What is Yield Farming? - Learn with FTX


Yield Farming

Cryptocurrency yield farming (also known as liquidity farming or liquidity mining) enables yield farmers (liquidity providers) to lend out their crypto coins to borrowers in exchange for interest or fees—or better yet, more crypto coins. But much like traditional bank lending, there can be risks involved for both the investor and the borrower.

Because yield farming crypto is a relatively new concept in the Decentralized Finance (DeFi) space, it’s important to understand what the process entails—and whether becoming a crypto yield farmer or borrowing from a yield farming liquidity pool is a worthwhile investment for you. 

Just like a commercial farmer plants corn seeds to grow corn crops, cryptocurrency-yield farmers plant crypto coins to grow, well, more crypto coins—that is, if the environment is just right.

In this guide, we’ll dig into all things yield farming—including helping you understand how it works, how returns are calculated, what coins are involved, and the risks. We’ll also mention a few yield farming platforms you can get started on. 

How Does Yield Farming Crypto Work?

To understand the most basic approach to crypto yield farming, we must start with decentralized apps (dApps). Investors stake their coins by locking them into liquidity pools (smart contracts that hold the funds) that live within a dApp. In turn, the dApp platform then lends out those coins to borrowers, most of which are interested in speculation.

In exchange for providing liquidity to the pool, investors earn rewards. The use of dApp platforms typically incurs fees, which can be paid out to investors based on the amount they deposited into the liquidity pool. Other rewards could include interest on borrowed coins, or actual coins themselves. Receiving coins as payments for yield farming can be highly lucrative for investors, especially if they’re unable to purchase a new coin on the open market or if their rewarded coins happen to appreciate rapidly. 

Note: It’s important to remember that each dApp platform hosting a liquidity pool will have its own rules on the implementation and distribution of rewards. And because this concept is so new, there will likely be new approaches to crypto yield farming in the future. 

How Are Returns Calculated?
Yield farming crypto returns are typically estimated by calculating the annualized rate of return. This figure shows the average of what an investor could earn over the course of a year—all while accounting for the effects of compounding. Much like traditional financial markets, the Annual Percentage Yield (APY) metric is commonly used to calculate the annualized rate of return on a yield farming investment.

Measuring Liquidity Pool Health
Before liquidity providers invest in a yield farming crypto strategy, they typically must first analyze the health of a liquidity pool. This is done by measuring the Total Value Locked (TVL), which represents the total amount of crypto that’s locked in any given liquidity pool. When a liquidity pool has more crypto locked in it, there’s a higher chance that more yield farming is taking place. Simply put, the higher the TVL in a liquidity pool, the higher the market validation and investment security for LPs.

What Coins Are Involved?
Several coins used in yield farming exist within the Ethereum ecosystem as Ethereum Request for Comments (ERC) 20 tokens. ERC-20 tokens adhere to technical standards set by Vitalik Buterin and Fabian Vogelsteller to ensure they function properly on the Ethereum blockchain. However, the future of decentralized cross-chain exchange could change things, as future dApp platforms could enable yield farming across multiple blockchains that feature smart contract capabilities. 

A few of the most common stablecoins deposited and borrowed from yield farming liquidity pools are:
  • Dai (DAI)
  • USD Tether (USDT)
  • USD Coin (USDC)
  • Binance USD (BUSD)
  • TerraUSD (UST)
  • TrueUSD (TUSD)
Yield Farming Crypto Platforms
There are several platforms that investors use to implement yield farming strategies, including:
  • Compound: An algorithmic DeFi money market (rates are adjusted automatically by an algorithm based on supply on demand) that enables investors with an Ethereum wallet to deposit coins in the Compound liquidity pool and quickly earn rewards. 
  • MakerDAO: A DeFi credit platform that enables investors to lock crypto in a Maker Vault. Using these locked coins as collateral, an investor can create DAI (a stablecoin that mimics the dollar) as a debt, which incurs interest (called a stability fee). 
  • Balancer: A DeFi liquidity protocol that enables investors to create customized token allocations in a liquidity pool. Investors can then earn fees for trades that take place in their pool.
  • Synthetix: A synthetic asset protocol that enables investors to stake Synthetix Network Token (SNX) or Ether (ETH) as collateral. In return, the investor can mint “synthetic” assets (any financial asset with a reliable price, even real-world assets that exist off-chain through blockchain oracles).
  • Aave: Much like Compound, Aave is an algorithmic DeFi protocol that provides investors with “aTokens” in exchange for crypto. These tokens then earn compounding interest. Aave also offers Flash Loans, which enable borrowers to collect tokens without collateral if liquidity is returned to the pool within one transaction block.

Can You Lose Money Yield Farming Crypto?
Nearly all the risks involved with yield farming—both for investors and borrowers—can lead to financial loss. At its core, yield farming can be a complex investment strategy that requires special attention and advanced knowledge of blockchain technology to turn a significant profit. In many cases, the most successful yield farmers already maintain large crypto holdings, which can give them leverage in earning more rewards for investing their own coins. 

What Are the Risks Involved with Yield Farming Crypto?
Due to the decentralized, permissionless nature of the liquidity pools housed in dApp platforms—as well as the inherent security vulnerabilities associated with blockchain technology—there are several risks involved with yield farming crypto, including:
  • Buggy smart contracts/Platform risk: Smart contracts that hold crypto liquidity are especially susceptible to bugs and hacking, regardless of their size or if they’ve undergone professional code audits. This is because smart contract technology is still new and requires highly technical testing. And because blockchain technology is immutable (unable to be changed), locking your coins into a buggy or hacked smart contract could result in substantial losses. 
  • Collateral liquidation: As a coin borrower, dApps will typically require you to put forth collateral for your loan—and oftentimes you’ll have to pay special attention to your collateralization ratio. In some cases, if your collateral loses value and drops below the dApp’s collateralization ratio requirement, it could be liquidated on the open market. Many dApp platforms require you to provide over-collateralization to prevent liquidation, but it’s important to pay close attention to the collateralization ratio to be safe. 
  • Value fluctuation: When it comes to crypto investments, volatility and fluctuation in coin values will always be a risk. If the values of your staked coins crash or surge while they are locked in a liquidity pool, you could lose out on your investments. Coin volatility also applies to borrowers, who could potentially lose even more during value fluctuations due to dApp fees, interest paid, or unlucky speculation. 
  • Market volatility: As a small-scale yield farmer, you could face the risk of market volatility when large market actors (investors who maintain large holdings) get involved with liquidity pools. For example, a large market actor could manipulate coin values by borrowing back crypto they invested into a dApp—which could trigger a false sense of demand and increase coin values. This means that large-scale yield farmers could take much bigger rewards from a liquidity pool than a small-scale yield farmer would.
  • Fraudulent schemes: Cybercriminals can take advantage of yield farmer investments by luring them into fraudulent schemes or projects. For example, “rug pulls” are a common type of exit scam in which a crypto developer collects investor coins to fund a project and then abandons that project—walking away with the farmer’s coins.  

Yield farming can be a great way to earn rewards, interest, or more crypto—but just like real farming, it can take a lot of upfront capital, expert knowledge, and an ideal environment to turn a real profit. 

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