Yield Farming is one of the hottest topics in the Decentralized Finance space. ( DeFi ). Chances are that you may have already heard some of the insane returns that yield farmers are making. So what is Yield Farming and how did it all start?
Yield farming is a set of revenue/reward generation strategies through which anyone who owns a set of cryptocurrencies can park their cryptocurrencies in a liquidity pool (known as supplying liquidity) of a Decentralized Finance protocol like Uniswap, Curve etc and earn rewards by leveraging different financial instruments the protocol offers.
If you’re looking to understand ‘ What is Decentralized Finance (DeFi)? ‘ check here
Yield Farming is a way of maximizing the rate of return on Capital by leveraging different DeFi protocols. Yield farmers try to achieve the highest yield by switching different strategies that are suitable and profitable for a particular scenario. The most profitable strategies involve a few DeFi protocols like Uniswap, Compound etc.
From time to time if the strategy stops giving results on a particular protocol, they move the funds to another one or swap their tokens to a different one that gives better returns. This procedure is sometimes called Crop rotation (akin to the real farming).
To better explain this, In our current banking system, people look to start a savings bank account that offers the highest Annual Percentage yield (APY) that a bank offers. In a traditional savings account, a bank would offer anywhere between 1% to 4% depending on the type of account etc. But when it comes to Yield Farming, some of the strategies would bring an yield farmer with as much as 100% returns.
How does Yield Farming offers high returns?
There are three main factors that makes it possible.
Liquidity Mining is the process of distributing the tokens to the users of a protocol. One of the first DeFi projects that introduced liquidity mining was Synthetix. It rewarded the users with SNX tokens for adding liquidity to the SETH/ETH pool on Uniswap.
Liquidity mining yields additional incentives for the yield farmers as token rewards are added on top of the yield that is generated by the respective protocols. Depending on the protocol, these incentives may be more valuable, so much that some farmers may choose to lose the initial capital just to get more of these incentives, which makes their overall strategy highly profitable.
A perfect example of this practice is the liquidity mining of the comp tokens introduced by Compound that was initially giving away higher rewards for users who were borrowing assets with Higher Annual Percentage Yield (APY) this incentivized farmers who were borrowing assets with the highest APY. This incentivized farmers to start borrowing these assets as the value of minted Comp tokens was compensating them for the high borrow rates they had to pay.
Comp liquidity mining got popular and was a catalyst for a wider spread of yield farming.
Leverage is a strategy of using borrowed money to increase the potential return of an investment. Leverage makes ultra high returns possible. Farmers can park their cryptocurrency assets as collaterals as one of the lending protocols and borrow other cryptocurrencies. Again, they can use the borrowed cryptocurrencies as further collateral and borrow even more crypto assets. By repeating the whole procedure, farmers can leverage their initial capital a few times over and start generating even greater returns on the initial capital.
With over utilization of Leverage comes greater risk. All the loans taken by the Yield farmer are overcollateralized and the supplied collateral is susceptible for liquidation. If the collateralization ratio drops below a certain threshold.
Besides the liquidation risks, we have standard risks like smart contract bugs, platform changes, ADMINKEYS, systemic risks and ETH sharply losing it’s value in the market.
Though most of the system is secure, some of the DeFi related risks cannot be ruled out where the liquidity pools could be attacked.
Despite these risks, the rewards are high and that’s what makes Yield farming lucrative.
Yield farming strategies are set of steps that aim at generating high yield on the capital. These steps usually involve at least one of the following elements like Lending borrowing, supplying capital to liquidity pools or staking LP tokens.
Lending & Borrowing
It is one of the primary forms of receiving high APYs on your capital. Farmers can supply stablecoins such as DAI or USDT on one of the lending platforms and start getting return on their capital. Liquidity mining and leverage can supercharge that. For example, liquidity miners can get rewarded with extra Comp tokens for lending on the Compound protocol. They can also borrow funds with their collateral to buy even more cryptocurrencies. This ofcourse comes with the risk of potential liquidations.
Supplying capital to liquidity pools
Yield farmers can supply coins to one of the liquidity pools like Uniswap or curve etc and get rewarded with fees that are charged for swapping different tokens. Liquidity mining can super charge this. For example, on the protocol, Balancer by supplying cryptocurrency to certain liquidity pools, farmers are rewarded with extra BAL tokens that yields high APYs.
Staking LP Tokens
Some protocol incentivizes users further, by allowing them to stake the liquidity providers or LP tokens that representation in a liquidity pool. Example, Synthetix, Ren and Curve entered a partnership where a customers can provide, SBTC, WBTC and RENBTC to the ;Curve BTC liquidity pool and receive curve LP tokens as a reward. The tokens can be staked on Synthetix MINTR where farmers can be further rewarded in CRV, BAL, SNX and RENBTC tokens.
Some of these strategies can be combined together and experimented regularly. Through these regular practises, Yield farmers tend to reap greater benefits. The key to being on top of the yield farming is to staying vigilant and noticing the trading patterns constantly.