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Yield Farming in DeFi – Beginner’s Guide

December 6, 2022

yield farming in defi

The blockchain ecosystem is wrapped around the idea of decentralized finance. Decentralized finance (DeFi) enables everyone to participate in a permissionless system with the aid of smart contracts. These smart contracts facilitate peer-to-peer interactions. As the decentralized finance space constantly evolves, more and more innovations spring up. One such innovation is yield farming in DeFi.

In this piece, we will be talking about the meaning of yield farming and the impact of yield farming on DeFi. This piece will not cover yield farming vs DeFi and yield farming crypto Binance.

That said, let’s dive right in!

What is Yield Farming in DeFi?

In simple terms, yield farming in DeFi is the act of adding tokens to a liquidity pool for returns. It is an investment strategy as it is a common way for crypto enthusiasts to earn passive income.

Yield farming is also known as liquidity mining. In yield farming, token holders lock their cryptocurrency to produce earnings. With the structure, yield farming in DeFi can be confused with staking. Is it staking? Not exactly. Yield farming is more complex. Unlike merely staking your tokens, special users (liquidity providers) contribute their funds to liquidity pools. What, then, is a liquidity pool?

A liquidity pool is a smart contract that contains funds. Let me break that down. Centralized finance is the opposite of decentralized finance. Right? A typical example of centralization in finance is a bank. A bank manages funds and facilitates incoming and outgoing payments. The bank is in charge of the entire fund. Take away centralization, and we have liquidity pools. Liquidity pools work with the aid of smart contracts. And liquidity providers add their tokens to ensure the constant running of the liquidity pool. Does it make sense?

Now that we have discussed yield farming meaning in crypto, why don’t we talk about how it all started?

The Beginning of the Yield Farming Hype

The launch of COMP started it all. COMP is the governance token of Compound Finance, a decentralized lending protocol. The team sought a way to ensure a fair distribution while maintaining decentralization. What did they do? Compound Finance chose to distribute the tokens as a reward algorithmically. So, users of the lending protocol were encouraged to provide liquidity while ‘farming’ for the COMP token.

Even though this move drew attention to the yield farming concept, it wasn’t the architect. Nonetheless, we can admit that it gave way for other decentralized finance projects to utilize yield farming to attract liquidity.

How Does Yield Farming in DeFi Work?

Users (liquidity providers) need to lock their crypto tokens for a particular period to earn rewards. These locked tokens provide liquidity to a liquidity pool. Many a time, these locked tokens are lent to other users. So, borrowers pay interest, while liquidity providers earn interest. However, not all interest earned on debts is paid to liquidity providers. Sometimes, it goes to the decentralized exchange. Keep in mind that the interest being received or paid can range from a few percentage points to triple digits.

Also Read: What is Crypto-Backed Lending

Many decentralized exchanges use an automated market maker to facilitate orders. These automated market makers use smart contracts to request prices from various liquidity pools rather than merely stating the current price of an asset. For an automated market maker to work, liquidity pools and liquidity providers are essential.

We have made it clear that liquidity providers add funds to a liquidity pool. This pool enables the borrowing and lending of tokens in a particular decentralized exchange. As users use the decentralized exchange, they pay fees. These fees are then distributed to liquidity providers based on their contribution to the liquidity pool. Hence, yield farmers receive returns from the transaction fees.

Although this is the major way that yield farmers receive returns, there are other ways. They can receive incentives from newly minted tokens and governance tokens. However, one thing to note is that liquidity providers or yield farmers receive rewards based on their share size in the liquidity pool.

Many times, DeFi protocols support stablecoins. Stablecoins are tokens pegged to the US dollar, like BUSD, USDT, USDC, and DAI. This is not absolute.

Also, users receive rewards in different tokens. Platforms like Curve incentives yield farmers with tokens like Bitcoin, Ethereum, and Polygon. Some protocols also issue synthetic tokens that represent the staked tokens. These tokens can be shared, traded, or transferred but can only be exchanged for locked tokens.

We have highlighted the most common way yield farming works across multiple DeFi protocols. But bear in mind that every protocol is unique. And it can get more complex as you dive deep into the unique implementations of every DeFi protocol.

Yield Farming Returns

Do you want to learn about yield farming in DeFi because of the expected returns, or are you just curious? Whichever way, you must have adequate knowledge of how returns work and how it is calculated.

Yield farming returns are calculated per annum. This implies that rewards are estimated every year. Terms like Annual Percentage Yield (APY) and Annual Percentage Return (APR) are often used in calculating returns in yield farming. APY and APR mean almost the same thing and are often used interchangeably. However, they are not the same. APY factors compound interest and APR does not. In this context, compound interest means reinvesting your income to earn more rewards.

APR and APY can also be called possible gains. The opposite of these terms is possible loss or impermanent loss. The impermanent loss is when the dollar value of your stake tokens on withdrawal is lesser than the dollar value at deposit.

Remember, I mentioned earlier that APR and APY are estimations. Why is this so? The market is highly competitive and incredibly fast. Once farmers discover that a DeFi yield farming strategy works marvelously, they will all flock in, making the returns fluctuate. With an unexpected crowd providing liquidity, an imbalance may be created, and the pool will struggle to disburse high rewards.

Also Read: A Guide on DeFi Smart Contract Development

Risks Involved in Yield Farming

risks in yield farming in defi
Risks in Yield Farming in DeFi:
Photo Credit: beanstalk.io

Many DeFi newbies only think of profit when they hear about yield farming. However, DeFi yield farming is not without its risks. At different points, we’ve highlighted the complexity of yield farming. If you are new to the space, it is best to harm yourself with knowledge of the risk involved.

Rug Pulls

Literally, a rug pull is when the carpet is swept off your feet. In DeFi yield farming development, it is when the developers or team remove liquidity from a project and leave you holding empty bags. Rugg pulls involve introducing and marketing a new token that will entice investors to lock their funds in a bid to provide liquidity. However, the team drains the liquidity and makes the token worthless. That way, investors can’t get their funds back.

Drained Liquidity Pools

The problem comes when many users start removing their locked funds. With high funds, removal comes high slippage. High slippage implies that users will receive less when selling their assets. Yield farming may cause high slippage, considering that tokens will have to be staked for a long.

Lack of Fixed Strategy

At times, a user may have funds staked in Pool A. Pool A suddenly drops rewards after a week. Then, the user discovers that Pool B has raised its rewards. Unfortunately, if they had waited a week longer, they could have hopped on Pool B. The problem is having to deal with various pools and their rewards.

Final Thoughts

Yield farming is complex, profitable, yet risky. Yield farming also contributes significantly to the decentralized finance ecosystem. Hence, the rewards. However, you must consider the risks and rewards before diving into this sector.

Written by Darshan Kothari

Founder of Vardhaman Infotech - Blockchain & AI development Company. Developed world's first KALQ Keyboard. Thiel fellowship runner up. Love reading books.

October 3, 2022

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