Crypto yield farming is one of the hottest topics in Defi (Decentralized Finance) and there is a high chance you may have already heard about the crazy returns that some of the yield farmers are making through these yield farming platforms.
Crypto Yield Farming
Crypto yield farming is a subsection of Defi that allows one to earn yield using Defi applications, wallets, and protocols that is only if you have idle crypto assets. So if you have some crypto assets like Ethereum, Tether, DAI, that are just sitting there in your wallet then you can put them to use to earn passive income with yield farming.
Another good thing about yield farming is that it often doesn’t require frequent buying and selling of existing assets i.e. you will have idle assets and you won’t need to try to buy low or sell high those assets. For example, if you have Ether and you have no intention to sell it for years or at least until a much higher price target is achieved then you might as well put it to use and try to earn yield off of your Ether.
Yield farming is often involved in providing liquidity in liquidity pools like Uniswap.
Yield comes in many forms so think about yield farming when you want to potentially earn:
- Market maker fees
- Liquidity incentives
- LP tokens or Liquidity provision tokens
A good example of the incentivized tokens is Synthetix.
The team behind Synthetix has pioneered offering LP rewards or LP incentives what they’ve done is they have allocated a certain amount of SNX tokens (the native token for Synthetix that is powered by Ethereum) and those SNX tokens can be paid to those that are acting as liquidity providers in the Synthetix-Ether pool in Uniswap.
So long story short it is another way for you to earn tokens because of some rewards that have been allocated by the protocol.
In essence, yield farming is a way of trying to maximize the rate of return on capital by leveraging different Defi protocols.
Yield farmers try to chase the highest yield by switching between multiple different strategies and the most profitable strategies usually involve at least a few Defi protocols like Compound, Curve, Synthetix, Uniswap, or Balancer.
If the strategy doesn’t work anymore or becomes less profitable and there is a better strategy available then the yield farmers move their funds around like for example yield farmers may move the funds between different Defi protocols or they may swap some of their coins for the other ones that are currently generating better yield and in the world of yield farming, this procedure is sometimes called crop rotation.
Compared to traditional finance the process is the same as people trying to find the best savings account with the highest APY. APY stands for Annual Percentage Yield and it is a common way of equating rates of return on your money across different products.
It’s also a common way of expressing the returns of different yield farming strategies. It is very common to see traditional saving accounts having around 0.1% APY and anything above 3% is pretty much unheard of.
However, when it comes to crypto yield farming the returns can be pretty insane with some of the strategies bringing as much as 500% APY!
There are three main elements that make such insane yield farming returns possible. These are:
- Liquidity Mining
Liquidity mining is a process of distributing tokens to the users of a protocol.
Liquidity mining creates additional incentives for yield farmers as the token rewards are added on top of the yield that is already being generated by using a certain protocol.
Depending on the protocol the incentives may be so strong that farmers may actually be willing to lose on their initial capital just to get more rewards in the distributed tokens which makes their overall strategy highly profitable.
One of the very first Defi projects that introduced liquidity mining was Synthetix that started rewarding users who helped with adding liquidity to their pool on Uniswap with SNX tokens.
Another good example of this strategy was the liquidity mining introduced by Compound (COMP) that was initially giving higher rewards to the users who were borrowing assets with the highest APY. This incentivized yield farmers to start borrowing the asset.
As the value of the minted COMP tokens was compensating them for the high bar rates, liquidity mining got super popular and became an essential catalyst for the wider spread of crypto yield farming.
Leverage is another crucial element that makes the ultra exceptional yields conceivable.
Leverage is a strategy of utilizing acquired cash to build the potential return of an investment in the yield farming world.
Yield farmers can store their crypto coins as collateral to one of the loaning protocols and get an extra set of coins and now they can utilize the obtained coins as additional collateral and get considerably more coins. By rehashing this entire methodology, farmers can leverage their underlying capital a couple of times over and begin to produce significantly more noteworthy returns on their underlying capital.
The last missing component for double or triple-digit annual percentage yield is Risk. It simply refers to the height of the risk that yield farmers are willing to take.
The first one that is related to the risk is the leverage i.e. all the loans that farmers are taking over their collateralized capital. The supplied collateral is susceptible to liquidation if the collateralization ratio drops below a certain threshold limit.
Besides the liquidation risk, there are also standard smart contract risks like bugs, platform changes, admin keys, and system risks, etc.
On top of all this, there are a few new attack vectors specific to Defi. For example, the attacks that aim at draining certain liquidity pools. Once put together, all of these risks become yet another reason why yield farming returns are so lucrative.
How to Earn With Yield Farming
Yield farming strategies are sets of steps that aim at generating a high yield on the capital. These steps usually involve at least one of the following elements
Lending, borrowing, and supplying capital to liquidity pools, or staking LP tokens (Liquidity pool tokens) are of utmost importance in yield farming.
Lending and borrowing are fairly simple ways of getting a pie on your capital. For example, farmers can supply stable coins such as DAO or USDT to one of the lending platforms and start getting a return on their capital.
Liquidity mining and leverage can supercharge this whole process. For example, farmers can get rewarded with extra COMP tokens for lending and borrowing on the compound they can also borrow funds with their collateral to buy even more coins. Also, remember that this also comes with a risk of potential liquidations supplying capital to liquidity pools.
Yield farmers can supply coins to one of the liquidity pools in protocols like Uniswap, Balancer, or Curve and in turn get rewarded with the tokens that are charged for swapping different tokens.
Liquidity mining can again supercharge this whole process even further. By supplying coins to certain liquidity pools, farmers can get rewarded with extra tokens. A good example of such a protocol is the Balancer that rewards liquidity pooled suppliers with extra tokens increasing their staking on LP tokens as well as APY.
Some protocols incentivize users even further by allowing them to stake the liquidity provider or LP tokens that represent their participation in a liquidity pool.
As an example, Synthetix, Ren, and Curve got into a partnership where users can provide WBTC, SBTC, and RENBTC to the CBTC liquidity pool and receive Curve LP tokens as a reward. These tokens can be staked on Synthetix where farmers can further be rewarded with CRV, BAL, SNX, and REN tokens.
Basically, some of these strategies can also be combined so yield farmers can maximize the returns even further.
It’s worth keeping in mind that yield farming strategies can become obsolete very quickly. For example changes in protocol or incentives can render a strategy useless so something that may be super profitable right now may not be profitable at all the next day.
So it is of utmost importance to keep an eye on the running strategies as well as rotating crops.
I trust that now you know somewhat more about yield farming. Its merits recalling that yield farming is a totally new thing and a long way from being a completely proficient market so there is a lot of chances that can welcome a significantly preferred return on our capital over what we can discover in traditional finance or even centralized crypto finance.
Like every other strategy, yield farming also comes with certain risks and we may not even be aware of some of them yet.
Although yield farming has a good potential for increasing user adoption and attracting more people to use Defi protocols it can also make life harder for normal users who may not be interested in yield farming. For example, users may see borrow rates on Compound changing dramatically and they may not be aware of all the intricacies of different COMP token distribution strategies.
Yield Farming Strategies
Below are the best yield farming strategies explained thoroughly.
Out of the best ways to earn via yield farming the below ones are the most common and probably the easiest ones. You will be able to earn yield in the following ways i.e.
- Market maker fees
- Lending interest
Consider the Curve Y stablecoin pool to better understand the yield.
Curve at its core is a stablecoin DEX (Decentralized Exchange) which means that you could come in and say you as a trader wants to swap a 100 DAO for 100 USDT and the thing worth noting here is that you’re trading between two assets at a near one-to-one rate and you’re getting it with the least amount of slippage i.e. the best possible rate. This is what people are using this for.
So those who are yield farming on Curve are the liquidity providers of the DEX. Yield farmers deposit the desired amount of stablecoins and those stablecoins then end up in the pool of the decentralized exchange.
All the stablecoins like DAO, USDC, Tether, and TUSD have different amounts of ratios to each other which reflects different demands for different stablecoins.
Yield Farming Interest
Suppose you deposit X amount of stablecoins to the pool and now you have 1% of the share in the pool.
Your deposited assets will reflect the total ratios of the amount available in the pool and your percentage share of the total pie will be shown accordingly. When you deposit your stablecoins that otherwise would have been sitting in your wallet not being used, they’re actually wrapped as what is called Y tokens and then your tokens go in whatever ratio you want.
So when a user swaps any of the tokens in the Curve exchange, you will earn a certain amount of the percentage share of that amount which ultimately makes you the liquidity provider.
Note: The higher amount you deposit, the better interest yield you will get.
You will also earn a market-making fee on your stablecoin deposits because when the users swap one crypto coin for another, they are going to pay a certain amount of fee. So for every swap, you are going to earn a fraction of the fee on every trade.
Since these are the decentralized exchanges, so they provide you with absolute control of your digital assets and you can withdraw all your assets to your own wallet whenever you want.
In this way, you can earn interest as well as market-making fees on your idly sitting crypto assets.
Yield Farming Lending Interest
Interest lending is another high potential strategy for yield farming which refers to lending your crypto coins to an exchange platform and then earning an incentive or reward for doing so.
For example, COMP token is earned for lending on Compound.
The yield for interest lending will vary according to the time and amount you’re going to lend or borrow.
The way that this works is that you’d have the ability on the supply side of the platform i.e. you could supply or lend any of the available assets and then you can earn whatever the interest rate is available on that particular asset.
Some of the coins give higher and some of them give a lower yield. All in all, you can earn anywhere from 5% to 20% but if the token which is much more volatile then you can earn as high as 30% or maybe even higher.
While on the other side of the spectrum where borrowers are paying the interest rates, suppose that borrower pays 32% then you as a lender will earn a predetermined fraction amount of that interest rate.
In essence, you’re going to earn the lending interest because of your participation in the market as a lender.
Yield Farming Leverage
Leverage increases potential of the profit as well as risk.
If you start to use leverage, you are shifting from the safer side of yield farming to the risky side but you will also threefold or fourfold the gains on your capital.
Take Compound finance with its COMP governance token as an example.
Suppose that a user X has built a leveraged position in Compound where he has 100 DAI and then he borrowed 100 USDC against those DAIs. X then redeposits for flash loans the DAI so now X has 300 DAI including the borrowed 200 USDC.
X has created a leveraged position now which he can use to threefold the gains because he can now do yield farming with 300 DAI compared to 100 DAI before using leverage.
However, if the debt is less than 75% and user X fails to manage the debt, he is going to get liquidated. This failure to clear debt is the main risk factor associated with leverage yield farming.
Firstly, I want to call out that there is a safer way to do yield farming by simply lending and earning interest as well as the COMP tokens.
Then comes the leverage which makes the whole process even riskier and could potentially liquidate the assets and make its users lose all their collateral.
With the involvement of leverage, yield farming starts to look more and more like trading.
In short, by using leverage you are going to provide a higher amount of liquidity while earning interest, incentives, and other rewards.
Yield Farming Market Maker Fees
Market maker fee is another prime way of earning in yield farming. For example, Synthetix offers a market maker an incentive for participating in some of the pools.
Let’s take Balancer and its governance token BAL as an example. Balancer works the same way as UNISWAP except that there is no 50-50 proportion between the two.
Suppose user X has eight tokens in one of these pools and he has 10% USDC and 90% SNX tokens. This allows X to become a market maker by depositing however much he wants.
As long as X has 90% SNX and 10% USDC tokens and the liquidity provision he could add that liquidity and then earn a market-making fee every time people trade. So when users are trading the funds that are in that particular pool X earns a portion of the fees.
X is able to earn liquidity provisions depending on the share of the pool that he owns.
Another way to think about it is Synthetix wants to provide its users the ability to be able to trade in and out of USDC and SNX tokens. This benefits those that use Synthetix because they have cleverly set aside funds to pay to their liquidity provider.
So if you provide liquidity, Synthetix will pay you in SNX tokens for being a liquidity provider and these payouts get distributed automatically at a given time.
You can stake the received SNX tokens further into the Balancer pool to earn the balancer pool tokens (BPT tokens) which in turn will reward you with more SNX tokens which will keep on accruing in real-time.
In short, you’re going to earn market-making fees in Balancer, BAL governance token, and SNX tokens because of further staking and that will allow the Synthetix protocol or the team behind it to be able to pay you in real-time for providing that liquidity.
So this is really the most powerful strategy to earn via three different rewards.
Yield Farming Drawbacks & Risks
Following are the drawbacks and risks associated with the yield farming.
Smart Contract Bugs
The most important thing to consider before investing in any of the Defi applications is the smart contract bug that tends to be the biggest risk for all the Defi applications, wallets, and protocols.
Many functional, operational, developmental, and security bugs pose a constant threat to yield farming and other subsequent applications of Defi.
Transition loss simply refers to the decrease in the value of a crypto asset before, during, or after the transition to another asset.
Yield farmers will bear the impermanent loss if the market goes down and the price of an asset changes so if a farmer has assets deposited in the SNX pool and the price of the SNX changes, he is going to be affected according to the price.
The involvement of leverage throws the safer side of yield farming out the window because when you use leverage, you build a leveraged position with the stablecoins which runs the risk of liquidation because the borrowing interest will keep on increasing and you will keep sinking into more and more debt.
One needs to keep the drawdown of prices in mind because cryptocurrencies are volatile assets with a price that is set by buyers and sellers and in the market.
That’s all, folks.
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