What is Yield Farming?
Yield farming is a form of Decentralised Finance in which Cryptocurrency can be locked into a liquidity pool in return for financial rewards such as transaction fees or tokens. Similar to the interest paid on a loan within traditional finance, yield farming involves static Cryptocurrency being lent out through DeFi protocols to gain a return (rewards). The larger the proportion of the pool your contribution represents, the greater the profit. Yield farmers may maximise their gain by depositing reward tokens in different liquidity pools, constantly moving funds between various protocols in search of higher yields. The recent growth of the DeFi sector owes much to the process of yield farming, with the Wall Street Journal describing it as ‘one of the hottest trends in Cryptocurrencies’. It is primarily done on the Ethereum blockchain using ERC-20 tokens, yet advances such as cross-chain bridges may expand the number of blockchains that allow DeFi applications.
How Returns Are Calculated: APY
Calculating yield farming return uses APY, Annual Percentage Yield. This figure is a representation of interest on an investment over one year. However, unlike Annual Percentage Rate (APR), it factors in compound interest following reinvestment. Potential returns are much more substantial than the usual 0.01-1.00% interest most traditional banks offer. However, APY varies between each liquidity pool, with an increased number of investors leading to a corresponding decrease in returns. Tracking the highest rates of APY is a means of maximising gains, with canny investors achieving this by moving their funds from pool to pool.
COMP and the Start of Yield Farming
Though it didn’t invent yield farming, the protocol Compound popularised the distribution of tokens to kickstart investment in a decentralised blockchain. The COMP token is a governance token that allows a holder governing rights within the Compound Finance ecosystem, awarded to those who supply liquidity to the platform or borrow from it. Users have developed clever methods of ‘farming’ COMP by borrowing lesser-used tokens and lending them back to Compound, receiving higher returns than if they had accepted the going interest rate. Initially distributed in June 2020, COMP initiated a craze that elevated Compound’s position within the DeFi sector.
Different Yield Farming Protocols
A variety of new protocols have since established themselves within the DeFi sector, each offering different options to investors:
- Allows lending and borrowing of a number of Cryptocurrencies with interest rates adjusted to current market conditions.
- Offers native ‘aTokens’ when depositing or borrowing on this platform.
- Allows people to earn money on the Crypto they borrow or deposit through interest rates and the distribution of the native COMP token.
- Allows users to make high-value coin swaps within stablecoin pools.
- Offers high returns and lesser risk.
- Base-APY can reach 10% whilst reward APY can go over 40%.
- A platform for ‘trustless’ token swaps at a 50/50 ratio.
- Liquidity providers earn fees from trades that occur within their pool.
- Another coin-swap platform that allows custom Balancer pools (rather than the 50/50 exchange requirement of Uniswap).
- Liquidity providers earn fees from the trades that happen in their pool.
- Decentralised aggregation protocol for finding the most profitable liquidity pool.
- ‘Second-layer’ application which farms more efficiently through means such as improving transaction speed.
- Funds are converted into yTokens.
- Users contribute to this liquidity pool to earn LP tokens which can be exchanged for Cryptocurrencies.
- On Binance Smart Chain rather than Ethereum.
Risks of Yield Farming
Yield farming can be a highly complex process where borrowers and lenders are exposed to many risks. Therefore, it is also generally suited to those with a large amount of capital in the first place.
Bugs and Hacking
Yield farming protocols can be susceptible to hacks and fraud due to systemic vulnerabilities within smart contracts. These risks are made worse by the intense competition between different protocols. Systems are constructed on limited budgets, and features go unaudited, increasing the chance of bugs. One notable example was Harvest.Finance, a protocol which in October 2020 lost over $20 million after being hacked. Users should study a platform extensively before engaging with it financially.
Within DeFi, interest rates can be highly volatile, meaning a greater chance of short-term loss and price slippage. Locked within a liquidity pool, a yield farmer’s tokens risk fluctuation in the value. Volatility makes it difficult to predict your rewards in the coming year.
Rug-pulling is a form of ‘exit fraud’ in which malicious developers create a new token, drive up its price by appealing to prospective investors, before abandoning the project without returning investments. These developers may stimulate hype on social media or inject a large amount of liquidity into their pool so as to stimulate investor confidence. This form of fraud thrives within the DeFi sector because users are easily able to list tokens for free without audit on blockchain protocols like Ethereum.
In Crypto, composability is the ability of different DeFi protocols to integrate with one another, building large structures, with tokens being compatible across multiple platforms. However, this inter-relatedness of the ecosystem, whilst being a strength of DeFi, means that some form of failure on one platform can have repercussions on others. Therefore, it is essential to understand what protocols your funds may rely on.
Should I start Yield Farming?
Despite the risk, yield farming presents an excellent opportunity for investors. However, the process requires knowledge and time that many individuals simply don’t possess. AQRU aims to give everyone safe access to high-interest gains from the Crypto market. Our platform offers simple-to-use features that will enable you to start making a meaningful difference to your finances today.