Yield farming allows you to earn rewards for depositing cryptocurrency using decentralized finance services. It’s like extreme couponing and credit card churning in the crypto world. Practitioners create complex connections across the blockchain economy to reap the greatest returns.
Yield farming is similar to traditional finance concepts. One parallel is earning interest in your savings account. Selling stock options is another way to make money from stocks that you own and lend them to others.
Make no mistake, yield farming is not offered by any bank or broker. It can be much more risky than investing in stocks or saving money.
Federal Deposit Insurance Corp. protections won’t be available in decentralized finance. You are responsible for any losses incurred by the product you use. You are taking risks with the crypto assets and rewards you earn. Chaining them across multiple platforms could increase those risks.
Potential yield farmers need to be aware of the possibility of total loss before they get started. However, those who manage the risks can sometimes get higher returns than those offered by banks.
How yield farming works
Don’t forget to mention that yield farming isn’t for beginners. You should be able to use your crypto without the assistance of a centralized exchange like Binance.US and Coinbase. Instead, you will use decentralized exchanges that are more complicated and whose users create their own markets to swap cryptocurrencies.
There are many ways to harvest yield, but one common approach is to deposit crypto you already have into a decentralized financial platform that promises returns. Stablecoins are widely accepted, although the types of crypto that are accepted will vary from platform to platform.
Depositing on the DeFi platform is different from depositing at a bank. Deposit cash at a traditional bank and the bank can use it for various purposes, such as lending to customers. Your deposit mechanics do not affect the eventual use of your dollars.
This is different than DeFi platforms like Curve and Aave where you can instead choose from many options called liquidity pools.
Liquidity Pools: What are they and how are they used
Decentralized exchanges are powered by liquidity pools. To summarize, if a DEX allows trading between any two or more cryptocurrency, it must maintain a reserve of all cryptocurrencies to ensure that users can trade at any time.
DEXs use algorithms that determine the price of a crypto at any given moment. This is different from centralized exchanges which match buyers and sellers to find prices and execute trades. These algorithms are supported by liquidity pools, which allow customers to make their transactions.
One platform may have many pools. They could contain different combinations of cryptos. Each pool has its own rate of return, which can be variable. Do your research before you choose a strategy. A pool that has been around for a while and offers reasonable returns may give you more security than if it is new.
Yield farming illustration
An example of yield farming will help you understand the concept.
You can deposit funds and assign your crypto to smart contracts. These digital agreements execute automatically when the conditions are met. You have direct control of your crypto on many platforms and can withdraw at any time.
A token representing your deposit will be sent to you. It’s like a ticket that you get when you leave your jacket with a coat check service. Only you can sell the ticket to another person, who can then redeem it later for your coat. For example, if your Compound deposit supports crypto, you will receive a “cToken” version of the coin that represents the amount of your deposit. You will receive $100 worth of Compound USD Coin (CUSDC) if you deposit $100 USD Coin (USDC). This can be used to trade or sell elsewhere.
Once you have deposited your crypto, you will be rewarded for that amount. Sometimes rewards are issued in crypto natively to the liquidity pooling system. Compound, for example, gives you COMP tokens in return for your initial deposit.
Why yield farmers want higher returns
People who want to maximize their returns often take the core process of earning rewards for deposits one step further by using the following strategies:
You can get better rates by searching for places that offer more opportunities to move your crypto. This can be like shopping at multiple grocery stores to find the best price for every item on your shopping list. However, it takes time and effort.
You can earn rewards for depositing LP tokens in other places. The first step in a long process is getting a token to represent your deposit. To earn more interest, you may be able deposit the token in another pool. The chain will continue if the token from the second pool, which was received in return for depositing the token of the first pool, is accepted into a third liquidity pool. Interest is earned at each step. Yield farmers have discovered combinations of tokens and platforms that allow this process to be repeated multiple times.
Borrow crypto. Borrowing crypto. This strategy is risky and carries a high-risk investment. You could lose all of your investment and still owe creditors if you leverage.
Crypto staking is a way to use your crypto to secure proof-of-stake networks. It also pays a return, similar DeFi platforms. Although it is as simple as pressing a button on an app of a central exchange, the rewards are not as high as yield farm.
The pros and cons of yield farming
Enticing yields. There’s a strong lure to watching your crypto stash grow, even if it yields double-digit returns.
Once you have it setup, it’s easy to use. Technical knowledge is required to deposit crypto on a DeFi platform. Once you have deposited it, you can do nothing until your withdrawal is ready.
This is one way to support cryptocurrency, in general. To provide stable and reliable services, decentralized finance services must have liquidity.
Lending pool services remain relatively new. There have been many projects that went bust, were hacked, or were imploded. Cointelegraph, a crypto website, reported that more than $1.6 Billion had been taken from DeFi users by hackers and scammers since January. One example: Crypto worth more than $100,000,000 was stolen from the DEX Maiar Exchange in 2022.
Rates can fluctuate constantly. Yield farming can only be considered a “set-it-and forget-it” investment strategy if you aren’t sensitive to changes in the markets.
It is not clear whether yield farming can be sustained. Experts have indicated that yield farming can lead to high prices, which will eventually come crashing down.
It is possible to have headaches due to bugs in the code. You don’t give your crypto to a custodian if you yield farm. It’s instead linked to a smart agreement. Smart contracts are irreversible and execute automatically. There may not be a way to recover funds if there is a bug in the code.