What is Yield Farming? 3 Simple Protocol Methods Explained

Yield farming involves depositing, and sometimes locking up, crypto assets in smart contracts in exchange for generating yields.

Yield farming can involve considerable risk. This article is for educational purposes only, and should not be considered financial advice. Please consider your personal risk profile before making any investing decisions.

One of the most exciting opportunities presented by DeFi has to be yield farming. Yield farming is a term used to loosely describe strategies of earning passive income from one’s crypto assets. The easiest way to conceptualize it is to imagine a high-interest yielding savings account at your traditional bank, or perhaps a dividend-paying bond, but that only scratches the surface when it comes to yield farming. 

The farming metaphor in yield farming references an initial deposit of crypto assets, and an eventual harvesting of rewards, similar to patterns practiced by farmers and agriculturalists. This article will discuss several specific methods of generating yields on crypto assets, crystallizing our understanding of the yield farming landscape more broadly.

In traditional finance, instruments yielding 5-15% for their asset holders are considered high. Savings accounts at commercial banks typically offer less than 1% APY for fiat currency deposits. Larger DeFi platforms like Celsius, on the other hand, offer higher yields on fiat stablecoins and other highly liquid crypto assets like Bitcoin, Ethereum, Paxos Gold, and many more.

Those numbers are small in comparison with DeFi offerings, with smaller protocols offering outrageous yields (think 800% APY) to attract capital to their protocols. These yields are typically seen as red flags, and only offered for smaller, often illiquid crypto assets, with yields turning volatile and gradually dropping significantly over time.  

This could leave yield farmers with their assets earning less than they expected, and as investors pull their tokens out to sell, the prices fall further. These ‘rug pull’ or Ponzi protocols often share similar designs in order to attract capital with high APY traps before the protocol’s creators begin selling off their coins or tokens to unwitting investors and disappearing altogether. High double-digit and especially triple-digit APY numbers should certainly be cause for extra scrutiny.

3 Simple Yield Farming Methods

Liquidity Providers (AMM Protocols)

The first method of generating yield from crypto assets involves depositing assets into liquidity pools. For decentralized exchanges, collecting funds into liquidity pools makes for quick and easy access for trades to take place moment to moment. That is, these funds are used collectively to process all of the trading that takes place on these protocols. 

Liquidity is absolutely essential for automated market makers (AMMs). AMMs offer permissionless trading using funds from LPs. Liquidity provider (LP) tokens are issued upon depositing funds in order to trace and verify contributions and calculate proportional shares of the pool for distributing yields.

On Uniswap v2, for example, pairs of crypto assets are deposited in equivalent value amounts in exchange for corresponding LP tokens. For example, one might deposit $500 of USD Coin and $500 of Ethereum into a liquidity pool smart contract in exchange for USDC/ETH LP-UNI-V2 tokens. Since Uniswap is an Ethereum dApp, the LP tokens created will of course also be specific to the Ethereum chain.

By providing liquidity to the protocol with their deposits, users generate yields from trading fees. Uniswap v2 charges a 0.3% transaction fee for every trade, and the fee is distributed proportionally to each LP token holder, depending on what their share of the liquidity pool happens to be. 

Using the above example, let us imagine that the $1,000 worth of USDC/ETH LP-UNI-V2 tokens represents 0.01% of Uniswap’s entire liquidity pool, meaning the whole pool contains an even $10,000,000 worth of assets ($5 million USDC & $5 million ETH). These numbers are kept hypothetical for the sake of simplicity.

If $10 million worth of USDC and ETH are traded on Uniswap per day and trading fees sit at 0.3%, then the liquidity providers would share $30,000 in rewards per day. If we keep with the example above, 0.01% of those rewards would net $0.03 per day to the LP, or roughly $11 per year. The rewards could be even greater if one speculates as to the future price appreciation of the UNI token over time. 

Of course, by providing more liquidity, one could expect to farm greater yields. In addition, providing liquidity to smaller pools means a larger share of the trading fees, though smaller pools are more likely to become illiquid or are prone to security breaches. Therefore, doing due diligence on matters of financial security is a must before becoming a liquidity provider.

Moreover, using Ethereum can be rather costly since gas fees are required to deposit both assets into the LP contract. Therefore many have turned to decentralized exchanges like PancakeSwap, QuickSwap, and SundaeSwap, which offer rewards to liquidity providers, but have lower fees compared to Ethereum since they run on the Binance, Polygon, and Cardano blockchains.

It should be noted that many liquidity pools reward LP token holders in smaller cap tokens such as CAKE or UNI, for instance. While these assets are widely held and traded, rates of inflation should be taken into account before making any long-term investing decisions. Critics also warn that liquidity on any given protocol could be significantly harmed if demand growth fails to materialize.

Money Markets (Lending Protocols)

Crypto money markets, or lending platforms, also provide opportunities for crypto users to generate yields on their holdings. For instance, Celsius, Aave, and Compound offer crypto loans to depositors using overcollateralization to manage counterparty risks. This means that in order to take out a loan in Bitcoin, for example, borrowers must post more collateral than they take out in the loan. 

To borrow a crypto asset on Celsius, users must first deposit another crypto asset and lock it into a smart contract, with higher levels of posted collateral allowing users to borrow at lower interest rates. Loan-to-value ratios range from 50% for the highest interest, riskiest loans to 25% for the lowest rates they offer at only 1% to borrow. 

By providing the capital for borrowers, users of Celsius can generate yields of the assets they deposited, or else opt to receive the CEL token in order to receive marginally better rates. Celsius offers 6.2% APY to depositors for their first 0.25 Bitcoin, with the rewards generated from fees charged to borrowers on the same platform.

Essentially, this empowers users to continue allowing their assets to generate yields while also having the option to access liquidity without incurring taxable events from having to sell the assets for cash flow. By taking advantage of yield generating opportunities in crypto money markets, yield farmers can generate more passive income with lower barriers to entry, since rates on DeFi platforms are so much higher than what’s found in traditional finance.

Validator Staking (Proof of Stake Protocols)

Staking is a term which describes users depositing crypto assets into a specific proof-of-stake protocol, sometimes ‘locking’ them into short-term smart contracts (though not always), and then generating crypto rewards which compound over time. Though it is not traditionally considered yield farming, staking technically falls into the category as it involves depositing crypto assets into a staking pool in exchange for a share of the node validator’s block rewards. 

For instance, staking ADA on Cardano involves joining a staking pool which consistently participates in block validation and is not fully saturated with stakers. After committing funds to a stake pool, users are rewarded with ADA coins every epoch (5 days), returning an estimated 4.5% – 6% APY on their deposits.

Tezos also offers staking rewards at 6% APY for running your own staking node, though this can be cumbersome for the average user. Centralized exchanges like Coinbase allow their users to stake funds through their own validator nodes, with stakers getting 4-5% APY and Coinbase keeping the rest for doing the technical heavy lifting. Funds can be staked or unstaked at will, making the yields highly attractive given the liquidity of this arrangement. 

Ethereum 2.0, recently rebranded as ETH’s ‘consensus layer upgrade,’ also allows users to stake funds and even run their own validator nodes once the upgrade is ready to go live. By validating transactions, stakers will earn rewards depending on a number of variables. To run a full validator node requires 32 staked ETH, while those with fewer Ethereum need to stake with a larger pool. 

Staking Ethereum on Coinbase, for example, yields users 4.5% APY. As with many other blockchains, running an Ethereum node will require capital investments in hardware, and additional resources dedicated to maintenance, node operations, on-chain penalties, and regulatory compliance.

Unlike the previously mentioned staking options, staked Ethereum cannot be unstaked for the time being, with users waiting indefinitely for the network upgrade to go live before their initial deposits can be accessed, not to mention yields from staking.

Yield Farming Risks

Yield farming comes with inherent risks, as is present with using any form of crypto. Nevertheless, it’s important to be aware of specific hazards to prepare for before doing any yield farming. 

Volatility risk is always present when using non-stablecoin crypto assets for yield farming. Those looking for yields on their crypto can easily get liquidated and lose money if their assets suddenly lose value and they aren’t able to add collateral in the case of DeFi lending. 

Impermanent loss is another concern, as price fluctuations between the paired assets might diverge in opposite directions from when the crypto was initially deposited. However, this only applies to liquidity providers, as impermanent loss does not apply to staking or money markets. 

Inflationary tokenomics is another concern for yield farmers. After all, if rewards are given too generously to liquidity providers, the spot price of the token might outstrip demand, creating downward pressure on the price, creating negative sentiment surrounding the token, and driving away liquidity or else failing to attract more over time. 

Rug pulls, pump and dumps, and outright fraud also pose a threat to those seeking to maximize their returns through yield farming. Depositing crypto assets into a protocol often means pairing the rug pull token with Ethereum as a liquidity provider. 

Once the spot price of the rug pull token reaches a certain threshold, the rug pullers sell off their tokens and disappear from the protocol. Liquidity providers might find that they had been earning high yields, but denominated in a devalued token. Other examples involve yields being locked and inaccessible until an indefinite date, leaving yield farmers suffering devastating losses. 

Finally, there are unknown regulatory risks associated with crypto assets in nearly every jurisdiction around the world, particularly when it comes to DeFi and securities offerings. Countries like El Salvador, Switzerland, Taiwan, Portugal, and Singapore have made clear that crypto assets are to be embraced, with friendly tax regulations and welcoming arms to welcome innovators and encourage economic dynamism. Interestingly, smaller jurisdictions seem to be taking the lead in crypto adoption and regulatory clarity, inviting questions as to why some have moved quickly while others lagged behind. 

Conversely, other jurisdictions have either strictly regulated exchanges or ownership of crypto assets or otherwise failed to provide enough clarity necessary for investors to participate meaningfully in the space. Nevertheless, positive regulatory developments have been the common trend globally, with places which had initially taken defensive stances against crypto such as Russia and Thailand recently announcing steps to regulate ownership and trading of the asset class.

Final Thoughts

Yield farming is a complicated and risky endeavor no matter which method is used. Nevertheless, the amount of value locked in DeFi contracts continues to trend upwards over time. When given the opportunity to put their money to work, crypto users are seemingly eager to pad their lifestyles with passive income. The decision to engage in yield farming involves considerable risk and is up to each individual to decide. Thus, this article should be considered educational, and is in no way an endorsement of yield farming as an investment strategy.

References

1. Baydakova, A. (2022, 21 Feb.). Russian government introduces crypto bill to parliament over central bank objections. CoinDesk.
2. Reuters Staff. (2022, 25 Jan.). Thailand to regulate use of digital assets as payments. Reuters.
3. Vermaak, W. (2021). What is yield farming? CoinMarketCap.

Related Articles

• What is Decentralized Finance?
• What are Smart Contracts?
• The Importance of Proof of Reserve Audits for DeFi and Crypto

Learn More

• What is ISO 20022 and How Will it Impact the Crypto Industry?
• Blockchain and Securities Markets: How Blockchain Securities Are Changing Traditional Investing
• CBDCs & The Interoperability of Digital Money