What Is Yield Farming?
Yield farming is an investment strategy that involves depositing cryptocurrency assets into a liquidity pool or a decentralized finance (DeFi) protocol to earn a return. Investors receive yield, usually in the form of governance tokens or additional tokens, for providing liquidity to decentralized exchanges (DEXs), staking tokens in a proof-of-stake (PoS) network or protocol, and lending assets in a money market protocol.
The main goal of yield farming is to generate yields on otherwise static crypto holdings, and to take advantage of the high-yield opportunities available in the DeFi market. However, it comes with considerable risks, such as price volatility, smart contract vulnerabilities, and impermanent loss.
Popular Methods of Yield Farming
Below are some of the most common yield farming strategies.
Lending
Investors can lend their cryptocurrency to others on DeFi platforms and earn a variable interest yield from the borrowed asset. Decentralized lending applications (dApps) such as Aave or Compound, make this process seamless by connecting lenders with borrowers.
Liquidity Provisioning
Liquidity providers (LPs) deposit pairs of tokens into DEXs, like Uniswap or PancakeSwap, to facilitate trading. LPs receive a portion of the transaction fees generated by the exchange as reward for providing liquidity. These liquidity providers may also receive additional rewards in the form of governance tokens.
Staking
Investors can also lock their tokens into a Proof-of-Stake (PoS) blockchain or a DeFi protocol to support the network’s security or operations. In return, they earn rewards in the network’s native token. Some examples of stakable tokens include Jupiter (JUP), Ethereum (ETH) and Celestia (TIA).
Here’s a pro tip — participants can increase their overall earnings by reinvesting their rewards back into the same yield farming strategy. This process, known as compounding, enables stakers or liquidity providers to generate additional returns not only on their initial stake but also on their accumulated earnings.
Yield Aggregators
Yield aggregators, also known as auto-compounders, are DeFi dApps that automatically compound yield rewards to optimize returns. They may pool resources from multiple investors to enhance capital efficiency through economies of scale, maximizing rewards. However, using yield aggregators also increases the smart contract risk that yield farmers face compared to manually compounding rewards themselves. Popular yield aggregators include Beefy Finance and Yield Yak.
Risks of Yield Farming
Yield farming offers the potential for high rewards, but it also has significant risks that investors should be aware of. Here, we discuss some of the most common challenges in yield farming.
Impermanent Loss and Volatility
Due to price fluctuation, liquidity providers may suffer impermanent loss, where the current value of their deposited assets is lower than their value at the time of deposit. Additionally, the returns from yield farming can be highly volatile, with the value of rewards often changing based on supply and demand dynamics, market conditions, and token prices.
Smart Contract Risk
Yield farming often relies on smart contracts, which may contain bugs or security vulnerabilities. These technical flaws can be exploited by hackers, leading to the loss of deposited funds. In addition, fraudulent projects (known as rug pulls) can trick investors and disappear with their money after accumulating significant liquidity.
Regulatory Concerns
Changes in regulations could also impact the legality or operations of DeFi protocols. Despite being decentralized, some yield farming platforms still experience regulatory scrutiny, as seen in the battle between Uniswap and the United States Securities and Exchange Commission (SEC).