Yield farming, aka liquidity mining, is an investment strategy that stakes or lends crypto assets to generate returns or rewards in the form of fees or additional cryptocurrency. The strategy is a risky (and very popular) application of decentralized finance (DeFi) that is probably not suitable for newbies to crypto investments.
Yield farming is an investment strategy used with cryptocurrencies. The strategy shares some similarities with depositing money in a savings account or making a loan. However, the returns on yield farming are likely to be much higher than either of those two options.
How yield farming works
When someone deposits money into a bank or loans money to someone, they usually earn interest. Yield farming works in a similar manner. It involves lending cryptocurrency to someone else, and the lender earns a reward in the form of fees or interest on the amount they borrowed. Yield farming is part of the greater decentralized finance (DeFi) ecosystem.
When a cryptocurrency holder lends out their tokens, it locks up their cryptocurrency. In most cases, yield farming is done on the Ethereum network because it involves smart contracts, a major feature of Ethereum. Yield farming is also known as liquidity mining because it locks up the holder’s cryptocurrency but earns them fees or interest in the process.
Although yield farming is carried out on the Ethereum network, it typically involves other cryptocurrencies. In many cases, yield farmers deposit stablecoins pegged to the U.S. dollar into the liquidity pool.
Some common stablecoins used for yield farming are Dai, Tether, USD Coin and Binance USD. However, some investors use other stablecoins for yield farming. Stablecoins can be converted to Ethereum or other cryptocurrencies when the funds are pulled out of the liquidity pool.
The lender in yield mining is referred to as a liquidity provider because they are providing liquidity to the network by lending their cryptocurrency. The rewards paid to the liquidity provider come in the form of additional cryptocurrency, which can then be reinvested to earn even more cryptocurrency.
The benefits of yield farming
The most obvious benefit of yield farming is the fact that investors can earn a return on their cryptocurrency. Yield farming is an excellent way for crypto holders to put their tokens to work. Those who don’t put their crypto to work in yield farming are just sitting on their tokens, holding them in a digital wallet or on a crypto exchange. It’s similar to stuffing fiat currency under the mattress.
Yield farming can also enable investors to get their hands on a cryptocurrency that may be hard to come by. Not all protocols pay out rewards in the same cryptocurrencies. They may not even pay out rewards in the cryptocurrency that was added to the liquidity pool by the provider.
Instead, some protocols pay rewards in the form of new or hard-to-find tokens, enabling investors to pick up some cryptocurrency they can’t find anywhere else.
Yield farming risks
As with all investments, there are risks associated with yield farming. Investors may discover that the strategies with the highest yields are extremely complex, which means only advanced investors should attempt them. Yield farming may seem simple, but it’s much more difficult than it seems at first glance.
Investors who try their hand at yield farming but don’t understand it may find that they lose money. One issue that’s unique to smart contracts, which are utilized in yield farming, is the risk of bugs. In decentralized finance, many small teams that don’t have much of a budget will build smart contracts for yield farming, and those contracts could have bugs.
On the other hand, some protocols are developed by well-known auditing firms, but that doesn’t mean that they will be free of bugs. Whenever there is a bug in a smart contract, there is a risk of losing money. A related issue deals with how integrated the blockchain ecosystem is. DeFi relies heavily on every one of its building blocks, and if one of them doesn’t work as it was intended to, the entire ecosystem could take a hit, causing yield farmers to lose money.
How to participate in yield farming
Crypto investors who want to loan out their tokens for yield farming purposes must start by adding funds to a liquidity pool. A liquidity pool is a group of smart contracts containing funds. The pools drive a marketplace that enables Ethereum holders to trade, lend or borrow tokens.
When a crypto holder adds funds to a liquidity pool, they become a liquidity provider. At that point, their Ethereum is locked up, and they can’t access it for a time. However, they are rewarded with fees or interest generated by their holdings in the liquidity pool while their cryptocurrency is locked up.
The tokens received as a reward for yield farming can then be deposited into other liquidity pools. In many cases, yield farmers will move their tokens from one protocol to another in search of higher and higher yields. The amount of returns a yield farmer earns from their investment is based on how much they invest and the rules the protocol is based on.
Calculating returns from yield farming
The terms used in calculating yield farming returns are similar to those used in lending fiat currency. Calculating yield farming returns are done on an annualized basis. Two important metrics to know are the annual percentage yield, or APY, and the annual percentage rate, or APR.
These metrics are similar, except that the APR doesn’t account for the effect of compounding, but the APY does. Investors benefit from compounding when they reinvest the profits they earned from yield farming into continued yield farming, generating even more returns on the reinvested money.
It can be difficult to calculate yield farming returns because of how quickly the market moves, causing returns to fluctuate wildly at times. Some yield farmers may find a strategy that works well for a while, but suddenly it might stop yielding high returns because a large number of other investors noticed the high returns and jumped on the bandwagon.
Yield farming can offer a great way for cryptocurrency holders to earn a return on their investment. However, it isn’t something investors should enter into without a deep understanding of it. Cryptocurrency investors should study yield farming and spend a lot of time learning about it before diving in.
Frequently asked questions about yield farming
Yield farming is a reward scheme that has become very popular in the DeFi crypto world. However, it is a new financial product, so you probably have plenty of questions. Here are some of the questions we are frequently asked.
What is DeFi yield farming?
DeFi stands for decentralized finance. DeFi yield farming, which is also known as yield harvesting, is a way of lending cryptocurrency. In return, you can receive interest, fees, or units of cryptocurrency.
Is yield farming profitable?
It can be. It’s a very volatile market. On a good day, yield farmers can earn as much has 100% APY. On a bad day, you can lose a lot of money. However, the potential for big profits still draws many investors.
Is yield farming safe?
Is yield farming the same as staking?
What is the difference between yield farming and liquidity mining?
Liquidity mining is a type of yield farming. It refers to yield farming where the investor is rewarded with the platform’s own token as well as interest or fees.
- Yield farming, also known as liquidity mining, is an investment strategy that stakes or lends crypto assets to generate returns or rewards in the form of fees or additional cryptocurrency.
- The strategy is a risky (and very popular) application of decentralized finance (DeFi) that is probably not suitable for newbies to crypto investments.
- Yield farming is similar to depositing money in a savings account or making a loan. However, the returns on yield farming are likely to be much higher than either of those two options.
- The strategies with the highest yields are extremely complex, which means only advanced investors should attempt them.
- The terms used in calculating yield farming returns are similar to those used in lending fiat currency. Calculating yield farming returns is done on an annualized basis.
- Two important metrics to know are the annual percentage yield, or APY, and the annual percentage rate, or APR.
Pierre Raymond is a 25-year veteran of the Financial Services industry. Driven by his passion for financial technology he has transitioned from being a quantitative stock picker to an award-winning hedge fund manager, credit risk manager to currently a RISK IT Business Consultant. Pierre is the cofounder of Global Equity Analytics & Research Services LLC (GEARS) and a current partner at OTOS Inc.