What is Yield Farming?
Yield farming is a way for cryptocurrency investors to earn rewards by providing a decentralized finance (DeFi) platform with liquidity. Depending on the platform protocol, rewards can either be financial or non-financial.
Financial rewards often consist of remuneration in tradable tokens or a percentage of the platform’s transaction fees. Non-financial rewards usually consist of remuneration in governance tokens or access to advanced platform features and services.
Technically, yield farming can be carried out on a single DeFi platform, but most farmers frequently shift their investments between platforms to optimize rewards. Here’s how yield farming works:
- The investor selects a DeFi platform that supports yield farming. Each platform’s rules and conditions for yield farming are documented in self-executing smart contracts.
- The investor deposits cryptocurrencies into the platform’s liquidity pool and earns rewards.
- The investor withdraws their deposited funds along with the rewards they earned. (This process is called harvesting.)
- The investor reinvests their rewards by depositing them back into another DeFi platform that supports yield farming. (This process is called compounding.)
It’s important to note that some DeFi platforms allow investors to withdraw funds and rewards at any time, but most platforms specify a defined period during which the invested funds are locked. To maximize earning potential, most yield farmers seek out platforms that lock funds for short periods and move investments frequently. (This process is called crop rotation.)
Difference Between Staking and Yield Farming
Techopedia Explains Yield Farming
In 2020, DeFi journalists began to use farming analogies as a way to describe new strategies for maximizing yield through opportunities like liquidity mining, staking, and lending.
- Liquidity mining – investors earn yield by lending funds to a decentralized finance platform’s liquidity pools for a defined period of time.
- Lending – investors earn yield by lending out tokens to other users. (Stablecoin lending often provides the biggest yields.)
- Staking – investors earn yield by lending funds to a specific platform to support the platform’s blockchain network.
Although the concept of yield farming is relatively simple, the technology behind it can be very complex. It requires investors to approach investment opportunities strategically and be familiar with smart contract development and multiple DeFi protocols.
Popular uses cases for yield farming include:
Diversifying an investment portfolio: When digital assets are invested in multiple platforms, it not only provides investors with more opportunities to earn higher rewards, it also leads to a better return on investment (ROI) over time.
Reducing risk: It’s important for investors to use platforms that have a strong reputation in the DeFi community. Many yield farming sites quote the expected returns on an investment in a liquidity pool as an annual percentage yield (APY). In general, the higher the APY, the higher the risk to the investor.
Closely monitoring market trends: It’s important for yield farmers to stay on top of market trends so they can identify new investment opportunities, understand new regulatory developments, quickly adapt to changing protocols and make informed decisions about when to enter or exit a market.
Becoming familiar with blockchain oracles: Yield farmers need to be familiar with blockchain oracles that connect smart contracts with off-chain information. Yield farming often involves staking assets whose value is determined by external price feeds. Oracles help yield farmers understand the accuracy and reliability of price feeds and the potential risks involved.
Popular Platforms and Protocols
Popular DeFi platforms for yield farming include:
Uniswap – a decentralized, permissionless and automated liquidity protocol built on Ethereum.
Curve Finance – allows investors to farm tokens on multiple blockchains, including Ethereum, Bitcoin and Polygon. Curve is known for using an algorithm that only moves price when the loss is smaller than the profit.
Sovryn – a decentralized, non-custodial and permissionless protocol for Bitcoin borrowing, lending and trading.
Aave – provides liquidity pools that generate rewards in return for loaning assets and staking.
Coinbase – allows yield farmers to earn cryptocurrency rewards.
YouHodler – stores funds in a combination of hot and cold wallets.
Yearn Finance – allows users to maximize their earnings on crypto assets through lending and trading services.
eToro – provides Cardano, Ethereum and Tron crypto staking services.
The Risks of Yield Farming
While yield farming can potentially be lucrative, it’s important to recognize the risks posed by price volatility and smart contract exploits.
Yield farm platforms typically lock investments for a predetermined period, and there is always a chance that during that lock-down period, other liquidity pools will increase their rewards.
There is also the risk that a new platform’s smart contracts purposely contain security vulnerabilities that can be exploited by malicious actors who want to conduct rug pull scams.
Rug Pull Scams
This type of scam can be used to deceive and take advantage of yield farmers by creating a seemingly legitimate project, luring investors with high returns and then suddenly withdrawing liquidity, causing the token’s value to collapse and leaving investors with worthless assets.
Here is how a rug pull scam works:
- The scammer creates a new DeFi project that has a flashy website, and promises high yield. They use social media platforms and influencer marketing techniques to generate hype around the project and attract yield farmers.
- The scammer creates a liquidity pool on a decentralized exchange like Uniswap, hoping farmers will stake their cryptocurrencies in the liquidity pool to earn rewards.
- The scammer uses various tactics to inflate the value of their token temporarily. These tactics may include wash trading (simultaneously buying and selling their own token to create the illusion of high trading volume) or using their own funds to buy the token and push up its price.
- The scammer performs the “rug pull” by either withdrawing the liquidity they initially provided, selling a large number of tokens they control or exploiting a hidden vulnerability in the project’s smart contract. This causes the token value to plummet and leaves investors with worthless tokens.
- The scammer shuts down the project’s website, social media accounts and other communication channels to make it difficult for affected investors to track them down.
Yield farmers are often exploited in rug pull scams because they are attracted by the high returns promised by these malicious projects. To minimize the risk of falling victim to such scams, yield farmers should conduct thorough research on any DeFi project they consider investing in and remain cautious of projects that seem too good to be true.