Yield farming is one of the hottest trends in the decentralized finance world. Since last year, it has taken the whole ecosystem by storm. It offers investors rewards for locking up their crypto holdings in a DeFi market. This guide examines yield farming and its components, its attraction to investors, and possible risks that lay ahead.

Here’s what you’ll learn in this Forkast.News explainer on yield farming:

  • What is yield farming?
  • Understanding liquidity pools
  • Example: Yearn Finance
  • Understanding the risks of yield farming
  • What the future holds for yield farming

What is yield farming?

At its core, yield farming is a process that allows cryptocurrency holders to earn rewards on their holdings. With yield farming, an investor deposits units of a cryptocurrency into a lending protocol to earn interest from trading fees. Some users are also rewarded with additional yields from the protocol’s governance token. 

Yield farming works in a similar way to bank loans. When the bank loans you money, you pay back the loan with interest. Yield farming does the same, but this time, the banks are crypto holders like yourself. Yield farming uses “idle cryptos” that would have otherwise been wasting away in an exchange or hot wallet to provide liquidity in DeFi protocols like Uniswap in exchange for returns.

Understanding liquidity pools, liquidity providers and automated market maker model

Yield farming works with a liquidity provider and a liquidity pool (a smart contract filled with cash) that powers a DeFi market. A liquidity provider is an investor who deposits funds into a smart contract. The liquidity pool is a smart contract filled with cash. Yield farming functions based on the automated market maker (AMM) model. 

This model is popular on decentralized exchanges. AMM eliminates the conventional order book, which contains all “buy” and “sell” orders on a cryptocurrency exchange. Instead of stating the price that an asset is set to trade at, an AMM creates liquidity pools using smart contracts. These pools execute trades based on predetermined algorithms.

The AMM model relies heavily on liquidity providers (LPs), who deposit funds into liquidity pools. These pools are the bedrock of most DeFi marketplaces where users borrow, lend and swap tokens. DeFi users pay trading fees to the marketplace; the marketplace shares the fees with LPs based on their share of the pool’s liquidity. 

Take Compound, for instance. The protocol provides liquidity to borrowers who want to borrow funds in cryptocurrencies. The Compound Finance system does this using smart contracts on the Ethereum blockchain. LPs deposit funds into the liquidity pools. These contracts serve as the matching engine for market participants. 

Once an interest rate for the loan has been agreed upon, the borrower gets the funds.

In exchange for their funds, LPs get Compound Finance’s native COMP tokens. They also get a cut of the interest that the borrowers pay.

Some of the most common DeFi-related stablecoins include USDT, DAI, USDC and BUSD. Some protocols can also mint tokens, which represent your deposited coins in the system. For instance, if you deposit ETH into Compound Finance, you get cETH. If you deposit DAI, you get cDAI.

Calculating yield farming returns

Estimated yield returns are calculated on an annualized model. This shows the possible earnings for locking up your cryptos for a year.

Some of the most common metrics include annual percentage yield (APY) and annual percentage rate (APR). The primary difference between them is that APR doesn’t consider compound interest, which involves plowing back your profits to increase your returns.

Still, most calculation models are simply estimates. It is difficult to accurately calculate returns on yield farming because it is a dynamic market. A yield farming strategy could deliver high returns for a while, but farmers could always adopt it en masse, leading to a drop in profitability. The market is quite volatile and risky for both borrowers and lenders.

Example: Yearn Finance — a yield farming optimizer protocol

Also known as yEarn, Yearn Finance has been perhaps the standout yield farming protocol of the past year. Launched by developer Andre Cronje earlier this year, the protocol became popular for providing users with the highest yields on ETH deposits, top altcoins and stablecoins.

When a user deposits tokens into yEarn, the protocol converts them into yTokens (such as yDAI, yUSDC, and yUSDT). The protocol’s smart contract looks into DeFi protocols with the highest APR for farming; once it finds it, it sends the tokens there.

The protocol also has the YFI Token, which Cronje launched last July to improve Yearn’s user base. YFI is an ERC-20 token that runs on the Ethereum blockchain. It is capped at 30,000 units and has seen its value explode by 122,417.5% since its launch not quite a year ago in July 2020, according to CoinGecko data. At press time, it was trading at US$38,629.

Should you try yield farming? First, understand its risks

Despite its obvious potential upside, yield farming has its risks. They include: 

  • Smart contract risks 

Smart contracts are paperless digital codes that contain the agreement between parties on predefined rules that self executes. Smart contracts eliminate go-betweens, are cheaper and safer to conduct transactions. But, they are susceptible to attack vectors and bugs in the code. Users of popular DeFi protocols Uniswap and Akropolis have all suffered losses to smart contract scams. 

  • Impermanent loss risk 

Yield farming requires liquidity providers to supply funds into pools to earn yields and trading fees from decentralized exchanges (DEXs). This offers LPs market-neutral returns, but it could be risky during sharp market moves. 

This risk is possible because AMMs don’t update token prices in line with movements in the market. For instance, if an asset’s price drops by 60% on a centralized exchange, the change won’t immediately reflect on a DEX.

As a result, a savvy arbitrage trader could use that narrow price gap to sell their token on a yield farming platform at a premium. LPs will eventually have to cover this difference, and incur losses when the price drops. Since their capital is locked in the pool, they can’t benefit when the price rises. One way of addressing this issue is to choose protocols that trade assets with low price slippages, such as the WBTC and renBTC pairs on Curve.

  • Liquidation risks 

As with the traditional finance space, DeFi platforms use their customers’ deposits to provide liquidity to their markets. However, a problem could arise when the value of the collateral drops below the loan’s price. For instance, if you take out a loan in ETH collateralized by BTC, a price increase in ETH would result in the loan being liquidated as the value of the collateral (BTC) would be less than the value of the ETH loan.

  • Capital intensive and complicated process

Yield farming is a capital-intensive operation. Most of the cost concern surrounds the issue of gas fees on the Ethereum network. Last August, Josh Rager, the founder of cryptocurrency trading service Blockroots.com, took to Twitter to complain that he had to pay as much as US$1,200 in fees to purchase tokens on a DeFi project. This is more of an issue for smaller participants than for wealthier users, who have access to more capital. Smaller participants might find out that they can’t withdraw their earnings due to high gas fees.

Getting into yield farming is a risky endeavor if you have no experience in the cryptocurrency world. You could lose all your investment in one fell swoop. Invest at your own risk. The world of yield farming is fast-paced and volatile. If you decide to try your hands on yield farming, you should not invest more than you’re willing to lose.

What the future holds for yield farming

Yield farming uses investors’ funds to create liquidity in the market in exchange for returns. It has significant potential for growth, but it’s not without its faults.

Most prominent is the use of the Ethereum blockchain. The DeFi space is now worth more than US$121.5 billion, according to DeFi Llama at publication time. Most DeFi platforms run on the Ethereum blockchain, which has suffered from scalability issues in the past. The congestion of the network also saw gas fees rise.

Vitalik Buterin, the founder of Ethereum, even promised not to dip his feet into yield farming until it “stabilizes.” Several other blockchains like Polkadot and Solana have tried wooing DeFi platforms with new features. Tezos completed an upgrade dubbed “Delphi” which it claims would reduce gas fees for developers by 75%. This proposition is expected to attract DeFi developers.