DeFi 101: What is Yield Farming?
The Decentralised Finance (DeFi) landscape has grown exponentially over the last 12 months. As with seemingly every new trend in the blockchain space, DeFi has presented many early adopters with the opportunity to gain vast riches, and some others with hard lessons and empty wallets.
In DeFi though, blockchain and, in particular smart contracts, have indeed found a use-case that even in its nascent form shows the potential to turn the financial landscape on its head. At the time of writing, some $26 billion worth of cryptocurrency is locked up in DeFi smart contracts. The figure is showing no signs of slowing down.
In this OXBC series of blogs entitled; “DeFi 101”, we will provide an introduction to the various facets of DeFi, and the applications and protocols that underpin blockchain’s fastest-growing niche.
We’ll start with the area that has become ubiquitous with the concept of DeFi, yield farming.
Part 1: What is Yield Farming?
Yield farming is the practice of locking up or staking cryptocurrencies, primarily in smart contracts on the Ethereum network, in return for tokenised rewards.
Typical yield farming protocols use the locked tokens to maintain liquidity pools that underpin the DeFi services they offer, including lending, borrowing, and of course, trading.
Rewards users receive can come in the form of a share of the protocol’s transaction fees, interest, or newly minted governance tokens, usually quantified by annual percentage yield (APY). $COMP is a high-profile example of the latter — a governance token issued to users of the lending-platform Compound Finance, now worth around $350 per token (at the time of writing).
Yearn Finance’s founder Andre Cronje famously described his project’s $YFI governance token on its launch back in January 2020 as “a completely valueless 0 supply token. We re-iterate (sic), it has 0 financial value”.
Buying one of the available 30,000 $YFI on the open market today would set you back $30,500. Not bad for a ‘completely valueless’ token.
Where can I farm my tokens?
Sushi, Pancake, Pie, Waffle, Doughnut, and Croissant may sound like a fantastic Deliveroo order, but they’re also names you’ll probably have come across if you’ve attempted to farm any of your tokens.
The number of protocols offering yield farming increases by the day, but Coinmarketcap provides a list of some of the more prominent entities, combined with a handy yield comparison tool.
With all true DeFi products, your tokens are farmed directly from your wallet. Products like Metamask and Wallet Connect make it incredibly easy to farm your tokens from your smartphone.
How do I Yield Farm
The answer to this question varies from protocol to protocol. One of the most user-friendly DeFi protocols around is Uniswap. Here’s an excellent tutorial from DeFiPrime on how to yield farm using Uniswap.
One reason some have found yield farming to be so lucrative is that it’s definitely not for everybody. In a lot of cases, profitable yield farming requires these in abundance:
● Significant funds
● High technical proficiency
● Taking on substantial risk
For example, even with the simplest type of farming operations — i.e., Staking one token type in return for rewards, the high cost of $ETH gas fees could be prohibitive — particularly in pools with low APY.
And that’s before we get into the thorny issue of impermanent loss…
What are the risks?
As with most new financial processes, there is plenty of risk involved in yield farming. Firstly, as this article by Crypto Briefing explains, “oftentimes, Investors can earn a better return by HODLing instead of farming for yields.”
Some of the more significant risks are:
● Impermanent Loss: This occurs when you deposit your assets into both sides of a liquidity pool, and the value of one asset changes substantially compared to the other. Because your share of the liquidity pool remains the same until it is withdrawn, you can end up being left with substantially less of an asset than you deposited. Binance Academy has developed a comprehensive explanation of impermanent loss here.
● Opportunity cost: Some protocols require assets to be locked-up for extended periods or charge substantial fees to remove liquidity. You could, therefore, miss out on the ability to sell should the value of your asset begin to depreciate.
● Smart Contract Risk: Should a smart contract that underpins a DeFi liquidity pool contain bugs in its code, chances are a hacker will find and exploit them. Such a catastrophic event happened to Yam in the summer of 2020 when an exploit caused the token value to drop to under $1 from a previous high of $167. Other users have fallen victim to “rug pulls,” whereby malicious actors drained their liquidity pools after users traded their $ETH for what they thought would be the next big mover on the Uniswap token list.
● User Error: While some DeFi protocols like Uniswap are relatively easy to use, many protocols are still developing their UI, and some processes can still be extremely complex — especially when users’ own security vulnerabilities are added to the equation. Be careful out there.
In conclusion, there’s no doubt that yield farming can be highly profitable if all of the right conditions are in place for a particular user. However, there are numerous, potentially catastrophic pitfalls too. There’s also no guarantee that any user would be better off using their tokens to yield farm rather than simply holding them and selling them for a profit. As always, doing your own research is paramount before jumping into this exciting facet of the new DeFi landscape.
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