What Is Yield Farming?
Yield farming is a high-risk, volatile investment strategy that involves investors staking, or lending, cryptocurrency assets on a decentralized finance (DeFi) platform to earn a higher return. An investor may receive payment on the return in additional cryptocurrency.
Yield farming took off in popularity due to its applications, such as in liquidity mining, which is the practice of lending crypto assets to a decentralized exchange in return for incentives. Yield farming was once the largest growth driver of the fledgling DeFi sector, but has lost most of its 2020 hype after the collapse of the TerraUSD stablecoin in May 2022.
Key Takeaways
- Yield farming is a high-risk, volatile investment strategy where an investor stakes, or lends, crypto assets on a decentralized finance (DeFi) platform to earn a higher return.
- An investor receives payment of the return in additional cryptocurrency.
- Yield farming is the largest growth driver of the DeFi sector, valued in 2022 at $6 billion.
How Does Yield Farming Work?
Yield farming allows investors to earn yield by placing coins or tokens in a decentralized application, or dApp, thereby providing liquidity to various token pairs. Some examples of these are cryptocurrency wallets, decentralized exchanges (DEXs), and decentralized social media.
Yield farmers typically rely on DEXs to lend, borrow, or stake coins—an exercise that allows them to earn interest and speculate on price swings. Smart contracts across DeFi clear the path for yield farming.
Top yield farming protocols include Aave, Curve Finance, and Uniswap.
History of Yield Farming
In June 2020, the Ethereum-based credit market, known asCompound,began passing out COMP, which is an ERC-20 asset that empowers community governance of the Compound protocol, to the protocol’s users.
This kind of asset is called a governance token, and it offers holders voting rights that give them power over platform changes. Interest in the token jump-started its popularity and movedCompoundinto theleading position in DeFi. After that, the term “yield farming” was coined.
Roles That Yield Farmers Play
A yield farmer can perform several functions. They can be a liquidity provider, lender, borrower, and staker.
A liquidity provider, who can work for exchanges such asUniswap orPancakeSwap, comes in after users deposit two crypto coins to a DEX to facilitate trading liquidity. The exchange imposes a fee to swap those two tokens, which the liquidity provider then receives, or they may be given new liquidity pool (LP) tokens. A yield farmer is a lender when coin or token holders lend cryptocurrencies to borrowers using a smart contract and through protocols such asCompoundorAave, eventually realizing yield from the interest paid on the loan.
On the other side, naturally, are borrowers, which are created when farmers use one token as collateral and are then lent another token. This activity allows the users to farm the yield with the borrowed coin(s). Doing this means the farmer retains their initial holding, which could rise in value, and earns yield on their borrowed coins.
The easiest way to be a staker and to start earning staking rewards is by doing so through a crypto exchange likeCoinbase. Onproof-of-stake (PoS)blockchains, the user receives interest if they pledge their tokens to the network as a safety measure.
Cryptocurrency exchange Kraken shut its U.S. staking-as-service business after regulatory action by the U.S. Securities and Exchange Commission (SEC). Coinbase is also under regulatory scrutiny but maintains that its staking services are not akin to securities.
Another reason to become a staker is for the user to earn yield twice, because they receive payment for introducing liquidity in LP tokens that they also can stake and earn more yield. They are staking accumulated LP tokens by providing a DEX with liquidity.
Risks of Yield Farming
Yield farming poses financial risk to borrowers and lenders. For example, when the crypto markets are volatile, users can experience losses and price slippage.
Risks to be aware of include:
- Rug pulls, a type of exit scam in which a crypto developer amasses investor cash for a project and then abandons it without repaying the funds to investors
- Regulatory risks, such as when the SEC or state regulators attempt to oversee yield farming and issue cease-and-desist orders against crypto lending sites like Celsius and BlockFi
- Turbulence, meaning market swings and the propensity for bear runs that can happen with most investments when they dip in value
What Is Decentralized Finance (DeFi)?
Decentralized finance (DeFi) is an emerging financial technology based on secure distributed ledgers similar to those used by cryptocurrencies. In the United States, the Federal Reserve and the SEC define the rules forcentralized financial institutionssuch as banks and brokerages. DeFi challenges this centralized financial system by empowering individuals with peer-to-peer digital exchanges on which they can buy, sell, and transfer digital assets. DeFi also eliminates the fees that banks and other financial companies charge for using their services.
What Are Decentralized Applications (dApps)?
Decentralized applications (dApps) are digital applications or programs that exist and run on ablockchainorpeer-to-peer (P2P) network of computers instead of on a single computer. DApps (also called “dapps”) are thus outside the purview and control of a single authority. DApps—which are often built on theEthereumplatform—can be developed for a variety of purposes, including gaming, finance, and social media.
What Are Decentralized Bitcoin Exchanges (DEXs)?
Decentralized bitcoin exchanges (DEXs) are operated without a central authority. They allow P2P trading of digital currencies without the need for an exchange authority to facilitate the transactions.
Among the benefits of decentralized exchanges: Many cryptocurrency users believe decentralized exchanges better match the decentralized structures of most digital currencies themselves, and they require less personal information from their members than other types of exchanges. But such exchanges, like all cryptocurrency exchanges, must maintain a fundamental level of user interest in trading volume and liquidity.
The Bottom Line
Yield farming is a high-risk investment strategy in which the investor provides liquidity and stakes, lends, or borrows cryptocurrency assets on a DeFi platform to earn a higher return. Investors may receive payment in additional cryptocurrency.
The popularity of yield farming has waned, and yields have muted, since the peak of 2020 after the collapse of the TerraUSD stablecoin last year. Yet it is only for the most astute investors who can withstand the downsides, such as volatility, rug pulls, and regulatory risks.
