What Is Yield Farming and How Does It Work in DeFi?

Try imagining constantly earning without moving a finger. It sounds like a dream, but it is a reality that is possible through yield farming. Yield farming is a strategy in the DeFi world where your crypto assets become active players instead of being idle to maximize returns. It involves strategically placing tokens in the right pools, staking them in the right protocols, and continuously reinvesting to make the most out of every opportunity. But like any investment strategy that offers high rewards, it comes with its own set of risks. In this article, we’ll delve into yield farming and its mechanics, types, and benefits.

What is Yield Farming?

Yield farming, also known as liquidity mining, is the process of depositing or locking your assets in a liquidity pool of a DeFi application to earn rewards. It is one of the popular ways of earning passive income and can help investors maximize returns on their holdings. The rewards can be part of the transaction fee, which comes in the form of liquidity provider (LP) tokens or governance tokens and is expressed as APY (annual percentage yield). Then, investors use the gained tokens on various DeFi protocols to earn additional rewards.

For instance, when an investor deposits their assets in a liquidity pool, they are used for token swaps or facilitate lending and borrowing activities, and the investor is rewarded for the activities. These rewards are reinvested into DeFi protocols, allowing investors to earn more rewards.

How Does Yield Farming Work?

There are several steps involved in yield farming, and they are,

Choosing a Platform: Different DeFi platforms use various protocols, so it’s important to choose a platform that aligns with the protocol you prefer. For instance, let’s take the Uniswap platform, which uses the Automated Market Maker (AMM) protocol.
Provide Liquidity: Deposit or lock the crypto assets on the liquidity pool. Based on the blockchain network on which the protocol is built, they support different crypto assets. For instance, if the protocol is based on Ethereum, you can only provide liquidity with Ethereum-based tokens like ETH, DAI, and USDC.
Receive Tokens: Once you have deposited tokens on the pool, you will receive LP tokens that represent your share in the liquidity pool.
Staking: With the LP tokens, you can go to any decentralized exchange that offers yield farming and stake your tokens. You will get additional tokens in exchange for staking and providing liquidity.
Claim Rewards: You will receive rewards (transfer fee) when someone swaps tokens from the liquidity pool. Once you reclaim the rewards, you can use them for reinvestment or other purposes.

What is the Annual Percentage Yield (APY)?

Annual Percentage Yield (APY) is the method used to calculate the total amount of money earned in a year, including the effect of compounding interest. In yield farming, APY is important because it considers the additional gains investors earn through different strategies other than just locking assets in the liquidity pool. In other words, it helps to know how interest accumulates over time.

The APY results can sometimes be over 100%, but this result is only possible if the investor keeps changing the strategies to maximize the gains. However, you should consider the risks associated with yield farming, especially when leveraging, as you might lose your entire investment.

Types of Yield Farming

Providing Liquidity: Liquidity providers (LP) deposit their tokens into the decentralized exchange’s liquidity pools to increase the liquidity in the DEX and earn LPs as part of the fees.
Staking: This involves locking your tokens or assets on Proof-of-Stake (PoS) blockchains, and the network will reward the investors based on the tokens staked and the period.
Borrowing: This requires yield farmers (investors) to lock their tokens as collateral and receive another token as a loan. Through the tokens taken as a loan, investors can earn interest by staking, lending, or as LPs while keeping their initial tokens safe.
Lending: A yield farmer can lend their tokens to borrowers in exchange for profit by depositing tokens on DEX platforms.

Benefits of Yield Farming

High Margin: Unlike traditional financial instruments, some DeFi projects offer substantial yields depending on market conditions.
Passive Income: Instead of just holding your coins, yield farming allows you to earn additional income in the form of tokens by depositing or locking your assets in DEX.
Liquidity Provision: Because of the liquidity offered by the pool, there is less slippage on DEX, which offers efficient trading.

Risks of Yield Farming

Volatile Prices: The price of a cryptocurrency can be volatile, and if the token from which you are receiving rewards is affected by volatility and falls sharply, the profits can be reduced.
Smart Contract Bugs: All decentralized finance(DeFi) protocols are based on smart contracts. If a bug in the code of the smart contract is found, hackers can easily exploit it, causing the loss of your locked tokens.
Rug Pull: A rug pull in DeFi is where someone creates a new project with a native token. The creator sets a liquidity pool for the native token with popular coins like Ethereum and attracts investors to invest in the token. Once the time is right, the creator who has a massive stash of tokens floods the liquidity pool. Through this method, the creator can earn large profits from the pool and run away while leaving investors with worthless coins.

Conclusion

Yield farming offers an attractive way for investors to earn passive income in the decentralized finance (DeFi) space by providing liquidity, staking, borrowing, or lending tokens. With the potential for high returns, which is expressed as Annual Percentage Yield (APY), yield farming allows investors to maximize their gains through strategic reinvestment of rewards. However, it comes with significant risks, including volatile asset prices, smart contract vulnerabilities, and the possibility of scams like rug pulls. For those willing to navigate the complex and rapidly evolving DeFi space, yield farming can be an excellent opportunity, but it is not without its challenges. Investors should carefully consider the potential rewards against the risks before getting into yield farming.