Yield Farming in DeFi - What is, How does it work, and Main Protocols
Yield Farming is an investment strategy that allows investors to maximize their returns by providing liquidity to DeFi protocols. Learn the many different ways to do it, as well as popular protocols used to this end.
Introduction
If you've been exploring the crypto realm, you've likely stumbled upon the term 'Yield Farming'. Particularly prominent during the DeFi summer in 2020 and subsequent bull markets, Yield Farming has become a buzzword. But what exactly does it mean and why has it sparked such interest?
For those unfamiliar with crypto, it may sound like a strange term, but it's actually a popular investment strategy favored by crypto degens. Let's dive in and learn more about it!
What is Yield Farming?
In essence, yield farming is a profit-maximizing strategy used in Decentralized Finance (DeFi). By 'locking' or 'staking' cryptocurrencies in a protocol, yield farmers can earn interest for providing liquidity to trading pairs or supporting other activities within a DeFi protocol.
Yield farming can be highly profitable, but it's not without risks, which we'll delve into later in the article.
How Does Yield Farming Work?
Yield farmers interact with DeFi protocols or Centralized Exchanges to lend, borrow or stake their assets, earning a certain yield and bonuses for providing liquidity. Here are some common strategies investors use to maximize their returns:
Lending
Yield Farmers deposit their assets into a protocol’s pool where other users will borrow them. The activity of providing liquidity to the protocol earns interest to Yield Farmers. For more information about this topic, check out our article about Lending and Borrowing protocols!
Lend then Borrow
This method is a mix of Lending and Borrowing. Yield farmers deposit assets (Lend) as collateral in a DeFi protocol, like AAVE, and earn interest on it. After doing so they borrow other assets and use them to gain interest in the same or other protocols. It’s a very risky activity because it involves leverage, but the high risk can also give high returns
DEX Liquidity Provider
Yield farmers deposit 2 coins in a Decentralized Exchange (DEX) to provide liquidity to a trading pair, for example, ETH/USDC or BTC/DAI.
When a trader uses a DEX to swap the tokens a fee is charged to them, and part of it is paid to the Liquidity provider in LP tokens or even the protocol’s native token.
Staking
This method is the most popular because it’s the basics of how a proof-of-stake blockchain keeps the network safe. Users deposit their assets to secure the network and receive interest in return paid in the blockchain’s native token.
→ Yield farming returns are often presented as Annual Percentage Yield (APY) or Annual Percentage Rate (APR), both familiar to traditional finance. The APY assumes reinvestment of earnings, resulting in a compounded return. In contrast, APR measures the return without reinvestment.
Protocols used by Yield Farmers
PancakeSwap
PancakeSwap is a DEX built on the Binance Smart Chain (BSC), also functioning on Ethereum and Aptos at the time of writing.
The protocol offers many different features, like Token Swaps, Liquidity Provision, perpetual futures trading, NFTs, and also a Bridge, which explains why many Yield Farmers and users in general use the platform, which today contains a TVL of U$3.5 Billion according to DeFiLlama.
PancakeSwap is famous for delivering lots of yield farming options containing enormous APRs (or APYs), especially with BSC tokens. It is essential to understand that usually, new or less-known tokens offer high returns, but this happens mostly as an incentive to provide liquidity to a very risky asset.
Uniswap
Uniswap is the most popular DEX today, built on the Ethereum blockchain. More than 4.5 Million unique wallets have interacted with the platform, containing a cumulative trading volume of U$1.34 Trillion.
Yield farmers deposit two tokens in a pool to create a market where traders can swap their tokens according to the pool’s pair. The liquidity provider earns LP tokens from trading fees.
Other Protocols
Many other DeFi protocols that deliver similar products as those shown above are used by Yield Farmers to practice their strategies, such as Aave, Curve Finance, Sushiswap, Compound, and MakerDAO.
Risks Involved in Yield Farming
Yield Farming is an activity that involves many times high risk and high reward, especially when dealing with low market cap/volume coins, and that’s also the reason why many people are attracted to this strategy and the PancakeSwap platform!
That being said, let’s explore some of the risks associated with yield farming:
- Rug Pulls/Scams
A Rug Pull is a practice where the developer/founder of a product, in this case, a cryptocurrency, gathers investors' money and simply abandons it without any explanation, keeping most part of the money for himself while the others lose all or most of it.
This is a risk in Yield Farming because many of the returns offered in this practice that attracts Yield Farmers are the ones with big APR numbers, which many times represent bad-intentioned projects where the developers are planning to scam the investors.
- Volatility
Yield Farmers have to lock their tokens inside a protocol to practice their strategy, which means that these tokens are many times subjected to price volatility.
The price of the deposited token might drop significantly while locked, which means that the interest earned will still be there, but the value of it and the initial investment will be less than expected.
- Smart Contract Risk
This type of risk exists in most DeFi applications. The smart contracts used in Yield Farming might have some vulnerabilities that can lead to bugs or even hacks, which could represent a total or partial loss for the Yield Farmer
Always check if the protocol’s smart contracts are audited by a trusted company. Although not eliminating the smart contract risk, it definitely reduces it by a lot!
- Impermanent loss
Impermanent loss is a risk related to liquidity providers when the value of the asset changes after depositing it in a pool. Tokens like stablecoins are usually less risky than other classes because their value is supposed to stay in a small price range.
Many times the fees that liquidity providers receive are bigger than the losses, but the price change could get to a point where it’s no longer profitable to the LP, or is less profitable than just holding a token while the price goes up.
Conclusion
This article offers a glimpse into the intriguing world of Yield Farming, an increasingly popular strategy in the crypto world.
Yield Farming can be whether executed with very risky assets and protocols or low-risk ones. If you are interested in maximizing your investment returns, consider using one of the practices presented in this article. However, always be mindful of the risks involved and only invest what you're prepared to lose!
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