lending projects also enable unique ways for liquidity providers to obtain different tokens for liquidity mining without having to buy them outright.


Liquidity pools & DEXs

Liquidity pools and DEXs include protocols such as Curve, Uniswap and Balancer. Their liquidity pools are critical to making the project run smoothly, and yield farmers typically earn from fees and governance tokens. A large liquidity pool can also underpin a great deal of second-layer farming applications such as Yearn.finance, Harvest Finance and CORE. Anyone can become a liquidity miner by adding funds to a given liquidity pool, which improves the health of the pool and reduces friction from trading the underlying tokens.


Staking and vaults

Staking tokens means locking them into a smart contract, sometimes for a set amount of time, to earn passive rewards. The concept of staking is to limit a token’s market supply, thereby increasing demand, reducing selling pressure and incentivizing users to provide liquidity. A liquidity provider is often rewarded with more of the token they’re staking, while farms might offer a governance token in exchange for staking on their website. Increasingly, a farming project will give rewards for staking Uniswap LP tokens since it’s the most popular DEX and liquidity providers help make the token more tradable. YFI took staking a step further by popularizing vaults for stablecoins and offering up to 5% APY.


Second-layer farms

The number of farming projects increases daily. Many are risky, and some are just copycat projects that have usually have a hyper-inflationary or useless token. A few protocols have surfaced recently that challenge the norm, find ways to farm more efficiently, or improve on the existing system. Pickle Finance, for instance, aims to limit the slippage for stablecoin trading pairs, and provides some benefit to the ecosystem. Similarly, CORE developed a new way to lock liquidity forever, yet reliably reward LPs through arbitrage and other techniques. We can expect a lot more from second-layer applications that build and improve upon existing DeFi architecture, and the next big project is always right around the corner.

Risks

It’s very easy to take missteps while learning how to yield farm. Unfortunately, many have had to learn things the hard way to really understand it. As new DeFi projects become more credible and secure, their interest rates should stabilize. Right now, however, rates can outperform anything in traditional banking by a huge margin. Some of the most visible risks include smart contract exploits, price volatility, and impermanent loss (which will be explained in a later piece). Mistakes during the learning process can also result in hefty transaction fees, making liquidity mining inefficient or unprofitable.

YIELD App’s solution

YIELD App understands that liquidity mining isn’t a realistic choice for most crypto investors who want to earn high interest on their stablecoins. Decentralized finance is too opaque, fast-moving and new for many users, and yield farming demands enormous amounts of time and energy. Furthermore, it’s not viable for many retail investors to foot the bill for transaction fees, which can add up quickly after a series of transactions. Led by an expert team, YIELD App finds the optimal APY available among DeFi products. Rates adjust daily to ensure funds remain safe and insured from any hazards, and the app lets users conveniently access their funds and decide which program suits them best. By using the best-available products and strategies, YIELD App democratizes DeFi and makes it accessible to all.

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