What Is Yield Farming?

Yield farming is a cryptocurrency investment strategy within the decentralised finance (DeFi) sector. It’s a high-risk investment strategy where an investor lends crypto assets on a DeFi platform with the aim of earning substantial returns, often in the form of additional cryptocurrency.

Just as its name says, ‘Yield Farming’ allows liquidity providers over a particular blockchain to earn yields after they have invested their tokens (usually a pair of tokens at the same valuation). 

Yield farming relies on decentralised exchanges (DEXs), allowing investors to lend or stake their crypto assets into a project and earn interest as traders transact using that crypto pair. Famous yield farming protocols are Aave, Uniswap, Solana, and Curve Finance.

Yield farming is simple terms.

An investor provides liquidity by depositing cryptocurrency holdings into a liquidity pool on decentralised exchanges like Curve, Solana, or Uniswap. In return, they receive liquidity provider (LP) tokens, representing their share of the pool. 

These LP tokens can also generate more income through staking or farming for additional rewards. The liquidity pool enables token swaps, and the investor earns a percentage of transaction fees for supplying liquidity. However, risks such as impermanent loss and market volatility exist, making it essential to weigh the potential rewards against the risks.

Brief History of Yield Farming

In June 2020, Compound, an Ethereum-based credit market, issued its native token called COMP, an asset that empowered investors to govern the compound protocol. 

This governance token was issued so that holders had the voting rights to decide the network changes. As interests began to trickle in for investors, it suddenly became a massive jump, and it moved the Compound network into a leading position in the DEFi ecosystem.  It was this event that led to the term yield farming.

What APY in Yield Farming

The interest an investor (Yield Farmer) gets by farming on a network is usually calculated in terms of actual percentage yield (APY). Yield farming is very lucrative, and investors are looking for an opportunity to take in 10-100 times the annual profit; however, with this massive profiting comes a tendency for an investor to get rug pulled. Also, because the interest on the investment is given as native tokens of the protocol, it is possible to get into huge gains or losses because of the volatility in price. 

Risks Involved in Yield Farming

Yield farming can be intricate and may involve considerable risks for both borrowers and lenders, but with careful strategy and risk management, it offers the potential for substantial rewards. 

A few of these are:

  1. High gas fee over the Ethereum blockchain 

If an investor is not transacting in thousands of dollars as capital, transacting on an Ethereum blockchain can be very impossible because of the high gas fees.

  1. Susceptible to hacks and fraud. 

If there is a problem with the smart contract of the protocol, then the chances of getting hacked are very high. If there is a bug in the codes of the particular protocol and another developing company uses those codes without auditing them. In October 2020, Harvest. Finance lost over 20 million dollars to hackers, and Yam Protocol lost more than 400 million dollars, which they had raised in a few days because a big was detected and exposed in their code.

  1. Interdependent over different DApps

DEFi protocols are permissionless and depend on several apps in order to execute their function seamlessly. If one of these apps is compromised, it can result in the permanent loss of the funds invested in the platform.

  1. Liquidity Risk

In the case where the network is congested or due to high demand, the pools can become illiquid, making it difficult for users to withdraw their assets from the pool. 

  1. Impermanent Loss

In an AMM, investors are expected to deposit a pair of cryptocurrencies into the pool, and it will be processed as long as the cryptocurrencies are of the same value. However, a change in the price of an asset in the pool causes the value of the token to diverge from its initial worth during investment.

Liquidity Mining

Liquidity mining falls under the topic of yield farming, and its goal is to provide users with incentives because they provide liquidity to a specific project. 

When a lender provides liquidity, they are given a token that has a particular value and can be traded with or held as the investor sees fit. In order for investors to maximise the profit from their investment, they can decide to participate in liquidity mining programs, and they get some more tokens for contributing liquidity to the pool.

As liquidity mining programs incentivise their users, it also gives the ecosystem of the project some level of balance, ensuring the growth and adoption of the project.

A typical example is when a DEX launches a liquidity mining program and begins to offer the farmers rewards for providing for a specific trading pair. This fosters a more powerful community of users for that project, thereby increasing its trading volume. 

Risk Management Processes for Yield Farming and Liquidity Mining

  1. Diversify your funds across different projects and networks in order to reduce the chances of losing all your funds in case there is a problem.
  2. Do thorough research on the team of developers, codes, and community that is involved in the project before investing your money into any project. 
  3. Ensure that you do diligent research if you have to invest in a project that is not audited. Although it’s best to stick to projects that are established and recognised.
  4. Take advantage of DEFi insurance platforms that cover investors in the case of a smart contract back.
  5. Join a community to stay informed and up-to-date on the latest trends in the DEFi ecosystem.