Yield farming, one of the core pillars of decentralized finance, has a lot of benefits.
The core premise with every open blockchain innovation in finance has been to replacing third-parties with protocols. It started out with Bitcoin successfully attempting a replacement of banks and payment gateways in online transactions.
Fast forward 2014, and Ethereum paved the way to using smart contract protocols to replace third parties in our contractual lives. The result of this change has been the replacement of third parties in every conceivable transaction scenario with permissionless protocols.
This replacement of third parties with protocols is what decentralized finance (DeFi) is all about. If you are new to DeFi, check out our article on DeFi, before going further.
The simulation of financial market operations over decentralized, self-executing protocols has paved the way for anyone to participate and earn on various DeFi protocols.
This possibility has also set the stage for a full-blown disruption of the financial market.
Yield farming is DeFi investing on steroids
So while DeFi protocols lit the flame for virtual alternatives of all sorts of traditional financial instruments, yield farming is DeFi investing on steroids.
For a bit of context, the term yield farming is coined from the science of making yields from actual farms. In agriculture, a farmer’s yield (in terms of cash made) is influenced by several decisions the farmer makes before cultivating and all through to harvest and sale. These decisions revolve around:
- The crop to cultivate.
- The time it’s cultivated.
- What plants to combine,
- How to combine them to get the best harvest,
- The size of the farm,
- And when to sell the harvest to make optimum profits
Image source: https://pixabay.com/
Similarly, DeFi investors use the phrase “Yield farming” to refer to the strategies used to maximize their profit, which is somewhat similar to the list above.
Ways to earn with Yield farming
That being said, with yield farming, there are various DeFi investment opportunities to exploit, which are mostly:
- Staking: This involves earning interest for locking up your tokens on a DeFi platform. It is also similar to proof-of-stake (POS) used in stand-alone blockchains for consensus and voting rights. Similarly, some DeFi projects also give tokens and voting rights as incentives to stakers. The idea of Staking on a DeFi smart contract encourages users to lock up their holdings, which usually has a positive macro-economic benefit on the token’s overall value.
- Liquidity Mining: exchanges generally require liquidity to make trades possible, which is called market making. The exchange operators of centralized exchanges provide liquidity this liquidity or make the market, hence keeping the fees. On the contrary, with DeFi exchanges, liquidity is pooled from voluntary Liquidity providers (LPs). In exchange, the L.P.s are rewarded with the fees generated from users of the exchange. A popular example is Uniswap.
- Interest on Loans: there is also the option of making interest from lending money through collateralized lending protocols. You get to earn interest from the borrowers’ interest for the loan.
- Earning interests for borrowing: Interestingly, on some DeFi protocols, users get some earnings for borrowing from a lending pool. While this sounds irrational at first though, it begins to make some sense since users are required to stake an excessive amount of collateral (which is called over-collateralization) to get a loan. If those collateral are put to use which they are, then there should generate interests.
In a nutshell, optimum yield farming interests come from the aggregation of fees and interests generated from lending, staking, borrowing, and a complex combination of all these windows across various DeFi platforms. Hence your rate of return is dependent on factors like:
- the annualized percentage yield of the pool, if it is a lending pool,
- fees charged to the platform users if it is a market-making pool,
- and the volume of transactions executed using the protocol, if it’s an AMM pool.
Where do you start your yield farming journey?
In the next section, we will be looking at two popular and trusted DeFi ecosystems, great for anyone just starting out on their DeFi journey. Finally, we will be looking at safety measures to have in hand why testing the DeFi waters.
Compound provides liquidity for borrowers using a decentralized liquidity pool. This means that lenders give cash to borrowers using Compound’s pool. The borrowers are also required to provide collateral that is more than the loan they get, and they pay a little interest on the loans to the lenders. The profit is split across every L.P. funding the pool.
This process is called Liquidity mining. With Compound, borrowers’ collateral is more than their credit line, by a collateral coverage ratio of 300%. What is means is, if you locked-in collateral of 300 DAI on Compound, you are allowed to get out about 100USDT.
One of the benefits of using Compound is that the interest rates are minimal. Another great benefit is that borrowers get some premium for borrowing. This makes a lot of sense if you realize that the borrower has some collateralized funds in the Compound pool.
Balancer is a protocol for programmable liquidity provision. This simply means an automated market maker smart contract protocol that provides pooled liquidity to exchange several ERC tokens.
This is a bit similar to DeFi exchanges like Uniswap. The only difference is that Balancer has a more diverse list of ERC assets.
This diversity has made its value and demand surge significantly. Think of it as an automated balancing index fund. In other words, you can create a pool on Balancer across several tokens and provide liquidity, diversifying your holdings, basically.
Another standoff feature with this protocol is that it supports over eight tokens in its pools with custom distributions. In other words, a Liquidity pool can be 40% MKR, 30% DAI, 20% USDC, and 20% WETH. On the contrary, another pool can be 70% MKR and 30% DAI.
There are other features like smart order routing (SOR) which routes trades to Balancer pools, providing the best rates possible for liquidity providers. Also, the Balancer governance token (BAL) determines your voting power as a Balancer community member since it is a decentralized autonomous organization (DAO).
Finally, out of the total supply of 100 million BAL tokens, 75 million BAL tokens are meant for L.P.s.
Risk management with Yield farming
Like all high yield investments, great potentials of yields come with great possibilities of losses, which is even more true for young markets like DeFi. Also, yield farming can get very complicated, with many new, untested ideas out there, making the chances of losses more likely.
As a beginner, however, you want to have the following measures in your yield farming journey:
Always investigate a project’s team before investing
Most DeFi projects are new, along with their codes, which is a higher likelihood of bugs. There have been several cases of hackers taking advantage of bugs in smart contract protocols to defraud users.
This is why you also want to do a proper background check on the team behind a project’s development before investing.
Only invest in projects you understand and believe
Most DeFi protocols are an outright pump-and-dump rehash of other successful projects, similar to the ICO craze of 2017.
The goal of the creators of these projects is to issue tokens, ask investors to lock-up the funds in a pool to drive prices high while they go on to dump once the price is right. This process is sometimes referred to as flash farming, and it’s usually only rewarding at the initial stage, no more. You definitely dont want your funds stuck in such a protocol.
Check out the annualized percentage yield (APY) and the gas fees before investing
One obvious situation with Ethereum protocols is high gas fees. Sometimes gas fees reach as high as 20$. Hence, if your yield farming strategy can’t guarantee a yield that exceeds $20, then you dont want to make that investment.
This is why you need to understand how the DeFi market works, not to get wiped out. We advise users to only try out low-interest yielding strategies until they have mastered the process.
Ultimately, you want to be money smart when trying out yield farming, and you always want to stay updated and ask questions. On good place to do this is to subscribe to our newsletter, on the sidebar of this post, and drop any questions you may have in the comment section of this article.