Yield farming refers to different yield-generating strategies an investor can pursue in DeFi.
These strategies are used to give investors methods of earning passive income on their crypto assets.
These strategies take the form of staking, pooling, or lending one’s assets – this is done by locking them in smart contracts in decentralised applications or dApps. In return for locking one’s assets, the “farmer” earns a yield, which is measured in terms of APY – this yield comes in the form of more tokens.
Since the summer of 2020, the amount of yield farming options has increased significantly and some yield farmers utilise multiple protocols to maximise and diversify their gains. Popular yield farming protocols include AAVE, Curve, Uniswap, THORChain and Yearn Finance. It should be noted that each protocol has its own nuances to earning yield. For instance, depending on the contract, the farmer may be able to immediately remove the funds or must keep it locked for a predetermined number of days. Additionally, some projects are more reputable and secure than others, so be sure to research which platform, risk level and yield farming strategy appeals most to you.
Liquidity providing is when an investor enters a smart contract to provide liquidity to a protocol and the protocol uses their crypto for swaps; this helps keep the market liquid. The pooler earns fees from trader transactions.
Lending locks one’s assets in a smart contract that will be used to lend your assets out to other users. In return for making your assets available to lend out to other users, the protocol offers yield incentives.
As mentioned above, some protocols are more secure than others and yield farming does come with inherent risks. Below are some of the most pervasive risks.
Cyber attacks: When staking, pooling, or lending, a yield farmer’s assets are no longer in a user’s wallet but rather in a smart contract or a pool. Sometimes, hackers are able to find some sort of exploit and steal funds from that smart contract. Therefore, one should not yield farm more than they are willing to lose.
Rug pulls: In terms of liquidity pools, a rug pull is a situation where a seemingly too-good-to-be-true new token will offer outrageously high APY. As more yield farmers deposit their funds into the liquidity pool, the rug puller, who has a significant share of the pool value ahead of time, will remove their share of funds and dump the tokens, essentially destroying the market for that token. Make sure you do your research on any protocol before yield farming on their dApp and pay attention to how the liquidity in the pool is started. (How much has been “locked” by the founders?)
Scam tokens: Some tokens/ dApps are actually scams that offer massive APY or promised utility to attract investors, farmers and then proceed to steal the funds. Again, it is necessary to put in the time and effort to fully understand which yield farming opportunities are genuine and which are not.