What is yield farming? Can you really earn 30–60% APY from it?

Let’s say you bought some Ethereum and now it’s sitting ideal in your wallet or crypto account. But what if you can reinvest the Ethereum you own without selling it and in return, earning more cryptocurrency.

One of the ways you can earn more cryptocurrency from your existing cryptocurrency is through yield farming.

Yield farming is lending or staking funds using smart contracts and generate rewards in the form of additional cryptocurrency.

Yield farming is the biggest growth driver for defi sector, growing its market cap from $500 million to a whopping $10 billion in 2020.

What is yield farming?

At its core level, yield farming is a way that allows you to lock your crypto into liquidity pools and in return, you’ll earn profit which is also known as yield.

Simply put, it’s like when you take a loan from the bank, you have to return it with some interest.

In this case, the cryptocurrency that otherwise would be sitting idle in your wallet or exchange is locked into liquidity pools via yield farming protocols which are a kind of smart contract.

Yield farming is typically done using ERC-20 tokens on Ethereum’s platform. Although, this might change in future. All returns are also in the form of ERC-20 tokens.

Yield farmers use complicated strategies and move their funds around quite frequently in search of high yield.

How does yield farming work?

Yield farming works on automated market maker(AMM) model which involves liquidity providers and liquidity pools.

Liquidity providers deposits funds in liquidity pools which runs a marketplace where users can lend borrow or exchange tokens.

These platforms charge fees which are then paid to liquidity providers according to their share in the liquidity pools.

AMM creates liquidity pools using smart contracts. These pools execute trades based on predefined algorithms.

The AMM model relies heavily on liquidity providers who deposit funds in liquidity pools. These pools are the backbone for many defi protocols.

How yield farming returns are calculated and how much can you earn from yield farming?

In yield farming returns are usually calculated for a year. Most common metrics are annual percentage rate(APR) & annual percentage yield(APY).

The primary difference between them is APR doesn’t take into account the effect of compounding while APY does. Here compounding means the reinvestment of the returns you are earning from yield farming.

These calculations are just projections. Yield farming is a highly competitive and fast-paced market where rewards can fluctuate rapidly. If a strategy works for a while then others will start using it which will result in comparatively lower returns.

While there’s a huge potential risk for newcomers. A seasoned crypto holder can earn up to 30–60% APY through yield farming which if compared to traditional savings banks interest of close to 5% APY is a lot more profitable way of letting your dollars make more money for you.

As a bonus, check out this tweet thread from Tony Sheng explaining how you can earn 100% APY from yield farming.

What are the risks involved in yield farming?

Despite its huge earning potential. Let’s have a look at what are the risks of yield farming:

  • Profitable strategies are highly complex and are recommended for advanced users.
  • It is highly suitable for those who have a lot of capital to deploy and can risk losing.
  • Due to the immutable nature of blockchain, vulnerabilities and bugs can lead to the loss of user funds.
  • Liquidity pools are created using smart contracts which are computer codes, so they are susceptible to vulnerabilities, bugs and hacks.

Yield Farming Protocols

There isn’t any set way to do yield farming and strategies can change by the hour. On top of that, each platform has its own set of rules and risks.

If you want to start yield farming, you must get familiar with how decentralized liquidity protocol works.

Let’s look at some of the most popular protocols for yield farming.

1. Compound Finance:

It is an algorithmic money market protocol that allows lending and borrowing of assets. Compound finance is one of the core protocols in the yield farming ecosystem.

Anyone with an Ethereum wallet can supply assets to compound finance’s liquidity pool. The rates are adjusted algorithmically based on supply and demand.

2. MakerDAO

Considered to be one of the first projects in defi, it is a decentralized credits platform that supports the creation of DAI.

DAI is a stable coin that is algorithmically pegged to the value of USD

You can lock your collateral assets like ETH, BAT, USDC and generate DAI as a debt. Yield farmers use maker to mint DAI to use in yield farming strategies

3. Aave

Aave is another open-source, decentralized protocol that allows lending and borrowing.

The interest rates are adjusted algorithmically based on the current market conditions.

Lenders get ‘aTokens’ in return for their funds. These tokens immediately start earning and compounding interest.

Aave also allows flash loans and is heavily used by yield farmers.

4. Uniswap

It is a decentralized exchange(DEX) protocol that handles trustless token swaps using smart contracts.

This protocol allows conducting automated transactions with cryptocurrency tokens on the Ethereum blockchain.

5. Curve Finance

This is an Ethereum based DEX protocol that enables efficient swap of stablecoins. Curve allows high-value stablecoin swaps with relatively low slippage.

Due to the abundance of stablecoins in yield farming, curve pools are a key part of the infrastructure

Closing thoughts and future of yield farming

No doubt that yield farming is a current rockstar in the defi space, it is incentivizing liquidity while enabling fair distribution of tokens. It is obvious that yield farming will continue to evolve and yield farming is going to stay with us.

That being said, we are yet to carry out a risk assessment and provide regulation in the yield finance sector.

Here’s a really nice video on yield farming I found on youtube by finematics: