What Is Yield Farming in Decentralized Finance (DeFi)?

Yield farmers will use very complicated strategies. They move their cryptos around all the time between different lending marketplaces to maximize their returns. They’ll also be very secretive about the best yield farming strategies. Why? The more people know about a strategy, the less effective it may become. Yield farming is the wild west of Decentralized Finance (DeFi), where farmers compete to get a chance to farm the best crops.

Interested? Read more below.

Contents

Introduction

So, how does a yield farmer tend to their crops? What kind of yields can they expect? And where should you start if you’re thinking of becoming a yield farmer? We’ll explain them all in this article.

What is yield farming?

What started the yield farming boom?

A common way to kickstart a decentralized blockchain is distributing these governance tokens algorithmically, with liquidity incentives. This attracts liquidity providers to “farm” the new token by providing liquidity to the protocol.

While it didn’t invent yield farming, the COMP launch gave this type of token distribution model a boost in popularity.  Since then, other DeFi projects have come up with innovative schemes to attract liquidity to their ecosystems.

What is Total Value Locked (TVL)?

Naturally, the more value is locked, the more yield farming may be going on. It’s worth noting that you can measure TVL in ETH, USD, or even BTC. Each will give you a different outlook for the state of the DeFi money markets.

How does yield farming work?

Yield farming is closely related to a model called automated market maker (AMM). It typically involves liquidity providers (LPs) and liquidity pools. Let’s see how it works.

However, the implementations can be vastly different – not to mention that this is a new technology. It’s beyond doubt that we’re going to see new approaches that improve upon the current implementations.

On top of fees, another incentive to add funds to a liquidity pool could be the distribution of a new token. For example, there may not be a way to buy a token on the open market, only in small amounts. On the other hand, it may be accumulated by providing liquidity to a specific pool. 

The rules of distribution will all depend on the unique implementation of the protocol. The bottom line is that liquidity providers get a return based on the amount of liquidity they are providing to the pool.

As you can imagine, there can be many layers of complexity to this. You could deposit your cDAI to another protocol that mints a third token to represent your cDAI that represents your DAI. And so on, and so on. These chains can become really complex and hard to follow.

How are yield farming returns calculated?

Typically, the estimated yield farming returns are calculated annualized. This estimates the returns that you could expect over the course of a year.

Some commonly used metrics are Annual Percentage Rate (APR) and Annual Percentage Yield (APY). The difference between them is that APR doesn’t take into account the effect of compounding, while APY does. Compounding, in this case, means directly reinvesting profits to generate more returns. However, be aware that APR and APY may be used interchangeably.

It’s also worth keeping in mind that these are only estimations and projections. Even short-terms rewards are quite difficult to estimate accurately. Why? Yield farming is a highly competitive and fast-paced market, and the rewards can fluctuate rapidly. If a yield farming strategy works for a while, many farmers will jump on the opportunity, and it may stop yielding high returns. 

As APR and APY come from the legacy markets, DeFi may need to find its own metrics for calculating returns. Due to the fast pace of DeFi, weekly or even daily estimated returns may make more sense.

What is collateralization in DeFi?

So, let’s say that the lending protocol you’re using requires a collateralization ratio of 200%. This means that for every 100 USD of value you put in, you can borrow 50 USD. However, it’s usually safer to add more collateral than required to reduce liquidation risk even more. With that said, many systems will use very high collateralization ratios (such as 750%) to keep the entire platform relatively safe from liquidation risk.

The risks of yield farming

Yield farming isn’t as easy as it seems, and if you don’t understand what you’re doing, you’ll likely lose money. We’ve just discussed how your collateral can be liquidated. But what other risks do you need to be aware of?

In addition, one of the biggest advantages of DeFi is also one of its greatest risks. It’s the idea of composability. Let’s see how it impacts yield farming.

As we’ve discussed before, DeFi protocols are permissionless and can seamlessly integrate with each other. This means that the entire DeFi ecosystem is heavily reliant on each of its building blocks. This is what we refer to when we say that these applications are composable – they can easily work together.

Why is this a risk? Well, if just one of the building blocks doesn’t work as intended, the whole ecosystem may suffer. This is what poses one of the greatest risks to yield farmers and liquidity pools. You not only have to trust the protocol you deposit your funds to but all the others it may be reliant upon.

Yield farming platforms and protocols

How can you earn these yield farming rewards? Well, there isn’t a set way to do yield farming. In fact, yield farming strategies may change by the hour. Each platform and strategy will have its own rules and risks. If you want to get started with yield farming, you must get familiar with how decentralized liquidity protocols work.

So, what are the most popular platforms that yield farmers use? This isn’t an extensive list, just a collection of protocols that are core to yield farming strategies.

Compound Finance

Compound is one of the core protocols of the yield farming ecosystem.

MakerDAO

Maker is a decentralized credit platform that supports the creation of DAI, a stablecoin algorithmically pegged to the value of USD. Anyone can open a Maker Vault where they lock collateral assets, such as ETH, BAT, USDC, or WBTC. They can generate DAI as debt against this collateral that they locked. This debt incurs interest over time called the stability fee – the rate of which is set by MKR token holders.

Yield farmers may use Maker to mint DAI to use in yield farming strategies.

Synthetix

As a decentralized lending and borrowing protocol, Aave is heavily used by yield farmers.

Uniswap

Uniswap has been one of the most popular platforms for trustless token swaps due to its frictionless nature. This can come in handy for yield farming strategies.

Curve Finance

As you’d imagine, due to the abundance of stablecoins in the yield farming scene, Curve pools are a key part of the infrastructure.

Balancer

Balancer is a liquidity protocol similar to Uniswap and Curve. However, the key difference is that it allows for custom token allocations in a liquidity pool. This allows liquidity providers to create custom Balancer pools instead of the 50/50 allocation required by Uniswap. Just like with Uniswap, LPs earn fees for the trades that happen in their liquidity pool.

Due to the flexibility it brings to liquidity pool creation, Balancer is an important innovation for yield farming strategies.

Yearn.finance

Yearn.finance is a decentralized ecosystem of aggregators for lending services such as Aave, Compound, and others. It aims to optimize token lending by algorithmically finding the most profitable lending services. Funds are converted to yTokens upon depositing that periodically rebalance to maximize profit.

Yearn.finance is useful for farmers who want a protocol that automatically chooses the best strategies for them.

Closing thoughts