If you’re anything like me a couple years back, a yield farming strategy would sound more like a strategy from a Sid Meier’s Civilization game than an investment strategy. But as blockchain technology evolves, DeFi platforms are growing and becoming more and more accessible to newcomers, and terms like yield farming are becoming more widespread.
It’s not just retail investors that have become more aware of Bitcoin, NFTs, and DeFi as a whole, even governments are taking notice. Regulations are being enforced, countries are adopting cryptocurrency as legal tender, and decentralized finance appears to be slowly entering the mainstream psyche.
For better or worse, yield farming is becoming more popular – but what is yield farming?
What is Yield Farming?
Yield farming is a method of utilizing the perks of decentralized finance (DeFi) platforms to maximize returns. Users of a DeFi platform can lend or borrow cryptocurrency, earning more crypto as a result.
For a more complex yield farming investment strategy, users can frequently move cryptos across multiple yield farming platforms to maximize their gains. This type of tactic is not recommended for newcomers, and doesn’t come without flaws – impermanent loss for example.
At a glance
- Yield farming allows users to maximize their reward tokens across many different yield farming platforms.
- By yield farming, you are providing liquidity to cryptocurrency trading pairs.
- The most well-known yield farming protocol is probably Compound or Aave. Uniswap, PancakeSwap, and Curve Finance also offer yield farming services and are widely used.
- Yield farming is risky. Impermanent loss isn’t the only worry – there are potential rug pulls, smart contract hacks, and extreme price volatility.
When did Yield Farming Begin?
While the ‘official’ start date for yield farming goes back to the first DeFi protocols to exist, the time when it really took off was in the summer of 2020, otherwise known as the DeFi boom.
Around June 2020, Compound began distributing COMP tokens to users of the Compound Finance ecosystem. This type of asset became known as a governance token. By using governance tokens, holders can vote in proposed changes to the protocol via a decentralized autonomous organization. Only democratically chosen proposals will take effect.
At the time, Compound led the charge of the DeFi bulls, and the term ‘yield farming’ was born. Investment strategies emerged that enabled users to make insane gains in a relatively short amount of time, amplified by the upwards volatility of the market at the time.
Another term came to light around the same time: “liquidity mining“. While liquidity mining is similar to yield farming, there are less risks involved with liquidity mining. There is more of an emphasis on strategy and maximizing profit with yield farming than there is with providing liquidity. Liquidity providers are generally happy to earn interest steadily from their liquidity pool rather than shift crypto from platform to platform in an effort to achieve even higher interest rates.
How do new DeFi platforms afford it?
So you might be wondering how there are so many DeFi platforms that appear out of nowhere. Some reach billions, while many reach millions of dollars in total value locked (TVL). How do they manage such a feat?
The TVL is not provided by the company that created the lending protocol, but rather through the participants in the network. The reason people can earn profit is because new governance tokens are created by the protocol and given as rewards for providing liquidity on their platform.
While this might not sound so appealing at first glance, when you see some of the initial interest rates, it’s understandable that it caused such a craze when DeFi platforms first started to boom.
The annual percentage yield (APY) of early DeFi platforms is extraordinarily high. I’m talking thousands of percent high. When Yearn Finance first launched, the creator (Andre Cronje) called the token valueless, yet it still rocketed to over $90,000 per token. This started with its sky high interest rates, the only way you could possibly earn YFI (the Yearn Finance governance token) was by crypto yield farming.
With this type of annual percentage yield, it’s no wonder that yield farmers rush to new platforms in hope of being one of the first (and therefore most profitable) liquidity providers.
It’s worth noting, however, that annual percentage yield is calculated based on compounding interest at the current level of liquidity. As more liquidity providers join the liquidity pool, the rates go down. If the platform doesn’t allow for automatic compounding, and you don’t regularly do it manually, then the interest rates drop even more. This is why it pays to be among the first liquidity providers in a new DeFi platform.
However, being one of the first yield farmers to provide liquidity in a new protocol can come with huge risks. The smart contracts are untested on a large scale at this point. Sure, they’ll have gone through rigorous back-end tests, and preferably at least one professional audit, but when the public arrives all at once, it’s extremely common for flaws to be found (and exploited) in the code.
As an example, you need not look further than Glide Finance, Elastos’s first decentralized exchange (DEX). Within hours of being able to provide liquidity, there was an exploit that allowed a malicious actor to steal upwards of $300,000.
Thankfully, the Glide Finance team reimbursed those who had lost money and went on to have a successful launch, reaching several million dollars in TVL at its peak.
There are some shady protocols that are released with the sole intention of running off with your money. This is called a rug pull. Learn more about what makes a rug pull and how you can avoid it here.
Rug pulls don’t have to be shady looking either. There are some that would say that Andre Cronje, founder of the aforementioned Yearn Finance, publicly rug pulled 25 DeFi projects simultaneously when he rage quit crypto entirely after users reported funds had disappeared from Solidly Exchange. He denied the claims and said users had been “trading via pairs that don’t have liquidity.”
What are liquidity pools?
So how does yield farming work exactly? What are liquidity pools?
Liquidity pools are essential for automated market makers (AMMs). AMMs are the underlying protocol that powers all decentralized exchanges.
According to Haseeb Qureshi, managing partner of DragonFly Capital, “you can think of an AMM as a primitive robotic market maker that is always willing to quote prices between two assets according to a simple pricing algorithm.” The algorithm in question is x + y = k. For a breakdown of how this works with a clear example, see Qureshi’s Medium article.
Essentially, a liquidity pool is a pool of paired tokens that are locked in a smart contract. This pairing is balanced by an algorithm that keeps the price steady, so long as there is enough liquidity to avoid high slippage (the amount at which you’re purchasing or selling affects the price). Liquidity pools also provide opportunities for arbitrage traders who can profit off the difference in the price of digital assets.
If all of this is going over your head, all you need to know is that a simple liquidity pool contains two separate tokens which you can buy and sell in a decentralized manner. When liquidity providers add tokens to a liquidity pool, they are deepening the liquidity in the pool and allowing for larger transactions to take place with less of an effect on the price. As this is favored, liquidity providers are rewarded – often generously – for their contribution.
Where do the rewards come from?
The rewards from providing liquidity come from token emissions. For example, in Glide Finance, if you provide liquidity for the GLIDE/ELA pair, you will receive GLIDE tokens as a reward. These are newly emitted tokens that are designed to support the network by incentivizing liquidity providers to join the liquidity pools.
This is liquidity mining.
Yield farming is a version of this, utilizing various strategies to maximize profit by constantly moving digital assets to new pools to receive the best returns. Yield farming can also include borrowing and lending platforms which are similar to liquidity mining, but vary slightly.
In a borrowing and lending protocol, you deposit funds into a pool that can be borrowed by another user. You benefit from the interest paid by the user when they return the funds. Most of these platforms require collateral so the borrower can’t simply run away with the cash.
What are crypto tokens?
Is there a difference between crypto tokens and coins?
A crypto token is what yield farmers receive for liquidity mining. These tokens are usually the backbone of the DeFi platform in question. They are given as rewards and can be used to vote on proposals on the network. Think of FilDA, Elastos Smart Chain’s fork of Compound. The token holders have a say in the future of the network.
Another important distinction between crypto tokens and crypto coins is that coins have their own blockchain whereas tokens are formed on an existing blockchain.
Finally, crypto coins are generally reserved for payments, such as gas on a network, whereas tokens have a use case outside of payments (governance, for example).
What are the Different Types of Yield Farming?
There are four basic ways to earn passive income from yield farming in DeFi protocols.
- Staking
The most simple of the bunch, a Proof-of-Stake (PoS) network allows staking as a means to decentralize and secure the blockchain in question. All staking requires is for you to lock away some of your coins or tokens to earn interest. Sometimes there is a set period of time that they need to be locked away for. Ethereum is currently transitioning to PoS as we speak, making it a lot more energy efficient.Another type of staking comes from Liquidity Pool tokens (LP tokens) that users receive from supplying liquidity on a DEX. This is a great strategy for yield farmers to take advantage of as it enables users to earn interest on their liquidity as well as receive LP tokens, which can then be staked to earn additional yield.Soon, Elastos will release an upgrade that will allow for liquid staking. Developed by the team behind Glide Finance, liquid staking will enable users to “[exchange] the native token for a derivative token representative of your staked position.” In turn, this will enable your ELA to secure the network and earn you interest, while you can still use it for various dApps on sidechains.
- Liquidity Providing
Liquidity providers deposit equal values of two coins in a trading pair on a DEX. Exchanges generally charge small transaction fees for trades, which are then paid to liquidity providers. Sometimes this fee is paid in new LP tokens, but often it is paid in the DeFi platform’s native currency. - Lending
Cryptocurrency coin or token holders can lend their investment to borrowers through the use of smart contracts and earn yield from interest paid on the decentralized loan. - Borrowing
A more complex (and risky) yield farming strategy is to borrow cryptocurrency from a lender by using another token as collateral. Borrowers can then use their new coins in different smart contracts to earn more yield.By doing this, yield farmers are earning interest on their borrowed coins, while still keeping their initial investment, which may increase over time.
How are yield farming returns calculated?
The two most common methods of calculating yield farming returns are annual percentage rate (APR) and annual percentage yield (APY).
Both of these methods are only estimations, and are subject to change depending on a wide variety of factors. Even short-term yield is difficult to determine in advance as yield farming is highly competitive. Things change fast in DeFi – including incentives.
As soon as yield farmers catch a whiff of a new strategy, more funds are invested and the yield farming returns taper off.
Can you use yield farming on Bitcoin?
Yes and no.
DeFi platforms are built on smart contract protocols like Ethereum, Solana, and Elastos. Bitcoin hasn’t yet been able to produce DeFi on its own network.
That, however, doesn’t mean that you can’t use your yield farming strategies on Bitcoin. You just need to wrap it first.
What is wrapped Bitcoin?
When you wrap a cryptocurrency, you lock your coins away and receive a 1:1 replacement on a different blockchain. WBTC is the wrapped version of Bitcoin on Ethereum. This means that you can still use your Bitcoin for DeFi, it just takes an extra step.
More often than not, the people borrowing your wrapped Bitcoin will be trying to short it by selling it immediately and buying it back at a lower price, keeping the difference for themselves.
While you could attempt that yourself, it takes an experienced and emotionless trader to know how to read the market. It’s not recommended unless you know what you’re doing. However, lending your WBTC and earning interest in the form of passive income sounds much more appealing.
Popular Yield Farming Protocols
There are several well-known yield farming protocols that you can dabble with if you want to try your hand at maximizing your yield. While no investment is risk-free, there are some DeFi yield farming platforms that are well-established and have billions of dollars locked in their audited smart contracts. Let’s take a look at some of them.
- Compound
Compound was arguably the first DeFi platform to introduce the concept of liquidity mining and crypto yield farming to the masses. It was with Compound that the DeFi boom of 2020 started.
Users can borrow and lend digital assets and earn rewards compounded in the form of a governance token, COMP. The protocol is audited frequently to prevent potential security breaches, and they also offer a $150,000 reward as a bug bounty.
Back in 2021, Compound was also known as the first DeFi platform to have more than $10b total value locked. - Aave
Widely considered the best yield farming crypto, Aave is a blockchain-based decentralized finance protocol that currently sits at the top in regards to total value locked.
You can typically earn between 4-12% on your investment by lending with Aave. Not to mention, the coin itself saves you fees and gives you voting power. - Uniswap
Quite possibly the most famous on the list, Uniswap is the largest decentralized exchange in the world by volume. It has consistently led the pack and was the first decentralized exchange to introduce a liquidity pool style AMM that has now become a staple in crypto yield farming. You can trade any two ERC-20 tokens.
The DEX offers great liquidity incentives for being a liquidity provider in the more voluminous trading pairs. - PancakeSwap
A clone of Uniswap for the Binance Smart Chain, yield farming works here in much the same way. It’s a decentralized exchange that has tons of trading pairs to make yield farming profitable. You can trade any two BSC tokens. - Curve Finance
Another high-volume DEX, Curve Finance is a great place to farm stable coins. Its unique market model allows for super low fees and low slippage.
Download the Elastos Essentials Super Wallet today to access all five of these DeFi protocols directly from your wallet, as well as those in the Elastos ecosystem. The mobile wallet has tons of features and is compatible with more than a dozen different blockchains, including native Bitcoin. Oh, and there is also Ledger Nano X support for both IOS and Android.
Other yield farming platforms
On the Elastos Smart Chain, crypto investors can stake and farm their crypto assets on the native DEX, Glide Finance. If you want a lending and borrowing protocol, FilDA is your choice. There is also CreDA, a loaning platform with a decentralized credit score. You can move assets between the three to optimize your gains.
DeFi on Elastos offers minimal transaction fees (a few cents at most) and rewards you with your chosen platform’s own native token: Glide or FilDA. The APR rates for farming on Glide currently vary from 5% to 78%, depending on the trading pair. There are auto farming crypto options, in which the compounding effect is taken care of automatically. There are some staking options on Glide too, in which you can earn rewards in ELA or other coins.
Don’t forget your Phantz NFT (non-fungible token) to boost your APR. You can activate three at any given time. One Phantz gives you a 7% boost, two Phantz gives you a 14% boost, while three Phantz boosts your APR by a whopping 28.22%!
Using NFTs to enhance DeFi is just the start. Read here to check out all the other ways NFTs can be used to shape web3.
Is Yield Farming Safe?
There are plenty of things to watch out for when entering the crypto markets as a yield farmer. If you’re new to yield farming, it’s better to stick with well-established and trusted protocols.
There are several reasons why yield farming is risky. To protect your digital assets, make sure you understand the following:
Rug pulls
Rug pulls are when the team quits and drains the funds from the smart contract on the way out. These can usually be avoided by researching the protocol thoroughly; read the whitepaper, research the team, check out the community, and read the code if it’s available (if you have the skills to do so).
New projects with shady followings pop up all the time. Try not to get sucked into hype and do due diligence before parting with your hard-earned money. If something sounds too good to be true, it usually is.
If in doubt, it’s better to sit out.
Hacks and exploits
Exploits are when an error is found in the code and taken advantage of by an actor who wishes to steal other people’s crypto investments from the smart contract. It’s extremely common.
Despite going through regular audits, it’s still possible for flaws to be found in the code, especially if the code is being regularly updated. Some DeFi protocols offer a bounty for anybody who can find an exploit. While this can calm fears somewhat, it still might not be enough to prevent a malicious actor.
There is an increased risk of exploits when the protocol first launches. This is when APR is at its highest and the platform is yet to be stress tested. To avoid hacks and exploits, never share your private keys, protect your passwords and avoid clicking on spammy links, especially from random people on Telegram. Also, ensure the DeFi platform has been audited at least once and, if you’re still uncertain, stick with established protocols.
Regulations
The Security and Exchange Commission (SEC) has declared that certain digital assets are securities, meaning they can enforce regulations upon them. In New York, state regulators have already issued cease and desist orders against crypto lending apps like Celsius.
If the SEC decides that decentralized finance services are securities then it could spell bad news for token holders who are active on the platform. This is all speculation, of course, but the future is uncertain regarding regulations. It may be wise to err on the side of caution if you are apprehensive.
Having said that, the entire point of decentralized finance is that it does not answer to any centralized body. This is the beauty of decentralization, and one of the reasons why a global peer-to-peer network is unstoppable.
Volatility
Crypto is a volatile investment at the best of times, but when you lock your investment in a smart contract, it can be difficult to move as quickly as you might like. Sometimes, there are lock-up periods. Checking out early could be impossible or come with a “fine”.
Impermanent loss
Impermanent loss is something you need to be aware of when beginning your crypto yield farming strategy. When you add two digital assets to a liquidity pool, you provide 50% of one and 50% of the other in FIAT value. However, if by the time you want to remove your liquidity token A has risen while token B has fallen, then the ratio of tokens in the liquidity pool will have changed to stabilize its total value.
You will still withdraw 50% of both tokens, but their values will have changed so you will not receive the same amounts of each coin back. This can work out to less profit than if you’d have just held onto the assets. The reason it’s called impermanent loss is because the loss is only realized once you withdraw from the liquidity pool.
For detailed examples of impermanent loss, check out ChainBulletin’s overview.
Ready to be a Yield Farmer?
If after reading this guide, crypto yield farming sounds like something you’d be interested in, then go forth and prosper. Download the Elastos Essentials Super Wallet and you can access hundreds of DeFi platforms from multiple blockchains without ever leaving your wallet – it’s one of the best ways to store your coins!
It’s the perfect place to store your cryptocurrency investments, and an ideal gateway into the wonderful world of DeFi.
A final note: always do your own research before investing, yield farming or not.
