Yield Farming: What Is It and How Does It Work?

Yield farming is one of the most popular yield-generating opportunities in the global DeFi markets, enabling you to potentially earn above-average yields by depositing crypto in yield farming protocols.

Read on to learn more about yield farming and how it works.

This is partner content sourced from Laura Shin’s Unchained and published by CoinDesk.

What Is Yield Farming?

Yield farming refers to depositing tokens into a liquidity pool on a DeFi protocol to earn rewards, typically paid out in the protocol’s governance token.

There are different ways to yield farm, but the most common involve depositing crypto assets in either a decentralized lending or trading pool to provide liquidity. In exchange for providing liquidity to these platforms, liquidity providers (LPs) earn a certain annual percentage yield (APY), which is usually paid out in real-time.

DeFi projects enable yield farming to incentivize the use of their platforms and reward their community for contributing liquidity, which is the lifeblood of most DeFi platforms.

How Does Yield Farming Work?

While the yield farming process varies from protocol to protocol, it generally involves liquidity providers, also called yield farmers, depositing tokens in a DeFi application. In exchange, they earn rewards paid out in the protocol’s token.

Yield farming rewards are expressed as APY. These tokens are locked in a smart contract, which programmatically rewards users with tokens as they fulfill certain conditions.

Generally, the yield farming process works as follows:

• Choose a yield farming protocol. Let’s go with an automated market maker (AMM) like PancakeSwap for this example.
• On the decentralized trading platform, you click on ‘Liquidity’ to access the section for liquidity providers.
• Then, you choose which assets you would like to deposit in a liquidity pool. For example, you could deposit BNB and CAKE in the BNB/CAKE pool.
• You deposit the two assets in the trading pool and receive an LP token.
• You then take that LP token, go to ‘Farms,’ and deposit it in the BNB/CAKE yield farm to earn your yield farming rewards (in addition to the transaction fees you receive as your share of the liquidity pool).

Many DeFi protocols reward yield farmers with governance tokens, which can be used to vote on decisions related to that platform and can also be traded on exchanges.

Benefits and Risks of Yield Farming

Yield farming offers an opportunity for individuals to earn passive income. However, the potentially high returns also come with substantial risk. Let’s take a look at the benefits and risks of yield farming.

Benefits of Yield Farming

• Passive income: Rather than just holding, users can put their holdings to work and earn rewards in the form of additional tokens and fee income without actively trading.
• Liquidity provision: Yield farming enables efficient trading and reduces slippage on DEXs. By providing liquidity, users play a crucial role in the functioning of the DeFi ecosystem.
• High yields: Some DeFi projects offer attractive yields that exceed traditional financial instruments. Depending on market conditions, users can potentially earn substantial returns on their capital.

Risks of Yield Farming

• Impermanent loss: Impermanent loss primarily occurs in AMMs because of the mechanism used to maintain balanced liquidity between the tokens in the pool. If the prices of the tokens in the pool change significantly after you’ve provided liquidity, the platform’s automated system may rebalance the pool by buying more of the cheaper tokens and selling the more expensive ones. This rebalancing action can result in a loss for yield farmers.
• Smart contract flaws: DeFi protocols are built on smart contracts. Hackers can exploit any bugs or vulnerabilities in the code, resulting in the loss of deposited funds.
• Fluctuating rates: Yields change based on supply and demand dynamics, which makes it hard to predict the potential rewards in the future. For example, yields can collapse as more people supply assets.
• Volatile prices: Cryptocurrency prices can be highly volatile, affecting the value of rewards and the assets you’ve deposited. if the token you are earning your rewards in drops significantly in value, all your profits could be eroded away.

Is Yield Farming Worth It?

While yield farming can be a lucrative way to earn yields in the crypto market, it is also one of the riskiest activities you can engage in.

Even if you are yield farming on reputable DeFi protocols, smart contract risk, and hacks could still lead to a complete loss of funds.

Moreover, your potential yield farming profits are highly dependent on the price of the protocol token you receive as your yield farming reward. Should the value of the protocol token drop, your yield farming returns could easily dwindle.

Finally, the yield you receive today may not be the yield you receive tomorrow. High yields tend to compress as more yield farmers start to move funds into a high-yielding farm, affecting your returns.

If you can stomach the risk, yield farming can be an exciting way to earn yield on your crypto. However, you should conduct your own research and never invest more than you can afford to lose.