Decentralised finance, or DeFi, seeks to decentralise traditional financial services. By utilising smart contracts, which are programmable functions updated on the blockchain, DeFi protocols are able to run an automatic, trustless and permissionless service.
DeFi protocols are experimental works in progress. Funds deposited into DeFi protocols in general can be at risk of smart contract vulnerabilities, malicious developers and hacks. DeFi Protocols are generally governed by token holders through a DAO (decentralised autonomous organisation).
The number of platforms and applications within this sector of the cryptocurrency industry has increased dramatically over the last 3 years. One of the more lucrative advancements for cryptocurrency investors is having the opportunity to lend cryptocurrency holdings for a return on investment. This process within DeFi is often referred to as yield farming.
What is yield farming?
Yield farming is the process of lending cryptocurrency assets to DeFi protocols so that the assets, or "liquidity", can be incentivised by others. In return for lending digital assets, users are rewarded with more cryptocurrency tokens. It is a way for cryptocurrency investors to earn passive income from digital assets that would otherwise be sitting idle.
The process is similar to staking as it involves depositing and locking cryptocurrency holdings for a certain period of time. However, while staking uses cryptocurrency tokens to power a blockchain or protocol, yield farming uses cryptocurrencies as liquidity for other investors or traders.
Those that take part in yield farming and provide liquidity to DeFi platforms are known as liquidity providers (LPs). The liquidity is often used for decentralised exchanges, trading or loans. As the sector advances, there will undoubtedly be even more use cases in the future.
At the time of writing, the total value locked (TVL) in DeFi protocols by liquidity providers is $65 billion.
How yield farming works
Yield farming is made possible by the application of automated market makers and liquidity pools, which are used to power decentralised exchanges or lending platforms.
Liquidity providers, those seeking to earn interest from idle cryptocurrency holdings, can deposit their funds into a liquidity pool. Liquidity pools can be thought of as a "pot" of cryptocurrencies that other users can use for exchanges or loans. To use the pot of cryptocurrencies, the user has to pay a fee. These fees are then distributed proportionally to liquidity providers depending on their share of the liquidity pool. The rewards are usually in the form of cryptocurrency tokens.
Automated market makers are algorithms (a series of smart contracts) that calculate the exchange prices and interest rates on a platform based on the available liquidity held within liquidity pools.
Rules surrounding the distribution of fees and the length of time cryptocurrency assets must be locked in can vary between protocols. The use of AMMs and liquidity pools has facilitated the growth of yield farming in the sector.
Yield is the annual return that a liquidity provider can receive for lending cryptocurrency assets. This is often written as a percentage, either as annual percentage rate (APR) or annual percentage yield (APY). As the AMM calculates interest rates using supply and demand, unlike traditional financial investments, yields can vary daily.
Yield farming refers to the process where liquidity providers move liquidity between high-yield pools to take advantage of these dynamic changes in yield. Obtaining the optimum yield could involve moving to a different liquidity pool on the same platform or changing platforms altogether.
Many DeFi protocols mint liquidity provider tokens when a user deposits cryptocurrencies into a liquidity pool. For example, if a user deposits ETH into the borrowing and lending protocol Compound, they would receive cETH tokens in return. The token represents the user's stake in the liquidity pool and ensures custody of the deposit remains with the user.
Yield farming strategies
Yield farming can be simple with a liquidity provider lending cryptocurrency assets to one platform. On the other hand, investors can incentivise complex strategies to increase returns. This involves moving cryptocurrency assets between liquidity pools to catch the best interest rates.
With a variety of platforms offering yield farming opportunities, there is no "best way" to yield farm. Risk management should always be the focus as opposed to high-yield returns. A user needs to understand the protocol and remain in control of their funds throughout.
Automated yield farming
Thanks to increased popularity, there are now platforms that automate yield farming, which can be attractive for many passive investors. Yield farming can be time consuming and confusing for those initially entering the space, so automated options are a good solution.
- Yearn Finance. This is a decentralised DeFi aggregator that compares the yield farming opportunities from a range of DeFi protocols. A user can deposit cryptocurrencies into a "vault" that will then be distributed to the best performing liquidity pools. The vault rebalances periodically to ensure the best yield farming opportunity is being exploited.
- Zapper.Fi. Although not automated, Zapper.Fi provides users with the opportunity to "zap" in and out of DeFi protocols with a few clicks. This greatly simplifies the process. It removes the need to become adequately acquainted with each protocol.
Popular yield farming platforms
The expansion of the DeFi sector has resulted in the expansion of yield farming opportunities. Here is a list of some of the most popular platforms currently used for yield farming:
- Compound. Compound is a borrowing and lending platform where rewards for liquidity are compounded over time.
- AAVE. AAVE is a decentralised borrowing and lending platform. Interest rates are adjusted by an algorithm based on supply and demand.
- MakerDAO. This is a credit platform where users can deposit cryptocurrency in return for the US dollar-pegged stablecoin DAI. Users then earn interest, which is added to their DAI holdings.
- Curve Finance. Curve Finance is a decentralised exchange focused on the trading of stablecoins. By focusing on stablecoins, Curve Finance is able to offer lower fees and lower slippage.
- Uniswap. Uniswap is a decentralised exchange that allows users to deposit funds into liquidity pools. The liquidity pools are then used to facilitate trades.
- Synthetix. Synthetix is a trading platform for synthetic assets backed by the native SNX token. Users can deposit native SNX tokens or ETH in return for rewards.
- Yearn Finance. Yearn Finance is a decentralised aggregator for finding the optimum yield across multiple DeFi platforms.
Risks of using yield farming
Although dramatically increasing in popularity over the last year, the DeFi sector is still a young industry which means that risks need to be evaluated carefully.
- Smart contracts. Smart contracts are the backbone of DeFi protocols and allow for many of the brilliant yield farming opportunities on offer. However, smart contracts are programmed by humans, so errors can occur. There are systems in place to mitigate this risk, but if a smart contract does malfunction, it could mean that a user's liquidity deposit is lost in the DeFi ecosystem.
- Composability. Smart contracts increase the composability of DeFi protocols. Composability refers to the interaction of different protocols within the DeFi ecosystem (think of different mobile apps all working together for a seamless experience). This is one of DeFi's greatest strengths, but it can also be considered a secondary risk as it can amplify any issues within a smart contract system.
- Hacks. The decentralised applications that front the DeFi protocols are connected via the Internet. Like anything connected to the Internet, there is always a risk of a security breach from hackers. Hackers also look for cracks in smart contract code that they can use to their advantage.
- Rug pulls. With any new industry, there are always those looking to exploit new users. Rug pulls are one such exploitation. Rug pulls are a risk primarily associated with decentralised exchanges (DEX). Due to the open-source nature of the blockchain, anyone can create a new cryptocurrency token. On a DEX, scammers can then create a new liquidity pool and pair the worthless token with a valuable one, such as ETH. Once enough liquidity enters the fraudulent liquidity pool, the owners pull the pool and leave with the valuable ETH, leaving little to no trace.
- Impermanent loss. When depositing liquidity into liquidity pools, this is usually completed in equal proportion. For the ETH-USDC liquidity pool, you would need to deposit the same amount of each as set by the current exchange price. However, if one of those assets significantly increases in price, the liquidity pool would not automatically adjust. This provides an opportunity for arbitrage traders. They can use the liquidity pool to buy assets at a discount and sell at real-world prices. This process eventually brings the liquidity pool back to a balance. However, the process will also mean a liquidity provider may end up with a slightly different ratio of assets compared with when they deposited. When withdrawing those assets from the liquidity pool, impermanent loss occurs if the value of the new ratio of assets is less than if they had just remained on an exchange or digital wallet.
Yield farming is undoubtedly one of the most exciting aspects of the DeFi sector. It hands control to the individual user and offers the opportunity to put cryptocurrency assets to work.
The industry is still in its infancy, which comes with associated risks, but it is advancing at an incredible rate. With each advancement comes increased security, improved decentralised governance and more opportunities.
Yield farming can be simple or complex, but it provides cryptocurrency investors with a way to earn a little passive income from otherwise idle investments.
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