A Short Introduction to Yield Farming
Maximise returns on your cryptocurrency assets
Before reading this article, feel free to do a bit of revision on decentralised finance (DeFi) first. Check out our real easy guide on DeFi!
Yield farming is a key feature of the DeFi ecosystem. In traditional finance, the term ‘yield’ broadly refers to income earned from investments. It includes price increases as well as dividends received and/or interest earned.
In DeFi, yield farming involves a more intricate process known as ‘liquidity mining’ whereby users are able to receive extra rewards in the from of a platform’s native tokens. This is in addition to any interest or fees earned from interacting with that platform.
Users who lend, borrow, provide liquidity, or stake their cryptocurrencies are rewarded with more tokens, hence increasing their ‘yield’ (if the value of the reward token rises). This attracts more users to a platform; incentivising them to provide the necessary financial capital, therefore generating liquidity.
Yield farmers essentially jump around different DeFi protocols, distributing their cryptocurrencies and attempting to earn the best yields while receiving additional tokens that might increase in value.
If you’re still confused, think of it as sourcing the best rates and tangible rewards offered by financial products (e.g. applying for a credit card which entitles you to additional sign-up rewards like shopping vouchers or electronics), except in a decentralised environment where the value of said rewards can quickly increase or decrease.
Examples of Yield Farming
Compound Finance — A lending and borrowing protocol. Compound started the yield farming ‘trend’ in the summer of 2020 by rewarding its users with COMP tokens. These are governance tokens which enables users to vote or propose changes to the protocol, therefore creating a decentralised form of governance.
Curve Finance — A decentralised exchange (DEX) that allows users to swap stablecoins — cryptocurrencies pegged to a more stable external asset like the USD.
Curve is also a stablecoin Automatic Market Maker (AMM) exchange, which means that assets can be traded in liquidity pools (a shared pool of cryptocurrencies) instead of between buyers and sellers. Curve rewards users with its native token — CRV, which represents a user’s eligibility to contribute to the protocol’s governance.
Yearn Finance — A yield ‘bouncer’. The platform automatically bounces users’ deposits into other protocols with the most yield. These deposits entitled users to additional yTokens that can be staked for a specific period of time to earn YFI tokens. YFI token holders are then able to participate in the governance of the Yearn Finance protocol.
Some strategies of yield farming include depositing an asset into a platform like Compound, using this initial deposit as a collateral to borrow more of another asset, and then lending it out again to maximise earnings on COMP tokens.
Risks of Yield Farming
The majority of DeFi protocols run on the Ethereum blockchain. Yield farming has increased the amount of transactions on the network leading to prolonged periods of congestion. This has led to a spike in gas fees making yield farming an expensive activity. However, Ethereum 2.0’s scalability upgrade can potentially solve this issue.
As with most DeFi platforms, yield farming strategies can be extremely complex. It requires users to have a sound knowledge of both decentralised AND traditional finance.
DeFi protocols are essentially computer softwares. This means that users might be committing their assets to an unregulated environment susceptible to smart contract hacks and wallet thefts. There are numerous unaudited protocols promising extremely high returns which users will naturally be attracted to. However, scam developers might perform a ‘rug pull’; funds are drained from a liquidity pool and the protocol ceases to exist.
The Future of Investing?
As mentioned in our previous article, DeFi might result in a paradigm shift in our understanding of finance. Yield farming could evolve into a widely adopted form of investment if the current risks can be mitigated.
Keep Tokenizing! Stay tuned for our more in-depth guide on Automatic Market Makers (AMMs) next week.
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