This article explores yield farming in decentralized finance (DeFi). It references staking, lending, and liquidity mining. If you are unfamiliar with the concept of DeFi, do read our introductory article to DeFi before reading this article.
What Is Yield Farming?
Yield farming is the process of earning interest on cryptocurrency assets in DeFi. It is a new form of passive income that has been innovated through the advent of blockchain technology. The most popular yield farming strategies include staking, lending, and liquidity mining.
Types of Yield Farming
Staking refers to the action of locking up crypto assets into smart contracts in exchange for rewards. You can either do so by running a validator node on a network or joining a staking pool. Most users stake their crypto by joining a staking pool as running a validator node has a high barrier to entry, which is the requirement to stake a substantial amount of crypto. In staking pools, users merge their resources to share the costs of running a node.
2. Liquidity Mining
Liquidity mining is a process where users provide their crypto assets to a liquidity pool and earn rewards in the protocol’s native token, also known as Liquidity Provider (LP) tokens. A liquidity pool is a group (or usually pair) of crypto assets bound to a smart contract, allowing users to swap one token for another. Instead of using the traditional order-book model where a buyer is matched to a seller, liquidity pools use Automated Market Makers (AMM) which are algorithms that allow users to buy or sell tokens from a pool at any given time. Liquidity providers deposit their assets into pools and earn rewards from transaction fees based on the percentage of the pool they own. For example, if you deposit $5 USD worth of tokens into a pool worth $100 USD, you will receive 5% of the total rewards in LP tokens.
Lending protocols function like banks. The mechanism is simple – users lend their crypto assets by depositing them into the protocol and receive an annual yield in return. This yield comes from the interest charged on users who borrow the assets. Interest rates on such lending protocols are so high because DeFi protocols do not require an intermediary to facilitate the entire process. On the other hand, traditional banks act as a central authority managing the lending and borrowing processes, taking a huge cut of the interest earned.
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What Is APR vs. APY?
If you have been looking at DeFi protocols, you may have noticed that yield farming rewards are usually listed in “APR” or “APY”.
APR stands for Annual Percentage Rate, which refers to the annual interest rate on assets paid to lenders and charged to borrowers.
APY stands for Annual Percentage Yield, which refers to the annual interest rate on assets paid to lenders and charged to borrowers, accounting for the effect of compounding.
Why Are Interest Rates So High?
In the world of DeFi, there are many yield farming protocols offering extraordinary interest rates. How are these projects able to give out rewards so generously?
The answer lies in the strategy and tokenomics of each project. In most cases, new DeFi protocols offer highly attractive interest rates to onboard new users, before lowering them over time. It is usually unsustainable to distribute rewards at such high interest rates, unless the protocol’s tokenomics and mechanism are exceptionally well thought out. On the other hand, fraudulent projects lure users to deposit large amounts of money into their protocol which trickle down into their own pockets.
Before depositing money into a certain protocol, it is essential to do your own research and analyze the project’s tokenomics and framework. A great tip for deciding whether a project is good or bad is to find out where the yield is coming from. Always look out for ponzi-like tokenomics and unsustainable farming models to avoid investing in a bad project or getting scammed.
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Risks of DeFi Farming
1. Impermanent Loss
Impermanent Loss is the unrealized loss sustained when the price of your assets in a liquidity pool changes from that of the original deposit. It is the difference between liquidity mining and simply holding your crypto in a wallet. When the price of either asset in the pool changes, arbitrageurs come to buy or sell, causing the ratio of assets to change. This can lead to your position being worth less than if you had just held it in your wallet.
2. Smart Contract Risk
DeFi protocols are developed using smart contracts, which are self-executing lines of code that run when certain predetermined conditions are met. Smart contract risk refers to the risk of networks or protocols being hacked via exploits of their underlying smart contracts. In March 2022, the Ronin Network was hacked for over 173,600 ETH and 25.5 million USDC in one of the largest crypto heists in history. The Ethereum Sidechain which was developed for the popular play-to-earn (P2E) game, Axie Infinity, had its funds drained by hackers who forged withdrawals using hacked private keys. To prevent exploits like this, networks and protocols usually run security audits on their code and host bug bounty programs rewarding hunters for discovering loopholes in them.
3. Rug Pulls
A rug pull is a type of scam where the creator of a project abandons it and escapes with all the deposited funds. This usually happens in the case where creators lure users with highly attractive returns, causing many of them to deposit huge amounts of assets in hopes of extraordinary gains. In November 2021, the creators of the SQUID token made away with over $3.3 million USD after abandoning the supposed play-to-earn game project and selling all their tokens. SQUID was up over 23,000,000% as its price rose from a mere cent to over $2,860 USD before its creators decided to vanish with everything. To avoid experiencing a rug pull, you should always do your own thorough research on the project and its team before depositing any funds.
Yield farming in DeFi is a new form of passive income which is accessible to any crypto holder. If you are looking for ways to earn stable returns on your assets instead of letting them idle in a wallet, you can consider staking or lending them out. Liquidity mining is also a great way of generating yield, but it has a higher risk considering factors such as volatile token prices and impermanent loss. No matter what kind of protocol you choose to deposit your crypto into, always remember to do your own research on the project’s background. It is not worth it to chase extraordinary gains just to lose all of your assets the next day.
New to DeFi? If you found this useful, check out our other Learn DeFi articles to dive deeper into the wonderful world of DeFi! Alternatively, browse our Insights section to read more in-depth analyses on the DeFi space. You can also try out our flagship product, Harvest, to get a comprehensive analysis of your DeFi assets. Lastly, subscribe to newsletter updates in the box below!