Complete Guide To Yield Farming

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Cryptocurrencies are known for volatility. Investors are constantly playing the gambling game, putting money into assets like Bitcoin and hoping for a positive return. But there’s no way to guarantee this. However, there are others ways to profit in the crypto space. 

Decentralized finance is one such market that’s seeing significant growth. More specifically, a process called yield farming has caught the eye of various investors.

What is Yield Farming?

Put simply, yield farming is the act of loaning out your cryptocurrency to earn more cryptocurrency in the form of interest. It’s very similar to putting money away in your savings at a traditional bank and earning interest on that; only with crypto, your funds are locked into a network rather than a bank account.

These networks, also known as decentralized applications (dApps), are blockchain-based versions of traditional finance products, each with its own cryptocurrency. By locking in your funding and allowing others to borrow it, you’re earning rewards in the form of said platform’s cryptocurrency, as well as interest on said loan. 

But why would a platform give you its tokens? To increase its value. Take the Aave platform for example. As Aave rewards users for lending cryptocurrency, the platform is ensuring its token is actually put to use. Tokens with a valuable use case go up in price, meaning more users flock to the network. It’s a cycle.

Ideally, both parties benefit, but we’ll get more into that later.

How Much Can I Earn From Yield Farming?

What you can earn from yield farming depends on the dApp you invest in. Some tokens might jump up in value as investors commit funds, while others may hold their value a while longer. It all depends on the number of investors allocating funds to the network. The more users participating, the higher the price will rise.

The Compound (COMP) blockchain network, for example, was the application to popularize yield farming. Compound is a lending and borrowing service that allows users to lend their funds to others in exchange for interest. These come in the form of user staking.

Essentially, Compound rewards investors for acting as a personal bank. It provides the tools, users provide the funds for others to borrow. What does Compound get out of this? By rewarding lenders with its COMP token, the value of said token increases. Considering significant amounts of COMP are held by the platform’s founders, it is in their best interest to increase its value as much as possible.

To incentivize staking, the platform was rewarding users with its COMP token. When this happened, Compound’s token topped the DeFi market in terms of volume in a single day. As of this writing, it holds a spot in 11th place, with trading pairs on the platform like DAI/COMP or wETH/COMP holding higher places.  

Those looking to profit significantly from yield farming take their investments from one successful project and stake them in another one. Generally, they choose the project with the highest annual percentage rate. That rate varies based on the platform, as well as the supply and demand for the asset in question.

Take Aave, a popular lending platform. Aave currently has 9.3 million DAI in available liquidity. If you deposit DAI as of this writing, you’d earn a 5.78% deposit annual percentage yield. That’s $578 on a $10,000 deposit. That interest is paid out in “aTokens” – the cryptocurrency of the Aave platform. If you stake 500 DAI, you’d receive 500 aDAI, for example. From there, users can choose to borrow your funds at a stable or variable percentage rate.

DAI’s stable annual percentage rate is 9.15%, so a borrower will have to pay you that much interest on whatever loan they take. You can check these rates on Aavewatch.com. If you create an account on the platform, you can utilize its borrow interest rate calculator as well.

Of course, this is just one platform. Compound shows a 3.97% annual percentage rate that borrowers must pay. The truth is, it’s impossible to predict just how much you’ll make from yield farming. It’s simply too volatile a market for now. However, there are success stories.

One yield farmer saw his portfolio grow over 40%, with the potential for a 800% annual percentage yield while farming on the Yearn.finance platform. Basically, he made $32,000. However, he doesn’t expect these returns to be possible for much longer.

Earnings like that were only possible due to the explosion of yield farming. But, annual percentage rates are stabilizing as more users enter the market. While it’s likely possible to make a return on your investment, you shouldn’t go in expecting to make tens of thousands.

That said, you can’t just provide a couple hundred dollars and call it a day. You need to provide significant amounts of liquidity to a platform. Thousands, if not tens of thousands, are required to start. Otherwise, you’re at risk of losing any profits to transaction fees, assuming you’ve provided enough to borrow.

What are the Risks of Yield Farming?

While yield farming is initially appealing, there are risks to doing so. For one, it’s entirely possible a project can fail shortly after you stake a hefty amount.

One example is the Yam (YAM) token. Yam initially launched with users’ option to stake COMP, Maker (MKR), and other tokens in exchange for YAM. The project saw close to $57 million locked in its network in just two days, massively raising its asset value. However, the team revealed a bug in the network shortly afterward. YAM crashed hard.

While the funds staked into Yam were safe, the asset itself was basically worthless. This is one of the less destructive cases as well. Lending platform bZx was hacked three times and lost over $8 million earlier this year. Fortunately, no investor funds were lost in this hack. But there’s always a chance.

It’s important to research a project and ensure its code is up to par before investing in a project. With so many projects essentially pump-and-dumping, the yield farming space could be compared to ICOs in the early crypto days.

There’s also the risk of artificial demand and price manipulation.

We’ll use the COMP platform as an example. Say a lender is staking their funds for others to borrow. They’ll earn COMP tokens for staking, but users also earn COMP from borrowing. So, some lenders will borrow their own lent cryptocurrencies, earn more COMP, and then stake the currencies they borrowed from themselves once again to earn even more. They’re essentially borrowing from themselves to hoard COMP. While sure, they’ll have to pay their own loans back with interest, the rewards for doing so are much higher than any interest they have to pay.

This process is also known as liquidity mining and isn’t at all sustainable. If the token’s value were to crash, these investors would lose everything.

In that same vein, there’s simply a lack of insurance in the cryptocurrency space. Sure, you’re probably going to see higher interest rates in crypto. However, if you lose your funds, there’s almost no way to get them back. It’s a high-risk, high-reward space for now.

During an interview with crypto publication CoinDesk, the CEO of crypto security auditor Least Authority described DeFi’s risk:

“DeFi, with the combination of an assortment of digital funds, automation of key processes, and more complex incentive structures that work across protocols – each with their own rapidly changing tech and governance practices – make for new types of security risks. Yet, despite these risks, the high yields are undeniably attractive to draw more users.”

Ethereum’s founder himself stated he’ll stay away from yield farming until it settles.

What Does the Future of Yield Farming Hold?

As of now, the DeFi space is experiencing a bit of a renaissance thanks to Ethereum’s upgrade to 2.0. Previously, the project ran on a proof-of-work consensus algorithm. It is now moving to a proof-of-stake platform, rewarding users who allocate their funds into the network. Considering Ethereum is home to the most decentralized applications by far, this upgrade is projected to increase the asset’s value and prop up existing lending platforms within the network.

The move to proof-of-stake should also help with scalability. On proof-of-work, Ethereum consistently saw congestion due to high transaction amounts, with the rise of yield farming contributing to this. Proof-of-stake allows for many more transactions to be validated at once. Assuming users flock to the network, they won’t face congestion as a result.

Otherwise, the future of yield farming is impossible to predict. We can be sure that users will continually lean on yield farming as it remains profitable. For now, yield farming tends to serve those first to the market, but even those examples are few and far between. Some early investors profited off of YAM and COMP’s launches, but that rush disappeared as quickly as it started. Eventually, all prices level out.

That’s not to mention any networks that lack Ethereum’s scale. Many platforms can experience congestion as transactions grow, causing yield farmers to look elsewhere for profit. To succeed in the space, investors must be adamant. Top yield farmers are constantly moving from token to token as values fluctuate. One week might see wETH/COMP generate the highest returns. The next week it could be DAI/COMP.

Where to Start Yield Farming?

If the risks of yield farming haven’t put you off, you’re probably wondering how to get involved and see some profit. While we can’t guarantee positive returns in such a volatile space, we can show you where to get started with yield farming.

To begin, you’ll want to join a liquidity pool. A liquidity pool allows users to stake their tokens for others to borrow, earning interest on the loans. All of your tokens are locked into a smart contract for users to borrow from. The most popular platforms that support liquidity pools are Uniswap, Balancer, and Curve Finance.

Borrowers request cryptocurrencies like Ethereum or DAI on these platforms. It’s up to providers to offer them. Head to one of the aforementioned pools to create a wallet. From there, fill that wallet with the cryptocurrency you’d like to stake, and earn rewards for becoming a provider.

While tracking your profits, however, it’s important to consider impermanent loss. This is the amount lost while providing liquidity due to the asset rising in value. 

Look at it this way: If you stake ETH when it’s at $300, the price of that staked ETH remains $300, even if the actual price goes up at exchanges and crypto price trackers. If ETH goes up to $325, and you withdraw your staked crypto, you’d be taking a $25 loss. It’s vital to leave those funds staked to prevent this loss.

So how do you avoid this? Different liquidity pools have different solutions:

Uniswap charges a 0.3% transaction fee for purchases on its platform. That fee is then added to the platform’s reserves and distributed evenly to all providers. The idea is that this fee should cover any impermanent loss. The platform achieved this number thanks to its “constant product” formula, x * y = k.

Basically, the formula accounts for the total amount of either asset in the pool. x and y are the two assets, while k is the constant – the price of the two assets multiplied together. Uniswap is trying to keep that k value the same at all times. However, if the price of x changes, then the total is obviously going to change as well. 

But as mentioned, when x changes, you can’t just pull out your tokens. Instead, the 0.3% fee comes into effect, covering for the price alteration. 

Another platform, Curve Finance, is a little different, focusing on stablecoins. Considering most stablecoins are tied to the United States dollar, they’re around the same value. This means impermanent loss doesn’t really exist. However, stablecoins don’t generate as much yield. Their value is more or less the same at all times. As a result, Curve is for users interested in yield farming without much risk.

Other platforms exist as well, but each has a solution to impermanent loss based on one of the big league providers above. The best platform for you is the one that provides the most balance. Do you have a ton of capital and are willing to risk? Try out Uniswap. Uncertain of risk and just want to make some smaller profits? Curve is the provider for you.

Conclusion

Yield farming is the latest way to profit in the cryptocurrency industry – a space that’s always finding new ways to boost your portfolio. However, like airdrops and cryptocurrency mining before it, there’s an inherent risk to jumping in blind.

Is yield farming the next big thing, or is it a fad? It’s impossible to predict. Understand if you can take the risk and know that you might not always profit. Like with any investment, proceed with caution.

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