What Is Yield Farming? – Don’t miss this Yield Farming Guide

Yield farming could be said to be a lifelong quest for fulfillment. One need go no further than to recall the quote from billionaire investor Warren Buffett:

“If you can’t find a way to make money while you sleep, you’ll work until you die.”

As the saying goes, it’s always easier said than done. However, blockchain assets within the decentralized finance (DeFi) continuum offer yield farming opportunities like never before in history. Terra and Celsius Network may have gone down the toilet, but keep in mind that they were CeFi lending platforms, not DeFi.

The likes of Aave, Curve, and Uniswap, plus Ethereum stake, still offer returns that dwarf the average savings account rate of 0.1%. This yield farming guide covers everything a passive income seeker needs to know to get started.

Yield Farming vs. Traditional Banking

What is meant by yield farming is any process that locks up crypto assets for the generation of passive income. This income is commonly represented as a percentage APY – Annual Percentage Yield, sometimes referred to as the EAR (Effective Annual Percentage Rate). Measures a future return on an initial investment.

For example:

  • Adam deposits $500 into a DeFi protocol with 6% APY.
  • The 6% interest rate is compounded each quarter.
  • The formula to calculate it is APY= (1 + r/n)north – 1, where “r” is the annual interest rate, while “n” is the number of compounding periods.

Since capitalization pays every quarter (every three months) and the year has 12 months, n=4. With r=6% (0.06) and n=4, the APY on a $500 deposit translates to a yield farming profit of $30.68, increasing the initial deposit from $500 to $530.68.

In yield farming, there is another metric to consider: APR (Annual Percentage Rate). Unlike APY, APR does not take into account compound interest, which is just a rate that accumulates on both the initial deposit and the periodic interest accrued.

For traditional savings accounts, this would involve depositing a sum of money for a fixed period and earning an interest rate for that period. Unfortunately, due to Federal Reserve monetary policies that discourage savings, such bank accounts yield up to 1.58% APY, at best. This may increase further if the Fed decides it is necessary to combat inflation.

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Yields on certificates of deposit (CDs) have been falling steadily as the Federal Reserve’s money supply and the national debt have risen. Source: BankRate.com

In other words, we’ve reached the point where low-yielding APY savings accounts are not only normalized but considered high-yielding.

This contrasts sharply with a new generation of finance based on blockchain networks and smart contracts. In the last two years, this new Finance 2.0 skyrocketed, going from less than $1 billion to more than $82 billion locked in smart contracts across various categories.

Font: The block

Ethereum is by far the largest blockchain network to have spearheaded DeFi, with $45 billion worth of crypto assets locked in its smart contracts. Because crypto assets are not tied to the central bank’s manipulation system, DeFi smart contracts that recreate financial services in a decentralized manner offer dramatically higher APY returns.

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APY returns from various platforms. Source: DeFiRate.com

Be it Uniswap, Aave or Compound, APY returns in DeFi rarely go below 2%. This is already three times the national average for savings accounts. However, not all DeFi yield crops are created equal.

Of course, there are always risks, and there is no better example than what happened with the Anchor Protocol of the Terra ecosystem. The now-infamous incident saw Anchor Protocol play a major role, resulting in massive drops in value.

What is gambling?

Anchor Protocol offered massive interest rates on UST deposits, almost 20% per annum. Without going into too much detail, setting up that stablecoin deposit resulted in the LUNA token exploding massively in a very short space of time. But things really took a turn for the worse when massive UST sell-offs began to take place, leading to even more panic and selling and consequently the decoupling of UST.

As UST was withdrawn en masse on Anchor, Anchor Protocol’s own ANC token began to crash as users began leaving the platform. Eventually, many Terra users kept their bags. The lesson here is that just because something has attractive returns doesn’t necessarily make it good.

Types of Yield Farming

In traditional banking, there isn’t much to consider except depositing money and earning an interest rate. It is then up to the bank to decide how to make use of those funds for its suite of financial products.

In DeFi, there are no financial institutions. They have been superseded by smart contracts stored on blockchain networks, and there is a wide range of yield farming opportunities:

stakeout: Smart contract blockchain networks, such as Ethereum, Cardano, Algorand, Solana, Fantom, and Avalanche, use proof-of-stake (PoS) consensus algorithms to secure and verify their respective networks.

Each validator running a PoS node (a computer that contains the entire blockchain record) uses staked crypto funds for transaction validation. Consequently, when merchants use the blockchain, validators get a cut, which is a form of yield farming.

Provide liquidity: If one wanted to trade token A for token B, such as ETH for USDT, a liquidity provider would lock their funds to either side of that trading token pair. For example, one could go to Uniswap and add USDT to a liquidity pool. Like tokens, liquidity pools are smart contracts but they serve the function of bank vaults. Therefore, when someone wants to trade tokens, they would tap into that pool of liquidity, giving liquidity providers (LPs) a yield farming income.

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ETH/USDT pair on Uniswap: Uniswap

we lend and lend: Liquidity providers can lock your crypto funds in pools for other merchants who want to borrow instead of trading tokens. Aave, Maker, Compound, InstaDapp, dYdX, and SushiSwap are just a few of the DeFi protocols offering yield farming income to lenders.

It is common for yield producers to be both borrowers and lenders. This is popular because one could obtain a yield farm with borrowed coins, relying on volatile assets to offset the cost of the loan.

For this reason, most of the loaned assets consist of stablecoins (up to 90%), while the collateral usually consists of volatile cryptocurrencies (up to 75%).

Source: IMF: Global Financial Stability Report (April 2022)

Thus, yield farmers who borrow and lend could keep the initial deposits.

Of course, if the value of the volatile asset falls, the holders would have to liquidate. Stablecoins generally yield the highest APY returns because supply is low and demand is high. Indeed, to gain an advantage over the current rate of inflation, one would have to go higher for profitable yield farming. That’s because the inflation rate denotes the amount of value the dollar lost over a year. For example, if the cost of a computer monitor was $300 a year ago, now you would have to pay up to $25 more for the same monitor. Why? Due to inflation.

Imagine what the effect would be if a developer decides to pump that much into some altcoin. The same supply and demand principles apply.