What is yield farming?

Holders of cryptocurrency have a choice between leaving their funds idle in a wallet or locking the funds in a smart contract in order to contribute to liquidity. The liquidity thus provided may be used to fuel token swaps on decentralised exchanges like Uniswap and Balancer, or to facilitate borrowing and lending activity in platforms like Compound or Aave.

Yield farming is essentially the practice of token holders finding ways of using their assets to earn returns. Depending on how the assets are utilized, the returns may take different forms. For example, by serving as liquidity providers in Uniswap, a ‘farmer’ can earn returns in the form of a share of the trading fees every time some agent swaps tokens. Alternatively, depositing the tokens in Compound earns interest, as these tokens are lent out to a borrower who pays interest.

Further potential

But the potential for earning rewards does not end there. Some platforms also provide additional tokens to incentivise desirable activities. These additional tokens are mined by the platform to reward users; consequently, this practice is referred to as liquidity mining. So, for example, Compound may reward users who lend or borrow certain assets on their platform with COMP tokens, which are the Compound governance tokens. A lender, then, not only earns interest but also, in addition, may earn COMP tokens. Similarly, a borrower’s interest payments may be offset by COMP receipts from liquidity mining. Sometimes, such as when the value of COMP tokens is rapidly rising, the returns from liquidity mining can more than compensate for the borrowing interest rate that has to be paid.

For those who are willing to take additional risk, there exists another feature that allows even more earning potential: leverage. Leverage occurs, essentially, when you borrow to invest; for instance, you borrow funds from a bank to invest in stocks. In the context of yield farming, an example of how leverage is created is that you borrow, say, DAI in a platform such as Maker or Compound, then use the borrowed funds as collateral for further borrowings, and repeat the process. Liquidity mining can make this a lucrative strategy when the tokens being distributed are rapidly rising in value. There is, of course, the risk that this does not happen or that volatility causes adverse price movements, which would result in leverage amplifying losses.

What is APY?

The returns to yield farming are usually described as an annualised percentage yield (APY). The APY describes the rate of return (normalized to be an annual figure) on an investment after including the effects of compounding returns.

With yield farming, an APY to the magnitude of 100% is not unheard of. However, achieving this kind of return usually involves regularly changing strategies to maximise the results. For example, a yield farmer may switch between assets on a platform, or switch platforms, or switch strategies from lending to liquidity provision on a decentralized exchange, and so on. Indeed, most sources of very high returns generally evaporate over time as more and more yield farmers exploit these opportunities. So, to maximise returns, a dynamic approach is required that involves monitoring and adjusting strategies on a regular basis.

It is also worth reiterating that there can be many risks involved. For instance, putting funds in a liquidity pool in a decentralised exchange can result in impermanent loss, an issue that we will return to in greater depth in a subsequent step. Moreover, as we have already seen, loans in the DeFi ecosystem are typically overcollateralized, so there is the risk of liquidation if the value of the collateral assets starts to fall. The risks associated with this are magnified when leverage is involved. There are also the usual risks associated with DeFi space, such as vulnerabilities or bugs with smart contracts that can result in a loss of funds.

As such, yield farming is an advanced investment strategy that requires a deep understanding of how DeFi operates, the opportunities it creates, and the potential for losses that are present.