Do you know the most lucrative way to earn a return on your investment in DeFi?

Yeah, you guessed it right. It’s through Yield Farming. It’s a prevalent yet risky investment instrument that can fetch you a better ROI than others.  

In 2020, Yield farming was one of the most trending topics in decentralized finance (DeFi), and investors and traders took a keen interest in this investment instrument. Interestingly, as of mid-2024, the total value locked in DeFi protocols, including Yield farming, stood around $50 billion. This number proves that DeFi trading instruments are well-adopted and appreciated by traders and industry experts.  

So, without further ado, let’s see what yield farming is and what makes it a popular earning instrument.

What’s Yield Farming?

The act of staking or lending crypto assets to obtain significant returns or rewards is known as yield farming. Liquidity mining and other recent improvements have contributed to the explosive popularity of this innovative yet volatile and risky use of decentralized finance (DeFi). The DeFi industry is still in its infancy. Still, yield farming is the main factor driving its growth, as it will propel the industry to reach a milestone of $100 billion.

Simply put, Yield farming protocols incentivise liquidity providers (LP) for their stake in crypto pools. Smart contracts lock these assets and decide on the incentives and rewards in the form of governance tokens. Moreover, incentives can include a share of transaction fees, interest from tokens, etc. These returns are calculated in terms of Annual Percentage Yield (APY). The APY rate is inversely proportional to the funds available in the liquidity pool.

Earlier, yield farmers had a higher stake in prevalent stablecoins USDT, DAI and USDC. But now things are different. The most popular DeFi protocol currency operates on the Ethereum network, providing users with governance tokens for liquidity mining. These tokens are harvested in liquidity pools, which induce liquidity to decentralized exchanges (DEXs).

After Compound successfully distributed the COMP token, liquidity mining became popular in decentralized finance (DeFi). Compound encouraged platform users to add liquidity to its pools by rewarding them with its governance token, COMP. This strategy drew in a sizable user base and encouraged the expansion of the DeFi ecosystem.
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The notion of providing governance tokens as compensation to liquidity providers has emerged as a fundamental component of numerous yield farming systems. These tokens, which are usually transferable and fungible, allow their owners to vote on how the protocol is developed going forward. Tokens related to governance are exchangeable on decentralized exchanges like Sushiswap & Uniswap, which further advances the DeFi protocols, and centralized exchanges like Binance & Coinbase, which provide more accessibility to a larger audience. Since liquidity is the lifeblood of most DeFi platforms, DeFi projects allow yield farming to reward their community for giving liquidity and promote platform usage.

How Does Yield Farming Work?

The process varies from protocol to protocol, but generally, it involves liquidity providers, i.e., yield farmers, depositing their tokens in a DeFi application. In exchange, they earn rewards usually paid out in the protocol’s token.

Yield farming rewards, referred to as APY, are managed by smart contracts. When the conditions are fulfilled, users are rewarded with tokens.
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Workflow of Yield farming:
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• Choose a yield farming protocol. We’ll use an automated market maker (AMM) like SushiSwap for this example.

• On the decentralised trading platform, click ‘Liquidity’ to access the section for liquidity providers.

• Then, choose which assets you want to deposit in a liquidity pool. For example, you could deposit ETH and USDT in the ETH/USDT pool.

• Deposit the two assets in the trading pool and receive an LP token.

• Take that LP token, go to ‘Farms,’ and deposit it in the ETH/USDT yield farm to earn your yield farming rewards (in addition to the transaction fees you receive as your share of the liquidity pool).
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Through these yielded rewards you earn, you hold a stake in the network, which gives you democratic power or voting rights to decide the next course of action for the DeFi protocol.

Benefits and Risks of Yield Farming

Let’s discuss the benefits first:
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• Passive revenue: Users can work their holdings and earn rewards through extra tokens and fee income without actively trading. This is an alternative to simply holding.

• High yields: Certain DeFi ventures offer enticing yields compared to typical financial instruments. Depending on the market, users may get significant returns on their capital.

• Provision of liquidity: On DEXs, yield farming lowers slippage and permits effective trading. By contributing liquidity, users play an essential part in the operation of the DeFi ecosystem.
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Talking about the risk:
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• Impermanent loss: This loss mainly happens in automated market makers (AMMs) due to the mechanism of balancing liquidity between the tokens in the pool. Suppose the prices of the tokens in the pool fluctuate significantly after you have provided liquidity. In that case, the platform’s automated system may rebalance the pool by purchasing cheaper tokens and selling the more expensive ones. This rebalancing can lead to losses for liquidity providers.

• Smart contract vulnerabilities: DeFi protocols rely on smart contracts. Hackers can exploit any bugs or weaknesses in the code, potentially causing the loss of funds deposited in the protocol.

• Variable yields: The returns from yield farming can change due to supply and demand dynamics, making it difficult to predict future rewards. For instance, yields can decrease as more users provide assets.

• Price volatility: The value of cryptocurrencies can be volatile, impacting the value of the rewards and the assets you have deposited. If the token in which you are earning rewards drops significantly in value, your profits could be completely wiped out.

Types Of Yield Farming

Each Yield Farming has its distinguishable characteristics and risk profiles:
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• Lending: To make a loan, borrowers deposit their assets into a lending platform. The lenders receive interest on these deposits. Loan-based yield farming is prevalent on platforms such as Aave and Compound.

• Staking: Staking secures cryptocurrency within a blockchain network to facilitate its functions, like transaction verification. Staker incentives come in exchange, frequently in the form of extra tokens. Platforms such as Polkadot and Ethereum 2.0 allow for staking.

• Liquidity Provision: Depositing assets into liquidity pools allows users to supply liquidity to decentralized exchanges (DEXs). They receive a share of the transaction fees that the exchange collects. The liquidity supply is a well-known feature of Uniswap and SushiSwap.

• Yield Aggregators: To maximize consumer profits, yield aggregators are platforms that automatically switch between various yield farming techniques. They streamline the procedure by identifying the most significant opportunities and reallocating resources. One well-known instance of a yield aggregator is Yearn Finance.

• Insurance Mining: Certain platforms offer insurance coverage for DeFi protocols, which presents the potential for yield farming. Users can get incentives by staking assets to offset losses from smart contract failures. One illustration of an insurance mining platform is Nexus Mutual.

Popular Yield Farming Protocols

1. Uniswap: Uniswap is a decentralized exchange (DEX) that allows users to trade cryptocurrencies straight from their wallets. Users can profit from a percentage of the transaction costs by lending liquidity to different trading pairs. Yield farming has become increasingly popular thanks to Uniswap’s automated market maker (AMM) approach.
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2. Compound: Compound allows users to lend or borrow cryptocurrency through a decentralized lending system. Borrowers can access money without conventional intermediaries, and lenders receive interest on their deposits. Participants receive COMP, Compound’s native cryptocurrency, as a prize.
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3. Aave: Aave is another decentralized financing platform with various yield farming prospects. Users can earn income by contributing assets to Aave’s liquidity pools. Additionally, Aave invented flash loans, which made sophisticated trading techniques and arbitrage possible.
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4. Curve Finance: Designed for stablecoin trading, Curve Finance is an optimized decentralized exchange. Users can earn transaction fees by adding liquidity to Curve’s stablecoin pools. Curve’s emphasis on stablecoins reduces transient loss and draws yield farmers looking for steady profits.
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5. Yearn.finance: The yield aggregator Yearn. Finance streamlines the process of locating the highest-yielding farming possibilities. When users deposit money into Yearn’s vaults, the platform re-allocates the money across several DeFi protocols to optimize returns. Yearn’s vaults handle the difficulties of strategy selection, making yield farming easier for users.

Yield Farming Strategies

Successful yield farming often involves utilising specific strategies to maximise returns. Some of the popular strategies implied by yield farmers are:
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1. Single Asset Staking
   It involves staking a single type of cryptocurrency in a staking pool to earn rewards, which is suitable for beginners.
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2. Liquidity Mining
   Liquidity mining involves supplying liquidity to a DEX or lending platform in exchange for rewards through platform tokens or transaction fees. Traders frequently combine two different asset classes to give a trading pair liquidity.
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3. Yield Aggregation
   Platforms for aggregating yield, such as Yearn. Finance automatically transfers money between various DeFi protocols to get the best yield. This strategy streamlines operations and optimises profits by exploiting the finest opportunities available.
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4. Risk Mitigation
   Some yield farmers employ risk mitigation strategies, such as using insurance protocols like Nexus Mutual to cover potential losses from smart contract failures. This adds an extra layer of security to their investments.
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5. Flash Loan Arbitrage
   Advanced yield farmers use flash loans to exploit price discrepancies between different DeFi platforms. Flash loans allow users to borrow assets without collateral, execute arbitrage trades, and repay the loan within a single transaction. This strategy requires a deep understanding of DeFi and smart contracts.

Takeaway

Yield farming is one of the most innovative ways crypto holders can earn passive income. Completely backed by smart contracts and DeFi protocols, these decentralized platforms have turned the table for liquidity pools. If you are looking for DeFi yield farming development solutions, contact us at info@webmobinfo.ch for 360 DeFi solutions.