What is yield farming?

March 01, 2024 

What is yield farming?

Yield farming is a term to describe a strategy of investing into cryptocurrencies to take advantage of the yields. Yield farming is considered a high-risk investment, as a lot of the cryptocurrencies on decentralised finance (DeFi) platforms are not always stable and can be illiquid, often locked into smart contracts preventing withdrawal. 

Yield farming is a popular form of liquidity mining which means that by staking a portion of cryptocurrency assets into a decentralised platform, you will receive a compounding reward in the form of yield and liquidity pool (LP) tokens.

What is yield?

To understand what yield farming is and how it works, we must first understand what yield is.

Yield is essentially the reward for staking risk. An investor will receive a certain yield on their investment, which is calculated as a percentage.

Yields are often referred to in relation to bonds. For example, the United Kingdom 10-year government bond currently has a 4.187% yield. This means that if you buy a bond and keep your money within the bond for the full duration, in this case, 10 years, then you will receive a 4.187% return per year. This can vary with different types of bonds and different durations.

Yield is a lot more fluid in practice, and will also include price increases as well as dividend payments.

Yield in crypto

Many cryptocurrency platforms offer yield in return for buying and holding certain cryptocurrencies. DeFi platforms need these investments in order to create liquidity and maintain stability, so they will need to encourage users to put in a certain amount of capital and keep it there. 

This creates a liquidity pool in which the volatility can be kept down. With significantly low liquidity, the cryptocurrency could become too unstable and may even collapse.

When users stake their crypto, they are putting these assets into the liquidity pool and creating liquidity in the decentralised market, therefore receiving a reward for the risk taken.

How does yield farming work?

Yield farming is therefore the process of making a series of investments as a liquidity provider in order to take advantage of the yields, some of which can be very high (in line with the higher risk).

The yield farming process works as follows:

• An individual will pick a yield farming platform. Popular options are Uniswap, PancakeSwap or Sushi. 

• Once on the platform, the user will go to the section denoted ‘farm’ or ‘liquidity’. For example, PancakeSwap’s Farm section is where users will go to yield farm. 
• From here, the user will choose the assets that they wish to stake.
• For example, a user might pick the USDT (Tether) and the SOL (Solana) pool.
• The user will stake their cryptocurrency into the specific pool and hold their money.
• This process of earning capital and LP tokens is known as yield farming.

In order to maintain market stability and act as a market maker (and therefore earn yield) you will be required to deposit an equal value of each cryptocurrency to maintain the pool's balance. You can also receive LP tokens, which we cover in greater detail in our article on crypto liquidity pools. 

Yield farming works using smart contracts which ensure that the conditions will be met. This can sometimes include ‘lock in’ terms which require the cryptocurrency to be impossible to withdraw for a set period, which will often garner greater rewards. Different platforms will have different variations of how users will earn yield.

Rewards of yield farming

The rewards of yield farming in crypto can be huge, but are not without significant risks.

The profitability of yield farms is measured as an annual percentage yield (APY). An APY is the rate of return that you will receive over one year on your investment.

Due to the high-risk nature of cryptocurrencies, some crypto savings accounts offer incredibly high yields – Bitcoin Minetrix currently offers 72% APY (however, please note that as of 8th of October 2023, Bitcoin Minetrix is no longer compliant with the FCA crypto marketing regulations).

Many other exchanges can offer over 100% APY for yield farming, but again, this is not without a notable risk to the staked assets.

While the APY earnings might be high, if either one of the cryptocurrencies in the pool collapses, the stake will essentially become worthless. This is common in the cryptocurrency space.

Therefore, yield farmers must assess the risk of each asset in the pool and determine whether the high APY risk is worth it.

Risks of yield farming

With high rewards there are always high risks. The higher the APY, generally the higher the risk, as you are being rewarded more for staking in a cryptocurrency pool that is in need of liquidity – meaning that it is likely to be highly illiquid. Furthermore, if you have locked your cryptocurrency in for a fixed period, you cannot withdraw it.

Monumental crashes such as the stablecoin TerraUSD (UST) and Luna crash in May 2022 wiped the entire value of the coin – Luna went from $119.51 to zero within a week, and around $60 billion vanished from the market. 

One of the largest appeals of UST was that if you staked your holdings on the Anchor lending platform, the APY was 20%, which was what incentivised so many investors to put all their capital into the project.

Yield farming scams

This lure of high APY is also what many scammers will use to entice investors into what is known as a rug pull. A rug pull is a scam whereby a fraudster will create hype for the coin, promote investment, and then withdraw all the money, or sell their own stake in the coin and abandon the project.

The Squid Game cryptocurrency scam was one of the most notable rug pulls in history, and off the back of the hype of the Netflix show, one so-called Squid coin managed to reach a valuation of $2,861. 

However, the project emerged to be dubious, and the coin price plummeted, leading many to realise it was a rug pull. The perpetrators were never discovered and were estimated to have pocketed a total of $3.38 million.

Is yield farming still profitable?

Yield farming is still profitable, and has potential to become a strong source of passive income. The support for yield farming and the DeFi sector was at an all-time high until the Terra-Luna crash, which has damaged confidence in the sector.

However, the cryptocurrency market is slowly but surely becoming more regulated, and many platforms have been running for years now with successful yield farming carried out by millions of users.

If you’re looking for a crypto exchange provider, then become a member of LiquidityFinder today.

You can also keep up to date with our crypto insights and even use our Match Matrix to find the liquidity provider that is right for you.

Author

Caleb is a financial copywriter with a specialisation in fintech and forex. Former copywriter at Barclays and Paysafe. Contributing writer for LiquidityFinder. You can message Caleb here.