Yield Farming 101 – What it is, How it Works, and its Risks and Benefits
Actual farmers calculate yield as the whole amount of a crop that’s grown. In the same way, DeFi advocates have now attached to the farming metaphor and brought into existence ‘yield farmers’ or users who measure yield as the amount of interest that has grown on top of underlying cryptocurrencies such as Dai, USDC, and USDT when used in DeFi platforms.
What is Yield Farming?
Yield farming is the practice of staking or locking up crypto assets in return for rewards. Although the expectation of earning yield on investments is not new, the concept of yield farming has been created by the decentralized finance industry.
The idea is that people can earn tokens in return for their participation in DeFi applications. Yield farming can also be referred to as liquidity mining. As every new project that appears provides new tokens or methods to earn rewards, users have been latching into it, hoping to get a part of the yield on offer. This, in turn, creates a demand that increases the value invested in the project and the tokens.
How Does Yield Farming Works?
The exact system of yield farming depends on the terms and features of the particular DeFi application. The practice began by offering users a small portion of transaction fees for taking part in liquidity on an individual application, such as Uniswap or Balancer.
However, the most popular yield farming method is to use a DeFi application and get rewarded with the project’s token. This procedure became common this summer when Compound announced it would start giving its COMP governance token to lenders and borrowers who use the Compound application.
Since then, numerous other projects have taken the same road by creating DeFi applications with linked governance or native tokens and giving them away to users as a reward. These copycat tokens have mirrored the success of COMP, one of them being Balancer’s BAL token, which went up 230 percent immediately after it was released.
Yield farmers usually stake stablecoins, such as Dai, Tether (USDT), or USD Coin (USDC), as they provide an easy way to monitor profits and losses. Still, it is also possible to farm yield using other assets such as Ether (ETH).
What are the Benefits and Risks of Yield Farming?
The benefits of yield farming are instantly apparent – profit. Yield farmers who are now participating in a new project can benefit from token rewards that may increase in price. If they sell those tokens at the right time, massive gains can be made.
Yield farmers usually have to invest a large value of initial capital to earn any significant profits, with even hundreds of thousands of dollars at stake at times. Because of the constantly changing nature of cryptocurrencies and especially DeFi tokens, yield farmers can see massive liquidation risk if the market drops unexpectedly.
Yield farmers also take risks on the project teams and basic smart contract code. The prospective for gains in the DeFi sector appeals to many developers and entrepreneurs who develop a project from the bottom up or even copy the code of their predecessors. Even though the project team is honest, its code can be unaudited and may be prone to bugs that make it weak and an easy target for attackers.
What are the Main Difficulties and Opportunities for Yield Farming?
The majority of DeFi applications are, at the moment, based on the Ethereum blockchain, which comes with some major challenges for yield farmers. Now, before the Ethereum 2.0 upgrade launches, the network is having a hard time as it lacks scalability.
As yield farming becomes more and more popular, a larger number of transactions congest the Ethereum network, which leads to slow confirmation times and spiraling transaction fees. This situation has created some rumors that DeFi could end up killing itself. Still, it seems more likely that Ethereum’s troubles will eventually work to the benefit of other platforms.
For instance, the Binance Smart Chain has appeared on the market as an alternative for the yield farmers that crowded to the network to benefit from the new DeFi DApps, such as BurgerSwap.
In addition, Ethereum’s existing DeFi operators are also trying to ease the issue with their own second-layer solutions for the platform. Therefore, presuming that the problems with Ethereum aren’t killing DeFi, the practice of yield farming could end up being around in the distant future as well.
Andreas Townsend Author
I am a technical writer, author and blogger since 2005. An industry watcher that stays on top of the latest features, extremely passionate about finance news and everything related to crypto.