What is Yield Farming and Why is it Useful?

Web3 users are becoming increasingly interested in the potential for earning passive income. Cryptocurrencies and blockchain offer more than just good investment opportunities. It’s important to learn about the range of DeFi investment tools that are available, including yield farming. But what exactly is yield farming?

Yield farming involves making returns or interest on cryptocurrencies. Cryptocurrencies are deposited into liquidity pools and lent to other users. The depositor earns interest when this happens. Yield farms rely heavily on smart contracts and have higher risk-reward potential than staking.

How Does Yield Farming Work?

Yield farming is not dissimilar to a traditional savings account. Instead of a bank, users deposit their money into a liquidity pool. A liquidity pool is a crowdsourced pool of cryptocurrencies or tokens that are locked into a smart contract. These digital assets are used to facilitate trades on a decentralised exchange (DEX). Oftentimes, these digital assets can be traded automatically and in a permissionless manner, using automated market makers (AMMs).

The deposited cryptocurrency is invested in smart contract applications and ‘put to work’. Yield farming works by locking away the cryptocurrency for a specific period of time. This is different to staking, but the concepts do possess several similarities. The cryptocurrency that has been deposited can be used as collateral or can provide liquidity to decentralised applications (dApps) and mining pools.

Depositors are rewarded for investing in the future of DeFi. Yield farming rewards are the primary reason that most people are interested in the concept. Yield farming returns vary depending on the yield farm, but often take the form of interest. Some yield farms or liquidity pools pay rewards semi-regularly, whereas others pay on a specific date in the future.

For those interested in seeing yield farming explained as simply as possible:

  • A liquidity pool is created
  • Investors deposit their digital assets – usually cryptocurrencies or crypto tokens – into the pool
  • Smart contracts, often in the form of a DEX or a similar DeFi protocol, utilise the liquidity pool and the deposited crypto asset
  • Investors are rewarded for their initial deposit

Different Types of Yield Farming

Lending

This type of yield farming involves a user putting their crypto assets into a lending protocol. Lending arguably has the greater yield potential but does come with increased risks.

Once the digital asset has been added to the lending protocol, it becomes available to borrowers. Borrowers pay interest on the loaned asset and this interest is paid to the depositor. The interest rate varies, depending on the asset’s supply and demand. Some protocols have decided to stabilise interest rates to ensure more consistent returns for lenders.

Lending specifically requires the use of a DeFi protocol. It works by exchanging one digital asset for an equivalent asset or token. The exchange rate on the tokens increases as interest is collected. Once the lender exchanges the tokens back for their original asset, they will receive more than they initially deposited. 

For example, users depositing a token (let’s say, ETH) will receive the equivalent value of a paired token (cETH). If 1 ETH is worth approximately 50 cETH (1:50), with an interest rate of 10% per annum, the exchange rate will change to reflect that interest increase. The value of ETH to cETH would therefore be 1.1:50 after the year was up. Removing the ETH from the protocol – by swapping in the cETH – would grant the lender a 10% increase on their investment. In this case, if the initial deposit was £100, the lender would withdraw £110.

Liquidity Provider

There are also other ways of utilising liquidity pools. Users can become liquidity providers for a DEX. Decentralised exchanges use liquidity pools to enable their users to swap one cryptocurrency for another. Using liquidity pools means the DEX can avoid actually holding any cryptocurrencies.

Most exchanges collect transaction fees for swapping one crypto asset for another. These fees, or at least a percentage of them, are paid to the liquidity providers. The amount paid to a provider is proportionate to their share of the protocol’s total liquidity.

If a user provided £100 of Cardano (ADA) and £100 of Monero (XMR) to a liquidity pool, whose total value was £10,000, their total share would be 2%. If the total fees collected for this particular liquidity pool were £5000 over the course of a year, the user would earn £100. This correlates to their 2% share of the pool and is in addition to their initial £200 investment.

Calculating Yield Farming Rewards

Yield farming rewards are calculated in terms of annual percentage rate (APR) and annual percentage yield (APY). Although there are various online calculators available, there is a relatively simple way of calculating APR from depositing a digital asset.

Yield Farming Calculation
Step One
Add the fee and interest rate that a borrower will need to pay for the loan.
Step Two
Divide the total from Step One by the amount of the loan.
Step Three
Take the result from Step Two and divide it by the total time period of the loan (in years).
Step Four
Multiply the outcome from Step Three by 100. This will leave you with the total APR.

Let’s create a fictitious example. A user deposits £1000 of Solana (SOL) into a liquidity pool. To borrow this SOL for a period of six months, a borrower would need to pay fees of approximately 5% (£5), with an interest rate of 14% (£140).

yield farming example
Step One
£5 plus £140 equals £145
Step Two
£145 divided by £1000 equals 0.14
Step Three
0.14 divided by 0.5 (half a year) equals 0.07
Step Four
0.07 multiplied by 100 equals an annual percentage rate of 7%

The Best Yield Farming Platforms

1. Uniswap

Uniswap is a decentralised exchange built on top of the Ethereum blockchain. Uniswap removes the necessity for third-party interference. Users simply need to connect their wallets to the exchange, so there is no need for account registrations, personal information or KYC documentation.

Uniswap is therefore an excellent option for completely anonymous yield farming. Uniswap is specifically designed to enable the exchanging of ERC-20 tokens. Estimated APY is not displayed by Uniswap, but the platform does have the advantage of Ethereum’s security.

Source: https://app.uniswap.org/#/tokens/ethereum
Pros
  • An excellent and decentralised option
  • Increased anonymity due to lack of registration
  • Benefits from Ethereum-level security
Cons
  • No estimated APY on yield farming
  • Might be difficult for beginners to understand
  • Only supports Ethereum-based tokens

2. PancakeSwap

PancakeSwap is a decentralised, Binance Smart Chain-based exchange. PancakeSwap enables yield farming with some impressively high yields. The platform is simple to use and clearly displays the estimated APR available, alongside a predicted multiplier that users can expect when providing liquidity for a particular token.

Source: https://pancakeswap.finance/farms
Pros
  • The best BSc-specific yield farming platform
  • No account registration is necessary
Cons
  • The site only accepts BSc tokens
  • Lots of yield farming pools are especially volatile

3. OKX

OKX is widely considered to be one of the best yield farming platforms. OKX is an innovative, low-cost trading platform. Users can stake cryptocurrencies, spot trade tokens and take advantage of the site’s generous yield farming opportunities. OKX partners with SushiSwap to offer Ethereum-based yield farming pairs.

Yield farming on OKX is offered on a flexible basis. There is no lock-up period for yield farms on the platform, meaning investors can remove their tokens whenever they want. OKX also offers savings accounts (with very generous annual returns) and staking, both of which can also provide passive income.

Source: https://www.okx.com/earn?from=home
Pros
  • Supports yield farming, staking and savings (interest accounts)
  • Flexible yield farming pools
  • Generous APYs compared to other cryptocurrency platforms
Cons
  • The site only offers ETH-based token pairs for yield farming

Advantages of Yield Farming

There are several advantages to yield farming. Firstly, the rewards have the potential to be very lucrative. Crypto assets can offer impressively high returns, potentially over 100% per annum. Compared to other methods of earning a passive income through DeFi, yield farming can be one of the most profitable.

Secondly, yield farming is a relatively decentralised endeavour. The usage of smart contracts removes the necessity for middlemen to get involved. This makes it a good option for passive income outside of the traditional banking system. Yield farming is an excellent example of what’s possible when finance becomes decentralised. This does, however, depend on how decentralised the blockchain in question is.

Risks of Yield Farming

Unfortunately, as with any DeFi involvement, there are some risks to consider.

The price of a cryptocurrency can rise or fall after it has been deposited into a liquidity pool. This is known as impermanent loss. Liquidity providers are entitled to a share of the pool, rather than a definite quantity of tokens. When the price of the asset changes negatively, the value of the withdrawal is lower than the value of the deposit. If the depositor chose to remove their assets during this period of time, they would lose money. However, if the fees earned over the course of the lending period were higher than the asset’s total lost value, this would negate the price fall. Additionally, the loss is considered impermanent because the cryptocurrencies may return to their original price.

Yield farming, much like other aspects of blockchain, is subject to scams and fraudulent activity. Considering the majority of protocols are built using smart contracts, there is potential for these to contain harmful code. This is why it’s important that users do their own research on lending or borrowing protocols before getting too heavily involved. It’s also worth looking for open-source and responsibly-audited code, to avoid these dangers.

Frequently Asked Questions

Is yield farming different to staking?

Staking and yield farming are very similar to one another. Both can serve as forms of passive income from DeFi. Staking involves supporting a proof-of-stake (PoS) blockchain network. Users stake their cryptocurrencies to be in with the chance of validating the next block on a blockchain. Validators earn cryptocurrency rewards for their role in strengthening the network. On the other hand, yield farming involves depositing a crypto asset into a liquidity pool. Depositors (or lenders) earn rewards based on the interest or fees paid by the borrowing party.

Is yield farming safe?

Yield farming is safe, if users know what they’re doing. However, there are some inherent risks that should be taken into consideration. Impermanent loss can occur when the price of a cryptocurrency falls whilst deposited. When this happens, the value of the investment will be worth less if withdrawn from the yield farm. This issue can be avoided by depositing stablecoins, whose value is much less likely to change, or by choosing yield farms that don’t require lengthy lockup periods.

Which cryptocurrencies allow yield farming?

Most cryptocurrencies allow for yield farming, although it depends on the specific platform. Decentralised exchanges that offer a wide range of cryptocurrency pairs will have a wider selection of yield farms. On the other hand, some blockchain-based platforms, like Uniswap, will only allow Ethereum-based tokens to be farmed.

Can you make money from yield farming?

Yield farming has the potential to be very profitable. In fact, yield farming has some of the best annual percentage returns of any DeFi investment opportunity. However, making money from yield farming is never guaranteed. It is always possible to lose money. It is important that users do substantial research before committing any real funds to a yield farm or liquidity pool.

What is the best yield farming strategy?

There are several good yield farming strategies, although none offer any guarantees. However, the investors that have the most success from yield farming are those that do thorough research before depositing their cryptocurrency. Different platforms offer varied APY on crypto assets, so it’s important to find the best potential percentage yield before depositing. Understanding when to remove a cryptocurrency, or cryptocurrencies, from a liquidity pool is also essential. This can stop impermanent loss.
CoinStove
Logo