What Is Yield Farming?
What is Yield Farming in Crypto
What is yield farming? Yield farming can be explained as a method of generating income in the decentralized finance sector through investment strategy and reinvestment strategies.
Cryptocurrency yield farming is a scheme in which a user provides funds to a DeFi project and thus ensures its liquidity. In exchange for this, the user gets fee deductions and receives project tokens, the price of which may grow over time, increasing the profitability of investments. Users earn and the project raises funds for its work and motivates clients to invest in liquidity pools.
What Are Liquidity Pools
The liquidity pool is the mechanism by which decentralized exchanges obtain liquidity. Investors provide their funds through liquidity pools.
There are two types of pools:
The first type of pool differs from the standard liquidity pool on a decentralized exchange in that it has only one asset. This is not a trading pair. The user deposits only one token and receives a reward in one token. Such pools are free from the so-called impermanent loss risk (see below), but their profitability is less than in pools with two assets.
Pools of the second type consist of a native project token (governance token) and a second underlying asset. Such pools directly create and maintain project liquidity. TVL (Total Value Locked) is the main indicator of the success of a yield farming crypto DeFi project. Each project seeks to attract as many liquidity providers as possible, including through yield farming.
What Are Native Tokens
A governance token or a native token is the main type of tokens that are earned in the yield farming crypto process. Their price directly depends on the success of the project. Such tokens are characterized by high price volatility. This characteristic is important to consider when engaging in yield farming.
In the early days of yield farming, many pioneer project tokens had a low value and were distributed among users. Those who did not immediately sell them, but kept these tokens, later could earn much more than expected from token growth.
In yield farming, it is important not only to farm tokens, but also to sell them on time, fixing the profits in more stable currencies or saving for the future, based on growth.
On What Blockchains Do Yield Farming Crypto Projects Operate?
What is crypto yield farming technological model? Yield farming crypto projects, like decentralized finance in general, operate on different blockchains. Ethereum yield farming is so popular, because most DeFi projects run on the Ethereum blockchain.
Bitcoin does not have a developed DeFi infrastructure, so yield farming based on the Bitcoin blockchain is impossible. The absence of BTC in the yield farming crypto segment of the cryptocurrency market is due to the architecture of Bitcoin: it does not provide for smart contracts necessary for the functioning of decentralized finance projects.
The solution to the problem of integrating Bitcoin into DeFi is the so-called wrapped tokens. Such a token is created in the blockchain of a particular cryptocurrency, backed by a cryptocurrency from another blockchain. The wrapped BTC is not the original one, but its price is pegged to the price of the "real" Bitcoin.
Due to the fact that many yield farming crypto projects integrate other blockchains into their ecosystems and enter into partnerships with other projects, one yield farming crypto project can have several smart contracts for its platform on several different blockchains.
What is Crypto Yield Farming Earning Model
There are dozens of large projects and hundreds of smaller (less reliable) ones that offer income yield farming crypto processes. The most popular options include:
Liquidity supply in a Currency Pair
In addition to earning on fees in the liquidity pool from each completed transaction in proportion to the user's share in the pool, he also receives additional income in the form of native tokens (LP tokens).
LP tokens go to the user's wallet immediately after he has invested in the pool. They give you the right to own funds in this pool and with their help you can withdraw funds. But you can also freely dispose of LP tokens at your own discretion – for example, invest them in another pool.
Also, liquidity pools in yield farming may not be 50/50 of two assets, as is usual for conventional decentralized exchanges, but, for example, 98/2.
In fact, any ratio of assets is possible, as well as the number of assets in one pool is not limited. Such pools can consist of different ratios of several assets at once.
In fact, this is the same liquidity pool, the only difference is that liquidity is provided for issuing loans, and not for providing liquidity in the trading pair. As a rule, profitability in such projects is lower than in trading pools.
Yield Farming Crypto vs Staking
There are complex combined cryptocurrency yield farming strategies, when more than one project is involved in the process, but several. Such strategies are sometimes called "loops" and are used to maximize profits from yield farming.
As it was said, when providing funds to the pool, the user receives LP tokens, which he can place in another project, and additionally receive LP tokens of this project. This strategy is also called LP tokens staking.
For each trading pool and project, there are many similar yield farming crypto strategies with different profitability.
The Main Risks of Yield Farming Explained
What is yield farming's main risk? Yield farming comes with a number of risks that need to be considered.
Impermanent loss occurs when, due to a change in the price of the deposited funds in the pool, when withdrawing them from the pool in dollar terms, the user receives less than he invests.
It often happens that the usual holding of one cryptocurrency from a pair would be more profitable than investing in yield farming and a liquidity pool.This risk is one of the most important in yield farming, so some sites even post, besides a DeFi yield farming calculator,
an impermanent loss calculator to assess the degree of riskiness of the project.
The lower the price volatility in a pair, the lower the risk of an intermittent loss for the liquidity provider. For pools of the first type, where the pool consists of only one asset, there is no such risk at all. Therefore, beginners should start yield farming with pairs of stablecoins and pools of the first type, although the yield in such pools is much lower.
Smart contract hack. Most DeFi protocols have complex algorithms, but professional hackers can find loopholes in these systems. A major hack, especially if the project is small, most often ends with the cessation of work and the complete depreciation of tokens.
Since the work on the architecture of smart contracts requires expensive specialists, new and cheap projects often simply copy other people's smart contracts, adding minimal changes. They turn out to be easy prey for hackers. Hacks are a ubiquitous phenomenon in the DeFi sector. Even the largest projects can potentially become targets of attacks.
Emptying the pool. When all or part of the blocked funds are withdrawn from the liquidity pool through complex manipulations, liquidity providers lose their investments.
There are also cases of fraud, when developers deliberately leave a loophole in the protocol and then, when the project raises enough funds, they use it to steal money. This phenomenon is often found in small DeFi projects and is called “rug-pulling”.
Transaction fees are a risk factor that also needs to be considered in yield farming.
It is necessary to make transactions to exchange on decentralized exchanges or when investing and withdrawing funds from the liquidity pool. When making transactions in the blockchain, a commission is charged, the amount of which depends on the load on the blockchain network at the time of the transaction itself.
The problem with commissions arises more with small investments. The larger the amount invested, the lower the risk associated with transaction fees. Investing $1000 in yield farming with an expectation of 20% annual income is not very profitable if you have to spend $100-200 on network commissions.
The most negligible risk, but still existing is slippage. This phenomenon is similar to the usual slippage on exchanges, which also depends on the fullness of the pool (in traditional exchanges – market depth) and the size of the transaction.
How Much Can You Earn on Yield Farming?
You can earn quite a lot, especially when compared with bank deposits of 2-5%, but in projects with large capitalization and TVL, high incomes are impossible. The return is comparable to the return in the traditional financial system.
To earn a lot on yield farming, you need to take risks, constantly monitor the market and study all available offers. Risky projects can yield returns of 20-30% and even 50%.
Projects with acceptable risks give a yield no higher than 10-15% per annum maximum.
Even an investor in a relatively safe and large liquidity pool with a low APY is at risk.
Some DeFi products have been compared to traditional savings accounts, but they are not. When investing even in the top ten projects, you should be mentally prepared to lose all your investments.
How to Choose a Project for Сryptocurrency Yield Farming?
What is crypto yield farming best project? You need to choose the best crypto for yield farming after a thorough analysis and study of all available information.
The yield in farming directly depends on the price of the token, so it is necessary to pay special attention to the distribution of tokens. Most often, distribution of tokens in yield farming is explained in the technical documentation of the project. The longer the main issue of tokens takes, the more favorable it is for its price.
It should also be taken into account that profitability can change daily and even within a few hours, so earnings depend on such factors as:
proper allocation of funds in projects;
risk assessment and timely monitoring of changes;
new offerings on the market.
There are tracker sites that collect up-to-date data about yield farming opportunities. They can make it a lot easier to find a good project or pool, and they often inform users what their APR and APY are.