Even with the recent downturn in crypto markets, the total value of assets locked in decentralized finance (DeFi) protocols is currently over $42 billion. For the uninitiated, decentralized finance is a growing collection of financial tools and protocols that allow users to trade, borrow, and lend money on the blockchain without the need for third-party approval.
Perhaps the biggest catalyst for DeFi’s growth has been the rising popularity of yield farming, a fairly risky ROI optimization strategy that offers significantly higher returns than traditional investments. Yield farming has quickly become one of the most popular use cases of decentralized finance due to its high risk, high reward, and general preference for crypto speculation.
What is yield farming?
Yield farming is the process of staking and lending cryptocurrency through decentralized finance protocols to optimize returns. While yield farming can technically take place via a single DeFi platform, most reputable yield farmers are continuously moving their cryptocurrency between numerous lending platforms to make the most of their yields. By jumping back and forth between platforms, users can earn and optimize platform-native rewards and achieve greater yield.
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It’s also worth noting that while this type of trading is risky, using a decentralized exchange can help traders avoid a recent string of crashes on centralized exchanges, notably FTX. In fact, some decentralized exchanges have seen a spike in activity as users flee centralized exchanges, including Uniswap, which saw a spike in new activity on its exchange in mid-November:
New users of Uniswap’s web app peaked in 2022. Self-management and transparency are in demand, and users are flocking to what they know and trust. Let’s keep building. pic.twitter.com/IwPqTmx58J14. November 2022
How does yield farming work?
Yield farming involves lending, borrowing and staking tokens in decentralized applications such as decentralized exchanges (DEXs) or open-source liquidity protocols. Each of these dApps is based on smart contracts that allow transactions to be executed autonomously without a central bank or intermediary.
Popular and trusted protocols are Curve, Aave, Balancer, Compound and Uniswap. Meanwhile, liquidity aggregators like Yearn offer credit aggregation that seamlessly moves pools of user funds across different protocols to maximize profit and returns.
While most DeFi protocols were originally based on the Ethereum blockchain, high transaction fees, known as gas fees, have forced the protocols to migrate to alternative blockchains, or sidechains, such as Polygon and Solana.
types of yield farming
Provision of liquidity: Liquidity providers provide the necessary trading liquidity that powers decentralized exchanges. To be a liquidity provider (LP) of a dual asset liquidity pool, e.g. BTC/ETH, you must provide an equal value of both assets.
In exchange for providing liquidity to liquidity pools, LPs earn a small percentage of each transaction. In addition, LPs receive LP tokens, separate exchangeable and deployable assets that represent the proportion of an LP’s contribution share relative to the overall pool.
For example, if you provide $100 worth of crypto assets to a total pool worth $1,000, you own 10% of the pool. To represent this ownership you will be rewarded with LP tokens which can be claimed at any time for 10% of the pool assets.
Loan: By enclosing tokens in self-executing smart contracts, yield farmers can lend their tokens directly to another person to receive the interest paid on the loan.
Loan: Yield farmers can pledge a cryptocurrency as collateral to receive credit in another token. Users can then deposit the borrowed coins into a DEX or Liquidity log for additional returns while keeping their original inventory.
POS staking: Proof-of-stake blockchains allow users to lock their tokens against interest to provide additional security to the network.
LP staking: Staking the LP tokens they receive when providing liquidity to a DEX allows users to earn double returns as they are paid for providing liquidity in LP tokens which they can then stake, to get more returns.
Native token staking: Protocols like Curve and Aave incentivize farmers to use their networks with native tokens like CRV and AAVE. These tokens reward users with benefits such as fee savings and governance voting rights on future platform-related decisions. These tokens can also be used for additional income on the platform.
Risks of yield farming
As with most crypto investments, which offer huge upside potential, yield farming is a very risky game and not for the faint of heart. It requires serious research, knowledge, and risk-taking, especially in turbulent markets like these. Make sure you understand where the returns are coming from, as some lesser-known protocols can work in a similar way to Ponzi schemes, paying promised returns to existing investors with funds from new investors.
As a rule of thumb, if you can’t see exactly where the return is coming from, your money is someone else’s return.
Below we outline some of the specific and broader risks that yield growers face, including some good reminders of the risks inherent in the cryptocurrency sector in general.
Exit Scam: Exit scams, often referred to as rug pulls, occur when the developer of a decentralized application or protocol abandons the project without returning users’ funds. A lack of research into where to lend and stake your tokens to generate returns can leave you empty-handed and without recourse. Unfortunately, this happens fairly often in DeFi, so it’s always important to do your research and watch out for warning signs. Beware of new protocols that offer unreasonably high yields.
Platform Hacks: Smart contract hacks are the second biggest risk in DeFi. While the quality and security of smart contracts has improved over the years with third-party audits and an influx of talented developers, smart contract hacks are still widespread. Once a smart contract has been hacked, it is generally impossible to recover funds.
Regulatory risk: Cryptocurrency regulation is still a Wild West as the SEC begins to tighten the currently vague definition of “securities” for digital assets. While much of DeFi’s premise centers on autonomy and a lack of central authority, tighter government regulation could have serious implications for ecosystem growth. (There could also be tax implications for cryptocurrency investments.)
Volatility: During crypto market downturns or periods of extreme volatility, yield farming becomes even riskier than usual. Large price fluctuations can lead to sharp slips, temporary losses or even liquidation of smart contracts.
A temporary loss occurs when the value of holding a cryptocurrency in your wallet is greater than that of a dual-asset liquidity provider. Depending on how an asset’s price changes over time, particularly during periods of high volatility, it may be better to hold the asset directly rather than use it to provide liquidity to a liquidity pool.
The final result
As with all cryptocurrency investments, yield farming is inherently risky. But when done responsibly and properly, it can lead to impressive returns. As a reminder, never invest more than you can afford to lose and don’t let FOMO take advantage of you. There will always be a new protocol that promises sky-high annual percentage returns. Trust your gut, and if it’s too good to be true, it probably is.
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