Yield farming was created to use decentralised finance (DeFi) to maximise returns on your cryptocurrency. It involves locking up your cryptocurrency for a set period in return for interest or additional crypto.
Yield farmers can use more complex systems to increase their potential returns. Their profits are measured as APY (annual percentage yields).
As with most investments, yield farming can be highly profitable, but it is also incredibly risky.
Introduction to DeFi Yield Farming
If you had some cash, you could earn interest by depositing it into a deposit account. Similarly, with crypto, you lock it away for a set period, known as staking, to earn interest or other rewards.
Farming is different from holding your crypto in a blockchain that allows you to sell or trade at any point.
Yield farming mimics how banks give out loans from the deposits they hold, which are paid back with interest. In other words, yield farming lends out crypto to generate a return.
Yield farming started in 2020, and many yield farmers have seen their returns go as high as three figures. Like most profitable investments, it is not without risk. Crypto is a precarious platform, and developers sometimes desert a project, taking investors’ funds with them.
How does DeFi yield farming work?
Yield farming takes place in decentralised apps. Investors deposit their crypto for other people to borrow.
The crypto lent is used to speculate over large swings in the crypto market in the hope of making a profit.
The apps entice investors to lock up their crypto by offering incentives. The funds are then lent out to other investors who want to speculate in the market.
Each app offers a smart contract written in code with different protocols. This staking process can make profits for everyone involved.
Yield farmers are also known as liquidity providers. They can earn interest or often extra crypto coins as a reward for locking up their crypto.
The other win is that the value of the invested coins often increases, but this is not assured as crypto is volatile with speedy fluctuations.
The whole process has been created to encourage early investors to lend their crypto to stimulate growth in the market. The apps encourage this by offering all kinds of incentives from tokens, transaction fees and additional funds.
What is hard forking?
A hard fork is created when a crypto network’s protocol changes, often forcing developers to upgrade the protocol.
Staking has the incentive of allowing yield farmers to accumulate enough crypto shares to force a hard fork and create a change to the infrastructure that they believe to be beneficial.
Why is this a good thing for crypto holders? It is a way for them to have some power over their crypto, much like shareholders in a company. They attain the ability to affect the direction of the crypto protocols. It changes crypto from being coin based to more like an investment portfolio.
What are the risks of DeFi yield farming?
Yield farming is full of risks. Understanding them is an excellent way to determine whether yield farming is for you.
- Volatile Investment: Crypto prices are highly volatile, so there is always the risk that while your crypto is locked away, the value could crash. Of course, it could always rise significantly too.
- Fraud: Crypto crime is an increasing problem. Yield farmers could be the subject of fraudulent activity where their crypto is lent to fraudulent projects that take off with the coins.
- Rug pulls: A large percentage of cyber fraud comes from abandoned projects known as rug pulls. Yield farmers can lose their investment if this happens.
- Smart contracts: The smart contracts used in yield farming are at risk of bugs in poor code, exposing them to hacking. Improved security would reduce this risk.
- Change in value: The whole point of yield farming is that you are locking up your crypto for a set period. This means you will be unable to sell your coins to realise a profit or avoid a fall in value. This is one of the most significant risk factors in staking your crypto.
- Lack of Regulation: The crypto market is still relatively unregulated. It often falls on users’ shoulders to assess the risk and legitimacy of the people behind yield farming apps to reduce the risks.
Is crypto yield farming profitable?
Knowing how risky it is to go into yield farming, it is unsurprising that many people are unsure whether it is worth it.
Fortunately, CoinMarketCap has provided some rankings showing the different liquidity pools and how they have performed in terms of their APY.
Yield farming is undoubtedly a speculative investment that can deliver high rewards to those prepared to risk huge losses.
The yield farmers who make the most profits are those who are willing to risk thousands of dollars in crypto and utilise some complex strategies to increase their chance of success.
Yield farming DeFi Platforms
Yield farmers can use DeFi platforms that incentivise with different protocols. Some examples of the various protocols on offer are:
- Aave is an open source liquidity protocol where users can lend or borrow crypto. Your interest is paid as AAVE tokens calculated based on the demand for borrowing.
- Compound is an open source protocol for developers. It pays an interest rate based on an algorithm and pays COMP tokens.
- Curve Finance is a liquidity pool on Ethereum. It uses an algorithm which allows users to exchange stablecoins. Involving a separate medium of exchange can make the transaction safer.
- Uniswap is a decentralised exchange where yield farmers stake both sides of the pool in a 50/50 ratio. They earn a share of the transaction fees and UNI governance tokens.
- Instadapp is designed for developers. It allows users to create and manage their decentralised finance portfolio.
Final Thoughts – What Is DeFi Yield Farming?
Yield farming is a digital form of lending with interest to make a profit for investors. Farmers must stake or lock up their crypto in exchange for interest or more crypto.
It is a risky investment with high stakes and possible large returns. The volatility of crypto means that your crypto value can change in either direction while locked up.
It is worth remembering that any profits made on crypto investments are subject to UK tax in the UK. You can find out more information here.
Yield farming is best left to those who understand crypto markets and can evaluate the risks accurately.