You've probably already heard of token farming and staking, which are quite popular options for those looking to grow their capital using cryptocurrencies.
Well, then you should definitely learn about yield farming, one of the many ways to profit from the rapidly evolving world of Decentralized Finance (DeFi). In this guide, you’ll learn what yield farming is and how to earn from it.
Learn more about the captivating world of DeFi from our comprehensive guide.
What is yield farming?
Yield farming is an investment strategy that implies that an investor stakes or lends their cryptocurrencies on a DeFi platform to gain a higher profit.
The name is associated with the strategy's features: you "sow" your assets where they will bring maximum benefit. The most important thing is to "harvest" in time in the form of income from crypto yield.
The idea is similar to traditional bank deposits. The only difference is that yield farming is based on DeFi protocols.
How does yield farming work?
To start farming, you have to become a liquidity provider, meaning you have to provide your money as a loan to the project you choose. But before doing so, it's worth learning how it all works.
1. The first thing to help you are Automated Market Makers (AMMs), the main engine and tool of yield farming. This is a kind of marketplace where you can lend or trade your cryptocurrency. AMMs automatically determine the prices of assets with the help of smart contracts.
2. AMMs operate in liquidity pools. Such pools are the final destination for your funds. When you deposit money in a liquidity pool, you help keep the market running smoothly.
3. Once your funds are in the liquidity pool, other users can borrow or trade them on a decentralized exchange (DEX) based on a specific liquidity pool.
4. Such exchanges charge fees from users. It is these fees that are then distributed among all the liquidity providers in the pool, and that is where you get your reward. The amount of a reward depends on their percentage participation in the pool – that is, on the amount of liquidity they provide to the pool. Simply saying, the more funds you contribute to the pool, the larger your share of the fees.
Risks and rewards of yield farming
In theory, yield farming rewards can be very high. Different projects offer annual returns ranging from several to thousands percent. However, on average, such projects provide 5-10% returns.
Unfortunately, the highest returns are often offered by fraudulent projects. Cases when projects’ creators disappear with investors’ money are not uncommon. Other yield farming risks include:
- project bankruptcy;
- phishing;
- hacks.
Getting started with yield farming
If these dangers don’t scare you, we're ready to tell you how to start crypto farming and earn passive income from it:
Choosing a yield farming platform. To maximise profits, liquidity providers move their funds between different platforms as yield conditions change. Considering that the DeFi sector is highly volatile and dynamic, it’s necessary to frequently reallocate funds and reassess strategies.
Today, there are numerous yield farming platforms, which makes it challenging to choose. However, we've selected a few popular options that you’ll get to know further in the text.
Setting up your wallet. Another important aspect is that you'll need a crypto wallet to start yield farming. We've already prepared instructions that’ll help you create wallets for the most popular coins: Bitcoin (BTC), Ethereum (ETH), Toncoin (TON), Tron (TRX), Polygon (MATIC), etc.
Find more info on how to store crypto in our special overview.
Yield farming strategies for beginners
In crypto yield farming, you can choose between two main strategies:
Earning interest involves locking up a certain amount of cryptocurrency in the project's account dedicated to lending, which allows you to earn interest on your deposit or governance tokens. This approach is also referred to as cryptocurrency lending.
Providing liquidity entails supplying your funds to the liquidity pool of chosen trading pairs, enabling trading on DEXs without intermediaries through smart contracts. In exchange, you receive a portion of the trading fees. This strategy is also known as liquidity mining.
Advanced yield farming techniques
Now you know all the basics of yield farming. Are you ready to level up and become even more skilled? Because we’re ready to show you what else can be done for yield optimization.
Maximising yield through liquidity pooling
A liquidity pool serves as an intermediary through which you can farm yield. It's the most popular option among farmers as even a small initial capital can be suitable for it.
Liquidity pools are cloud storage facilities for tokens that ease operations in the crypto market. They contain locked cryptocurrencies voluntarily provided by investors.
A farmer contributes liquidity to the pool of their choice and earns interest in return. These returns are calculated in the form of APY (Annual Percentage Yield), representing the rate of profit an investor receives over the course of a year on specific investments.
Managing risks in yield farming
The higher the stakes, the greater the risks. And no, not all of them are related to scams. Here are a few more important things to know if you decide to become a liquidity provider.
Impermanent loss occurs due to price differences. A farmer may experience it when the price of a cryptocurrency or stablecoin they hold on a DEX suddenly falls in relation to the other asset. This typically happens when markets become unstable.
The instability entails significant fluctuations in investments in any direction and is called volatility. During times of volatility, an asset can plummet in a very short period, literally within minutes.
Another pitfall is high fees. They can erase profits, especially if the invested amount was small. Pay special attention to the deposit fee–the fee for depositing funds. Because of it, a farmer may end up with losses even at the stage of transferring currency into the pool.
Trading with high leverage also carries hidden risks. If the leverage is too high, the farmer may lose the funds they deposit into the liquidity pool.
Even if your trading strategy navigates all these risks, danger still lurks. Smart contracts of the projects where a farmer decides to invest funds may have vulnerabilities. Sometimes auditors or white hat hackers discover them, but other times they are exploited by cyber criminals who can drain all the money from the pool. Including yours.
Yield farming tools and resources
There are several tools and resources that can assist you in optimising your yield. Let’s look at some of the most notable ones.
Uniswap is the big thing in the game. It’s a popular DEX that enables users to become liquidity providers for various trading pairs and earn fees. It allows the exchange of almost any ERC20 token pair without intermediaries.
Uniswap website
PancakeSwap is another notorious DEX. This exchange also offers an opportunity to profit from liquidity pools and staking. On this platform, users can earn CAKE while supporting PancakeSwap by staking Liquidity Pools (LP) Tokens.
PancakeSwap website
Another tool that may catch your eye is Aave. This one is a liquidity protocol where users can participate as suppliers or borrowers. For yield farming with Aave users need some Ethereum first.
Aave website
Compound is one of the most well-known platforms with a long history in the market. It offers a high and algorithmically adjusted interest rate. Additionally, on Compound, you can earn the project’s governance tokens, COMP.
Compound website
Last but not least is Yearn.finance, an automated yield aggregator. It helps you find the most profitable yield farming services and select a winning strategy to maximise profit.
Yearn.finance website
Conclusion and future of yield farming
Yield farming is a relatively new investment method suitable for both beginners with small crypto capital and experienced investors in the market. It offers earning opportunities for those willing to navigate the rapidly changing world of DeFi.
However, like any other earning method in the crypto market, farming comes with serious risks. These are mainly associated with the threat of scams or choosing the wrong project.
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This article is not investment advice or a recommendation to purchase any specific product or service. The financial transactions mentioned in the article are not a guide to action. It’s not intended to constitute a comprehensive statement of all possible risks. You should independently conduct an analysis on the basis of which it will be possible to draw conclusions and make decisions about making any operations with cryptocurrency.
