Decentralized finance, also known as DeFi, has become vastly popular among cryptocurrency traders thanks to the extremely high yields on investment compared to the traditional markets. At the most fundamental level, DeFi operates by paying people a return for leaving their funds, so the bank has the liquidity needed to facilitate trading or lending activities.
However, yields on offer in DeFi can go far beyond the base level of interest paid on deposits — thanks to the feature that allows anyone to mint tokens on a blockchain. This improves capital efficiency and allows users to earn governance token rewards simply for participating in DeFi. As such, the sector attracts people looking for higher returns through a practice known as yield farming.
Defining Yield Farming
Yield farming, also referred to as liquidity mining, is a way to generate rewards with cryptocurrency holdings. In simple terms, it means locking up cryptocurrencies and getting rewards.
In some sense, yield farming can be paralleled with staking. However, there’s a lot of complexity going on in the background. In many cases, it works with users called liquidity providers (LP) that add funds to liquidity pools.
What is a liquidity pool? It’s basically a smart contract that contains funds. In return for providing liquidity to the pool, LPs get a reward. That reward may come from fees generated by the underlying DeFi platform, or some other source.
Some liquidity pools pay their rewards in multiple tokens. Those reward tokens then may be deposited to other liquidity pools to earn rewards there, and so on. You can already see how incredibly complex strategies can emerge quite quickly. But the basic idea is that a liquidity provider deposits funds into a liquidity pool and earns rewards in return.
Yield farming is typically done using ERC-20 tokens on Ethereum, and the rewards are usually also a type of ERC-20 token. This, however, may change in the future. Why? For now, much of this activity is happening in the Ethereum ecosystem.
However, cross-chain bridges and other similar advancements may allow DeFi applications to become blockchain-agnostic in the future. This means that they could run on other blockchains that also support smart contract capabilities.
Yield farmers will typically move their funds around quite a lot between different protocols in search of high yields. As a result, DeFi platforms may also provide other economic incentives to attract more capital to their platform. Just like on centralized exchanges, liquidity tends to attract more liquidity.
How does Yield Farming work?
In many ways, yield farming works like a savings account, where you deposit money with a bank, which then pools depositor money and lends it forward while you earn interest on the funds you deposited. But instead of being converted into a mortgage or a business loan, the cryptocurrency in a yield farm is invested in smart contract applications.
Smart contracts are types of computer programs using blockchain technology, which powers most digital currencies.
With yield farming, users stake their currency — the cryptocurrency equivalent of making a deposit — with others investing in the same farm. Staking may require you to leave your funds invested for a specific period. Your cryptocurrency may then be used as collateral or to provide liquidity to mining pools, depending on how it is invested.
Yield farming begins with the creation of a pool of cryptocurrency assets. These are the steps that take place to facilitate yield farming:
- Liquidity pool is created: The first step in yield farming is creating a liquidity pool. This relies on a smart contract that facilitates all investing and borrowing for that specific yield farm.
- Investors deposit assets: Investors can connect their digital wallets to deposit currency in the liquidity pool. This is sometimes referred to as “staking.” This is somewhat similar to customers making a deposit in a bank or investing in a mutual fund or ETF.
- Smart contract enables borrowing: The smart contract can facilitate several processes, including adding liquidity for a cryptocurrency exchange market, or lending to others.
- Reward payout: Interest, bonuses, and rewards may vary by yield farm. You may be paid at regular intervals or on a specific future date.
The Risks of Yield Farming
Yield farming is a complicated process that exposes both borrowers and lenders to financial risk. When markets are turbulent, users face an increased risk of temporary loss and price slippage. Some risks associated with yield farming are as follows:
Rug pulls
Rug Pulls are a form of an exit scam in which a cryptocurrency developer collects investor cash for a project and then abandons it without repaying the funds to the investors. Rug pulls and other exit scams, which yield farmers are particularly vulnerable to, accounted for about 99% of big fraud during the second half of 2020, according to a CipherTrace research report.
Regulatory risk
Cryptocurrency regulation is still shrouded in uncertainty. The Securities and Exchange Commission has declared that some digital assets are securities, putting them within its jurisdiction and allowing it to regulate them. State regulators have already issued cease and desist orders against centralized crypto lending sites like BlockFi, Celsius and others. DeFi lending and borrowing ecosystems could take a hit if the SEC declares them to be securities.
While this is true, DeFi is designed to be immune to any central authority, including government regulations.
Volatility
Volatility is the degree to which the price of an investment moves in either direction. A volatile investment is one that has a large price swing over a short period of time. While tokens are locked up, their value may drop or rise, and this is a huge risk to yield farmers especially when the crypto markets experience a bear run.
Impermanent loss
During periods of high volatility, liquidity providers can experience impermanent loss. This occurs when the price of a token in a liquidity pool changes, subsequently changing the ratio of tokens in the pool to stabilize its total value.
Smart contract hacks
Most of the hazards associated with yield farming are related to the smart contracts that underpin them. The security of these contracts is being improved via better code vetting and third-party audits, however, hacks in DeFi are still common.
DeFi users should conduct research and use due diligence prior to using any platform.
Final Thoughts
DeFi yield farming protocols will continue to evolve even more complex strategies. Already, leveraged yield farming has introduced some of the first under-collateralized loans — managed by smart contract — in the crypto industry. This functionality seeks to address several DeFi shortcomings, including capital efficiency and the providence of deeper capital markets. In addition to these systemic improvements, crypto yield farming is helping to establish more mature DeFi protocols and increase their earning potential, fueling growth across the entire ecosystem.
