What is Yield Farming? A Complex System Easy Explained

Yield Farming has been one of the most interesting investment strategies implemented by a lot of cryptocurrency traders, specifically within the region of Decentralized Finance (DeFi).

There are many ways through which you can make money through cryptocurrencies, and yield farming has been one of the most popular methods lately.

Investors that heavily invest within the world of cryptocurrencies and decentralized finance (DeFi) look for as many sources of income as possible to maximize their returns, and this is one of the most popular methods due to its efficiency and easy setup process.

Simply put, instead of just having your crypto sit in your cryptocurrency wallet, you can put it to work, where it can generate high returns and rewards for you. However, while Yield Farming isn’t the only way through which you can earn money passively, as you also have staking, lending and liquidity mining, it has proven to be the one of the most popular.

In fact, numerous Yield Farming protocols have popped up on the market that have attempted to truly provide users with an easier way through which they can engage in it.

That said, today, we’ll dive a bit deeper into everything you need to know about Yield Farming, and hopefully, by the end of this guide, you’ll be prepared to start with it and have another crypto source of additional income.

Quick Summary for Fast-Reader

  • Yield Farming is the process of putting your cryptocurrencies to work by staking them within a liquidity pool where they will give value to other users. 
  • The returns you earn by Yield Farming are expressed as APY, or the rate of return you would earn during a year.
  • Each liquidity pool will have its own APY, as well as the level of risk associated with it.
  • APY estimates give you the yield that could be generated if funds were locked in a pool for a certain period of time under the same market performance conditions.
  • There are many Yield Farming protocols out there, so knowing which one works best for you is essential, as you want to get the most out of your investment.

What is Yield Farming in Crypto and DeFi?

Decentralized Finance (DeFi) is the term that describes a financial system that operates without any central intermediaries and has many use-cases. These include exchanges, insurances, yield farming, staking and more. It is the system through which software is written, one that runs on a blockchain network and makes it a possibility for users to interact with one another on a peer-to-peer basis, where each transaction is facilitated through software, not by other entities.

Yield Farming is the process of locking up funds, otherwise known as staking, in order to generate high returns or rewards for doing so in the form of cryptocurrencies.

There are many Yield Farming protocols in decentralized finance (DeFi) that incentivize users to lock up their crypto assets in a smart-contract-based liquidity pool.

These incentives range from transaction fees generated from the pool, for example, or interest from lenders, alongside a governance token native to the pool, used. 

Most of the time, these returns will be expressed as an annual percentage yield (APY), and as more investors end up adding funds to the liquidity pool in question, the value of the returns will decrease as a response to that.

What is so Special About Yield Farming?

Through Yield Farming, you are essentially locking up your crypto in different DeFi protocols with the goal of earning fixed or variable interest as the result of those efforts. 

These rewards are much greater than ones gained from traditional investments. However, they have a higher level of risk associated with them.

For example, when you take out a loan in a real-world bank through FIAT currencies, the amount which is lent out to you will need to be paid back with interest.

Liquidity Pool Example

In Yield Farming, however, cryptocurrencies are lent through DeFi protocols and locked in smart contracts, generating returns. Once the loan is repaid, instead of the bank only profiting from the interest, you get a percentage of the fees for staking the tokens, to begin with. Most commonly, this is a process that’s typically carried out by ERC-20 based tokens, where most of the rewards are also based on the token standard that was staked.

How does Yield Farming Work?

Yield Farming works with a liquidity provider (LP) and a liquidity pool, which is essentially a smart contract that gets filled with cash and powers a DeFi market. 

The LP, in this case, are the investors that deposit the funds into a smart contract. An Automated Market Maker (AMM) relies on liquidity providers to deposit funds into liquidity pools.

To make it as simple as possible for you to understand how Yield Farming works, we’ve created a step-by-step guide through which you can learn everything you need to know.

Tutorial Step by Step Explanation to make money with Yield Farming

  • Step 1: A user adds funds into a liquidity pool, which is a smart contract that contains the funds—the pool powers a marketplace, where users can then exchange, borrow or lend tokens through it.
  • Step 2: Once the user has added these funds to a pool, they become a liquidity provider (LP),
  • Step 3: All that’s left for the user to do in this case is to just sit back and relax, as the pool will generate rewards for them through fees from the DeFi platform.

The tokens that are received as a reward can be deposited in liquidity pools, which adds even higher earning potential for the LP here. This way you can then earn compound interest. 

How Yield Farming investors get rewarded

That said, lending a specific token on a decentralized, non-custodial money market protocol and receiving a reward is Yield Farming.

Liquidity providers can essentially deposit funds into what is known as a liquidity pool, where these deposited funds will be stablecoins that are linked to USD in most cases. The returns the LP gets are based on the amount they end up investing and the rules upon which the protocol is based. LPs can create multiple investment lines by reinvesting the reward tokens they get into other liquidity pools.

Yield Farming Example

Think of Yield Farming as a literal farm, where you would like to bury a specific crop to bloom into a state where it can be farmed and sold for money. Except here, it automatically grows, waters itself, and sells itself, and you get a percentage of the total sale.

Here, you aren’t really burying anything; you are just putting money into a pool, which automatically does some work and gets you to yield in returns. 

Liquidity providers (LPs) essentially deposit their tokens in the liquidity pool, where they are rewarded for doing so.

They benefit from this liquidity as they can use it to perform actions such as trading or lending.

How Much Can You Earn With Yield Farming?

The returns you earn by Yield Farming are expressed as APY, or the rate of return you would earn during a year. Typically, this will be in the range of 6% or even more, depending on the specific protocol you deposit in. 

There have been cases where users have gotten 8% or even over that, so this is all dependent on the pool and protocol in question, as well as how much you end up staking and which cryptocurrency tokens you deposit. Those are the best exchanges for staking rewards.

How to Calculate Your Returns for Yield Farming

Most of the time, the estimated Yield Farming returns are calculated on an annual basis. This estimates the returns that you can expect throughout the course of a twelve-month period.

The most common metrics used here are Annual Percentage Rate (APR) and Annual Percentage Yield (APY).

Their main difference is that APR does not consider any effects of compounding, while APY does indeed do this.

Within this specific case scenario, compounding refers to reinvesting the profits you are generating with the goal of gaining more returns.

For example, suppose a specific DeFi protocol announces that its annual interest rate is 4%.

In that case, the percentage of compounds per block is calculated by dividing 4% by the total number of blocks published on the blockchain within a specific year.

An annual rate in DeFi is not always constant as protocols are affected by market conditions and can shift tremendously at times.

This means that you can expect APY estimates to give you the yield that could potentially be generated if funds were locked in a pool for a year under the same market performance conditions.

What Is the Difference Between Yield Farming and Liquidity Mining?

Yield Farming is a process where you lock up your funds and earn rewards in the process of doing so by lending various cryptocurrencies through various DeFi protocols through which you can earn variable interest. Based on the amount of time these funds are deposited in the pool, you can receive a reward. You can create multiple investment lines by reinvesting the reward tokens you get this way.

In liquidity mining, you earn tokens by giving liquidity. 

Liquidity is the availability of tokens within a given platform, which is essential for the platform to be able to grow and expand in DeFi markets. 

Mining is a technique through which computational power is made available, and new coins are introduced to the algorithm. 

In order for a person to engage in liquidity mining, they must give liquidity to one of the pools they are interested in. In exchange, the user gets an LP (Liquidity Provider Token), which will be needed for them to be able to redeem the rewards. 

If a LP leaves their tokens in the pool, they can earn a portion of the protocol’s revenue through swap fees. This means that they are getting a percentage of the fees across all trades. 

They are typically collected as a reward in the form of the protocol’s native governance token.

Yield Farming vs. Staking

Staking is yet another way through which you can put your cryptocurrencies to work and earn rewards from using them this way. This is a process that involves you committing your cryptocurrency assets to support a blockchain network and confirm transactions. 

This is specifically available to cryptocurrencies and blockchain networks that use Proof-of-Stake (PoS) as a consensus model to process their payments. 

When participants within a blockchain network pledge their coins this way, the protocol that powers it chooses validators to confirm blocks of transactions. 

The more coins get pledged this way, the more likely the user is to be selected as a validator.

Additionally, each time a block is added to the blockchain, new cryptocurrency coins are minted and distributed as staking rewards to the block’s validator. These rewards are the same cryptocurrency that was staked, but there are blockchains that will offer different types of cryptocurrencies as rewards as well.

Yield Farming vs. Lending

Through Yield Farming, you get interest and a portion of the fees generated when you engage in yield farming. Yield Farming uses smart contracts, or automated market makers (AMMs) in order to facilitate crypto trading.

An investor will collect crypto assets and lend them out to borrowers, which can pay back interest on the loan to the investor, which can be fixed or variable with the rates decided by the platform used.

A farmer deposits their coins as collateral to the lending protocols and can then borrow other coins. They can leverage their initial capital multiple times and generate cumulative returns by using the borrowed coins as additional collateral to borrow more coins. They can also get the native governance token of the protocol as a reward.

Cryptocurrency lenders and borrowers are typically connected through a third party, such as an online crypto lending platform. There need to be three parties involved in these crypto loans, including the lenders, the borrowers, and the lending platform.

The lenders are the ones who want to lend cryptos, stablecoins, or cash and earn passive income from their cryptocurrency investments.  

What this means is that a user can lend their cryptocurrencies and earn some interest in return. These interest rates can differ and can either go from 3% to 7% or even more, depending on the case. 

Borrowers, in some cases, will also have the chance to stake their cryptocurrency as a guarantee of loan repayment or as security. This means that in the event where the borrower is unable to pay the loan, they can sell the crypto assets and recover their losses. 

What Are the Risks of Yield Farming?

There are many risks when it comes to Yield Farming, but the most important ones that you need to be aware of are the complex system and the impermanent loss.

Complex System

You need to know right away that Yield Farming isn’t a simple process and that the most profitable Yield Farming strategies will be highly complex. 

If you do not know what you are doing exactly or how you are putting your cryptocurrency tokens to work, you could end up losing money in the process. No matter how simple it might sound on paper when it comes down to it, there are a lot of factors in play here which could heavily impact your overall experience and potential APY in the long term.

Impermanent Loss

Another risk you need to be aware of is impermanent loss. Impermanent loss is a unique risk involved with providing liquidity to dual-asset pools within DeFi protocols.

To put things into perspective, it is the difference in value between the two cryptocurrency assets which are deposited within an Automated Market Maker (AMM)-based liquidity pool.

So, when you deposit them into an AMM and withdraw them at a later date, you could be at a loss, compared to a scenario where you could have just HODL’d them and left them in your wallet. These losses can be further-amplified depending on how the market moves. 

To summarize, the impermanent loss is when a liquidity provider experiences a temporary loss due to the volatility of the trading pair they have deposited. 

Summary

Hopefully, now you know a bit more about what Yield Farming is and what you can expect the moment you decide to try Yield Farming yourself.

This is a complex method through which you can heighten your passive income and has high risks associated with it; however, if you put in enough time and effort into mastering it, you could reap the rewards in the long term. 

While there are many ways through which you can earn passive income within the world of cryptocurrencies, Yield Farming has been a popular option for a lot of investors due to the high APY offered by some protocols, as well as the overall hype and popularity surrounding it.

Do not let the risks intimate you too much, and make sure to give Yield Framing a chance if it is something that has piqued your interest or if you want an alternative way through which you can generate passive income in your portfolio. 

That said, before you decide to dive into the world of Yield Farming, be prepared for anything, and never invest more than you can afford to lose.