What is Yield Farming? A Beginner's Guide to DeFi Profits

What is yield farming in crypto? In simple terms, crypto yield farming encompasses various tools and strategies that enable profit generation from digital assets through decentralized protocols. Essentially, Decentralized Finance (DeFi) users lend their coins or tokens, receiving rewards as specified by the protocol.

Understanding Yield Farming

Definition and Overview

defi yield farming is a method for earning cryptocurrencies and tokens by contributing assets to liquidity pools or offering flash loans through smart contracts on DeFi platforms. This approach combines crypto lending and liquidity mining, allowing asset holders to generate income rather than leaving their cryptocurrencies idle. In lending, users rent their crypto to others for rewards, while liquidity mining involves providing liquidity to traders.

The Evolution of Yield Farming

The decentralized finance (DeFi) market began with the launch of the Ethereum network in 2015, which introduced smart contracts and enabled the creation of decentralized applications such as decentralized exchanges (DEXs), lending platforms, and automated market makers (AMM) protocols. The term "DeFi" was coined in 2018 by Ethereum co-founder Vitalik Buterin and entrepreneurs from Dharma, likening the process to agriculture where holders "plant seeds" to reap rewards. A pivotal moment in defi yield farming development came in 2020 when the sector's total capitalization exceeded $10 billion for the first time, and by March 2024, the total value locked in DeFi protocols had surged to over $94 billion.

How Does Yield Farming Work?

Liquidity Pools Explained

Lending protocols in the blockchain technology ecosystem facilitate loans secured by cryptocurrency through a process that involves locking coins and tokens in a smart contract to create a liquidity pool for borrowers. Borrowers must provide collateral, which covers the interest owed and is secured within the contract. If a borrower defaults or liquidation occurs — when the collateral's value nears the loan amount — the locked assets are transferred to the lender. Conversely, if the loan is repaid, the collateral is released back to the borrower. Participants in the pool share rewards, with higher total value locked (TVL) leading to greater potential returns, allowing for flexible asset management within the pool.

How Rewards Are Calculated

DeFi protocols commonly use APY (annual percentage yield) and APR (annual percentage rate) to calculate returns. APY reflects the annual return an investor can expect, including the effects of compounding interest from deposits. In contrast, liquidity mining income is typically reported in APR, which does not consider the frequency of interest compounding. To entice investors, many protocols offer their native yield farming tokens, which can boost yields but also increase volatility.

Yield Farming Platforms and Protocols

Top Platforms to Consider

Below are some of the most well-known and widely used DeFi platforms for yield farming.

Lido

Lido is the largest protocol on Ethereum, with a market capitalization recently exceeding $34 billion. In 2021, Lido was not even in the top five, but following Ethereum's transition to Proof of Stake (PoS), it experienced rapid growth, surpassing major platforms like Aave and Uniswap.

EigenLayer

EigenLayer is a DeFi protocol that enables users to leverage their staked ETH on the consensus layer to earn additional profits. This capability has propelled EigenLayer's market capitalization from $2 billion to an impressive $12 billion within just 2024.

Aave

Currently ranking among the top three protocols, Aave has a TVL of nearly $10.3 billion. Users lend their assets to others and, in return, earn AAVE tokens. This platform boasts one of the highest annual yields among lending protocols, reaching up to 15%.

Choosing the Right Platform

There are more than a thousand distinct farming protocols available, with the total value locked (TVL) in each of the seven largest DeFi platforms surpassing $1 billion. Given this vast selection, selecting the right crypto farming platform can be challenging; often, newcomers focus on high interest rates while overlooking the risks associated with newer protocols. Established projects may offer lower returns, but they tend to be more trustworthy, as they undergo regular audits and are vigilant about various vulnerabilities.

Types of Yield Farming Strategies

Simple vs. Complex Strategies

Yield farming in the digital assets field involves various strategies that offer different returns and risks, with higher returns generally accompanied by increased risk.

Common Strategies:

Single Asset Farming: Investors can convert a portion of their cryptocurrency into platform-specific tokens (e.g., sETH on Balancer) and contribute to liquidity pools for extra earnings.

Lending and Farming: Some investors borrow funds to stake while retaining their assets. For example, collateralizing ETH to obtain USDT allows participation in liquidity pools without liquidating ETH, although this carries liquidation risks if ETH's value drops.

yield farming vs staking: Users can stake multiple tokens in single pools to earn rewards. For instance, contributing BNB and USDT to a liquidity pool can yield CAKE tokens, which can then be staked for additional rewards.

Leveraging Lending: This strategy allows users to borrow against their crypto as collateral, creating multiple income streams. For example, using MATIC as collateral to obtain USDC and then lending that USDC.

Liquidity Mining: A popular yield farming strategy where holders add assets to liquidity pools, receiving liquidity tokens (LP) that entitle them to a share of trading fees. Profits come from these fees and any distributed protocol tokens. Returns are influenced by the demand for swaps and the overall supply of liquidity.

Benefits of Yield Farming

Potential High Returns

High Returns: Even with stablecoins, annual yields can reach up to 20% or more.

Passive Income Opportunities

Enhanced Earnings: If you already hold cryptocurrencies, engaging in crypto yield farming can generate additional passive income.

Superior APY

The annual percentage yield (APY) from DeFi tools often surpasses traditional bank interest rates, which typically barely keep pace with inflation.

yield farming risks and Challenges

Impermanent Loss

Liquidity providers on decentralized exchanges (DEX) encounter the risk of impermanent losses. These losses occur during periods of high volatility when the value of one asset in a liquidity pair fluctuates significantly. If liquidity providers withdraw their assets during such volatility, the losses can become permanent.

Other Risks

While yield farming can yield attractive returns, it also carries significant risks that must be carefully evaluated before investing in DeFi tools. General risks affect all earning methods, alongside those specific to certain farming strategies. A major concern is protocol vulnerabilities and asset theft; in 2023, over 600 hacks in the cryptocurrency sector resulted in losses of approximately $2.61 billion, with DeFi protocols being the primary targets. This is primarily due to the sector's popularity, which attracts both genuine investors and malicious actors. Cybercriminals exploit weaknesses in smart contracts, allowing them to withdraw assets directly, and decentralized platforms lack the safeguards available on centralized exchanges to prevent such thefts.

Price volatility is another critical risk, as cryptocurrency values can fluctuate dramatically, sometimes by tens of percent within hours. An investment of $100 might soar to $10,000 or drop to $1 within a year, influenced by factors such as platform development, market trends, competition, and random events. To manage these volatility risks effectively, it's crucial to adopt sound risk management practices, including diversification and regular rebalancing of investment portfolios.

Liquidation risk primarily affects individuals who borrow or lend cryptocurrencies. This risk occurs when the value of collateral falls below a specific threshold, leading to the automatic closure of a loan and the release of the collateral to the lender. The loan-to-value (LTV) ratio determines this threshold; a higher LTV indicates an increased risk of liquidation.

How to Start Yield Farming (Step-by-Step Guide)

Choosing a Platform

The first step in yield farming is choosing a platform, with resources like DeFi Prime, DeFiLlama, and DApp Radar helping you identify suitable options. It's important to determine which network the platform supports — such as Ethereum, Binance Smart Chain (BSC), or Tron — and which crypto assets you'll use. Next, select a wallet; while hardware wallets offer maximum security, mobile wallets and browser extensions are more user-friendly for regular access. If you plan to invest a few hundred dollars, focus on BSC or Tron platforms to avoid high fees. After setting up and funding your wallet, connect it to the platform and allocate your assets for lending or liquidity mining to start earning rewards.

Providing Liquidity

Lending in DeFi involves users providing loans governed by smart contracts. Lenders deposit funds into a platform's smart contract, while borrowers secure loans with cryptocurrency collateral. Lenders earn interest in the form of platform tokens, such as COMP from Compound. If the collateral's value falls to match the loan amount plus interest, it is forfeited to the lender. This method offers advantages like higher returns (3.8% to 8.4% annually) and collateral protection, but it also has downsides, including high minimum investments due to transaction fees and the risk of scams.

Common Mistakes to Avoid in Yield Farming

While yield farming offers attractive returns, it also carries significant risks that potential investors must carefully evaluate. General risks in DeFi investments include protocol hacking and asset theft; in 2023, over 600 major hacks led to losses of around $2.61 billion, with DeFi protocols being the primary targets. This vulnerability arises from the sector's popularity, which attracts projects that may have exploitable weaknesses. Cybercriminals can find backdoors in smart contracts, allowing them to withdraw funds directly, and decentralized platforms lack the safeguards that centralized exchanges have to prevent such thefts.

Another major risk is price volatility, as cryptocurrency values can change dramatically in a short time, leading to significant gains or losses. An investment of $100 might grow to $10,000 or drop to $1 within a year, influenced by various factors such as market trends and unexpected events. Additionally, borrowers face liquidation risks when the value of their collateral falls below a certain threshold, which can lead to automatic loan closures.

Conclusion

Yield farming in DeFi presents numerous benefits for crypto investors, but it also comes with significant risks. The allure of the industry attracts hackers, and various structural issues can complicate the experience. Additionally, while decentralization offers many advantages, it may not always protect investors.

The challenges are further exacerbated by the absence of legal regulations, which often leaves law enforcement unable to assist victims in many situations. However, DeFi also democratizes access to financial products, enabling users to earn higher returns compared to traditional financial avenues.

If you're considering diving into yield farming, it’s crucial to approach it with caution. Educate yourself about the risks and explore trusted yield farming platforms.

To stay informed about DeFi trends and make wise investment choices, consider reading more about the latest developments in the space.