When Ethereum was first introduced in 2015, it created a hub for developers to create innovative applications powered by smart contracts. Soon after the growth and demand of blockchain, DeFi’s popularity grew exponentially. Traders and stakeholders were interested in DeFi’s new-age assets, which gave them a reliable substitute for traditional investment modes. These peer-to-peer financial solutions’ total value locked (TVL) is approx—$ 45 billion. The metric denotes the overall worth of crypto assets deposited in DeFi protocols, including staking, lending, and liquidity pools.

Among these pools of options, Compound, a prominent borrowing and lending protocol built on Ethereum, began to test out a new strategy for traders to maximize their return on crypto. So, the Compound distributed COMP tokens to its users, offering them control over protocol activities. This move became an instant hit, and in a single trading cycle, Compound elevated to the top of the DeFi protocol list, achieving a whopping $500 million in holdings.

The strategic implementation of these maiden projects inspired DeFi communities to build the early version of yield farming, turning it into one of the highly sought-after earning mechanisms in DeFi protocol.

What is DeFi yield farming?

In yield farming, you deposit funds into decentralized protocols to earn interest, usually through governance tokens or other financial rewards. Other participants in the ecosystem can then borrow these funds for margin trading or use them as liquidity in decentralized exchanges powered by automated market makers (AMMs). This approach allows you to actively and passively put your capital to work rather than letting it sit idle.

How does DeFi yield farming compare and contrast with traditional investment methods?

Yield farming has transformed DeFi, but the concept itself is not new. In traditional finance, you can earn interest and rewards by opening a savings account, purchasing a certificate of deposit (CD), or investing in dividend-paying equities.

However, these traditional methods rely on intermediaries or third parties. In yield farming, you operate in a decentralized environment where borrowing and lending happen peer-to-peer (P2P) and are automatically managed by smart contracts.

Pros of DeFi Yield Farming

Yield farming benefits both DeFi platforms and their users.
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When you distribute tokens on platforms, you increase token circulation, which boosts user participation and liquidity. If your tokens provide governance rights, you help platforms maintain healthier decentralization.  

For users, yield farming offers opportunities for passive capital appreciation and active speculation, potentially yielding higher returns than traditional financial instruments. Additionally, yield farming is accessible to everyone, regardless of net worth, due to lower capital requirements than conventional banks.

How Does DeFi Yield Farming Work?

Like other investing and trading activities in DeFi, yield farming is powered by smart contracts, automating borrowing, lending, and capital exchange. You deposit the assets into a smart contract address associated with a specific protocol, which may have different lockup periods.
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The mechanism of yield farming varies from protocol to protocol with a defined strategy.

Underlying Protocols in DeFi Yield Farming

You can engage in DeFi yield farming on the Ethereum network using ERC-20 tokens. Within Ethereum, you can perform yield farming on various platforms, including decentralized exchanges (DEXs), lending and borrowing protocols, and liquid staking providers. Popular platforms for yield farming include Aave, Curve Finance, Uniswap, Balancer, and Yearn Finance.
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One thing to note is that you cannot perform yield farming on Bitcoin.
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However, using wrapped Bitcoin (wBTC), you can bring Bitcoin to the Ethereum network and other DeFi protocols, enabling similar borrowing and lending opportunities.

Key components of DeFi yield farming

In DeFi yield farming, you can use various strategies, both active and passive, but the three major components are staking, lending, and providing liquidity.
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• Staking involves purchasing and locking up tokens for a specified period in exchange for interest.

• Lending happens when you make deposited funds available for others to borrow on margin.

• Providing liquidity means depositing tokens into decentralized exchanges (DEXs) to increase capital availability and share in trading revenue.

Hidden Risks of DeFi Yield Farming

Most high-reward strategies in traditional and cryptocurrency financial markets come with high risk. Yield farming is no different. Let’s explore the hidden dangers associated with yield farming, including smart contract vulnerabilities, impermanent loss on returns, and market volatility.
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Smart Contract Vulnerabilities

Smart contracts automatically execute transactions involved in yield farming, enhancing efficiency and accuracy. However, a bug in the code can create vulnerabilities, exposing the system to hacking and fraud and potentially causing a token’s price to drop. For example, in 2020, the DeFi protocol Harvest Finance suffered a multi-million-dollar flash loan attack.
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Rug Pulls

Rug pulls are a scam in which someone creates a new cryptocurrency token, promotes it to attract buyers, and then exits the project without returning funds to the buyers. Often, these scams involve the creator holding a large token sum and selling it into the liquidity pools, draining the liquidity provided and rendering the token worthless.
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Impermanent Loss

Impermanent loss occurs when the initial value of funds deposited into a liquidity pool differs from their subsequent value. This loss can impact yield farming in various ways, such as rapid token price shifts causing deposited funds to lose significant value. You can mitigate impermanent loss or negative impact on returns by depositing asset-backed stablecoins, which typically experience lower price volatility than other digital assets. Additionally, participating in a platform that offers high transaction fee revenue can help compensate for some losses.
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Liquidity Pools Drying Up

Liquidity pools rely on contributions from users worldwide, so the amount of liquidity can fluctuate as people withdraw their tokens. Low liquidity results in higher slippage, meaning you will receive less money than expected when selling tokens into the pool. Many exchanges allow you to set slippage tolerances to limit this risk. However, there are still situations where liquidity is so low that you lose money when exchanging your tokens. Yield farming can increase the risk of low liquidity because tokens must be locked for a set period and cannot be sold.
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Market Volatility Impact

Market cycles can bring higher levels of volatility, directly affecting token prices and available interest rates. However, if you are skilled at analyzing market volatility, you can take advantage of arbitrage opportunities or other cyclical strategies.

How Can You Get the Best Returns?

Many DeFi protocols let you withdraw your tokens with a button. However, there is often a defined period during which your funds must be locked in before you can withdraw them. Since APRs fluctuate daily, many users look for yield farms with short lockup periods to redeposit their assets into pools with higher earning potential quickly.

Popular DeFi Yield Farming Options

There are several ways to earn returns on tokens deposited in a liquidity pool.  

Here are a few of them:
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1. Interest on Lending Deposits

Earning interest on deposits is the most straightforward way to gain DeFi yields. You deposit cryptocurrencies in pools governed by smart contracts and, in return, receive an interest-earning token. Generally, the interest is generated by the borrowers who accept loans from the liquidity pool.
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2. Transaction Fees for Offering Liquidity

Another method of yield farming involves supplying cryptocurrencies as liquidity to pools on decentralized exchanges (DEXs). The exchange usually charges users around 0.3 percent for swapping their tokens, distributed among the pool’s liquidity providers.
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3. Token Incentives from Protocol Operators

This concept, popularized by Compound Finance and Uniswap, involves protocol operators allocating tokens to past and current users to reward their participation and loyalty.
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4. Token Incentives from Pool Operators

When a new blockchain launches its token, the liquidity in the pool is often low. To address this, blockchain project owners commonly engage in “liquidity bootstrapping.” In this model, they attract liquidity providers by offering additional token incentives.

Stages of DeFi Yield Farming

• Step 1: At the beginning of the DeFi yield farming journey, you create multiple smart contracts that act as liquidity pools or interact with existing LPs. Providers deposit their funds into these pools using stablecoins and other standard cryptocurrencies.
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• Step 2: Users are given a marketplace to invest, trade, or borrow yield farming tokens.
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• Step 3: Users or borrowers pay fees to the yield-farming DeFi platform in exchange for their borrowed tokens.
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• Step 4: The DeFi yield farming application rewards the liquidity providers or traders based on their stakes in the liquidity pools.
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• Step 5: Once lenders earn interest on their invested amounts, they can reinvest their earnings into other liquidity pools with higher Annual Percentage Rates (APRs).

How Can Webmob Help You with DeFi Yield Farming Development?

At Webmob, we have developed prominent DeFi yield farming platforms for global clients. One is integrated with an existing protocol while the other is built from scratch. For both projects, we followed a methodology that spans conceptualization to delivery.
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Here’s a breakdown of the process:

Product Discovery

1. We start by providing product-building ideas, performing a thorough SWOT analysis, and offering solutions to mitigate them.

2. We create milestones for deliverables all while following agile methodology.

Blockchain Integrated Solution Designing

Smart Contracts

1. We identify and code decentralized interactions into smart contracts for storing and retrieving assets and funds.

2. We define the smart contracts’ architecture, choosing the design pattern and modularity.

3. Based on the designed architecture, we write smart contracts for:
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   • Creating liquidity pools or interacting with existing LPs.
   • Configuring the platform, including event timings like harvest rewards and opening pools.
   • Developing strategies to move funds for increased yield.
   • Managing assets.
   • Interacting with other yield farming protocols like Yearn.
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Middleware Architecture

1. We build secure, robust, scalable middleware that wraps smart contracts and creates a RESTful API model for the front end and admin.

2. This middleware supports additional features such as social features, DAO, or embedded crypto news.
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System Architecture for Component Interaction

1. We model the interactions between various layers: smart contracts, middleware, frontend, and admin (if needed).

2. We design inter- and intra-component interactions to form the system design.
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Technical Documentation

1. We document the technical aspects of the system design.

2. We build documents that communicate program blocks.

3. We create logic for payments and rewards.
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For User Interface:

1. We create transaction functionalities for users.

2. We connect to web wallets.

3. We transmit transaction messages to the blockchain.

4. We retrieve data and contract information from the blockchain.
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For Admin Interface:

1. Based on requirements and use cases, we add attributes like:

• Analytics of transactions and volume.

• Managing platform/protocol fees.

• User management and more.
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Component Integration

1. We follow an iterative cycle to integrate components, creating a complete workflow.

2. We perform unit/module testing.

Testing and Quality Assurance on Testnets and Custom Environments

We conduct user acceptance testing (UAT) and quality assurance (QA) on testnets and custom environments.

Production Level Deployment & Delivery

We address all changes, deliver the platform, and show product demos.

Connect with our team of experts for your next big idea on DeFi yield farming at info@webmobinfo.ch