What Is Yield Farming, and How Does It Work?

If you've spent any time exploring the world of decentralized finance (DeFi), you've likely come across the term "yield farming." For some, it's an exciting way to earn rewards through cryptocurrency holdings, while new users in the crypto space are still unsure of what the buzzword means in DeFi. But why has yield farming become increasingly interesting for traders and DeFi users? Below, we'll cover yield farming, simplify the concept for new users, and help you understand the benefits and drawbacks of the mechanics behind yield farming.

Yield farming is a way through which crypto traders and holders could potentially earn passive income by lending or providing liquidity their existing assets on DeFi protocols. It's an investment strategy that helps provide liquidity for DeFi use cases in the case of loans or enhanced liquidity for other DeFi integrations.

Yield farming comes from claiming or harvesting rewards, similar to real-life farming. In crypto, however, the rewards come as assets that can be added to the existing liquidity or withdrawn from the farm. In short, yield farming is a DeFi strategy that gives token holders the freedom to potentially earn new tokens by distributing them securely on DeFi protocols and locking them in smart contracts.
 

Yield farming leverages smart contracts and DeFi protocols to secure asset deposits by users, who are considered liquidity providers. Yield farming works by having liquidity providers deposit funds onto a platform for liquidity, lending, or staking. Any crypto assets deposited are locked in smart contracts and used across trading, borrowing, or lending protocols.

To providing liquidity, users can earn rewards in the form of interest. This means that a user's rewards are a portion of how much they deposit and are referred to as an APY or annual percentage interest. It's worth mentioning that every liquidity pool has varying APY percentages and depends on the tokens used.

To clarify, yield farming is administered through smart contracts that self-execute programs on the blockchain to remove uncertainty and help ensure fund security.
One notable case of yield farming involves the Compound protocol. Compound—a decentralized borrowing and lending platform on Ethereum—gained popularity by distributing its COMP tokens as rewards to users. These tokens granted governance rights, allowing users to vote on platform decisions. In May 2021, within just 24 hours, Compound briefly emerged as the leading DeFi protocol, reaching nearly $500 million in total value locked (TVL). Currently as of writing, Uniswap holds the top spot with a TVL of $4.735 billion, while Compound has a TVL of $2.644 billion.
 

Several elements enable yield farming to function effectively within the DeFi ecosystem. Here's a closer look at the key components:

Staking
Crypto staking is one of the key components of yield farming, where crypto holders lock up their assets to provide liquidity or support a blockchain's operations—such as transaction validation or securing decentralized protocols. In yield farming, participants often stake their tokens in liquidity pools or lending platforms to earn rewards, typically in the form of additional cryptocurrency Staking is primarily used in the proof-of-stake consensus mechanism for securing a blockchain, within yield farming, it can also involve staking liquidity provider (LP) tokens or other assets to participate in DeFi protocols.

Lending
DeFi lending platforms allow users to offer their crypto assets as loans to others. Borrowers often provide collateral, and lenders, which are liquidity providers, earn interest in return. Platforms like Aave are leaders in this space.

Liquidity
Liquidity is central to most DeFi protocols, and for smooth trading on DEXs, users need to require significant liquidity to ensure successful trades. Yield farmers contribute their crypto to liquidity pools—collections of assets locked in smart contracts on platforms like Uniswap or SushiSwap. These pools enable efficient trading and earn contributors a share of the transaction fees or other incentives.
 

Yield farming can be appealing, but like any investment strategy, it has its fair share of pros and cons. Here's what you need to know:

Yield Farming Benefits

• High Returns: Yield farming could offer higher returns than traditional finance, such as bank deposits or others.   
• Passive Income: By lending, staking, or adding liquidity, crypto holders can earn passive income without having to sell their assets.
• Access to New Tokens: Many projects reward users with governance tokens that provide decision-making power within the protocol.
• Community Growth: Yield farmers contribute to the liquidity and utility of DeFi platforms, fostering innovation within the crypto community.
   

Yield Farming Risks

• “Impermanent” Loss: When you provide liquidity to a pool, the value of your assets can fluctuate based on price changes. If one token in the pool increases or decreases significantly in price, you may end up with less value when you withdraw your assets than if you had just held the tokens. This loss is "impermanent" as long as the prices return to their original ratio. However, if you withdraw your assets before the prices rebalance, the loss can become permanent.
• Smart Contract Vulnerabilities: DeFi platforms rely on smart contracts, which can be risky because they can have specific points of failure, leading to smart contract exploits and loss of funds.
• Market Volatility: The crypto market is notoriously volatile, and any token price changes could impact a user's expected returns.
• Regulatory Uncertainty: As governments develop policies around crypto, new regulations could affect DeFi platforms and their offerings.
   

Is Yield Farming Risky?
Yes, yield farming carries risks, such as price volatility, "impermanent loss" in liquidity pools, and potential security vulnerabilities in smart contracts. "Impermanent loss" occurs when the value of tokens in a liquidity pool changes, leading to a loss compared to simply holding the tokens. If you withdraw your assets before prices rebalance, this loss can become permanent. It's essential to conduct thorough research and only invest what you can afford to lose.

Is Yield Farming Still Profitable?
While the DeFi market has evolved, yield farming can be profitable when done strategically. Factors such as the choice of protocol, market conditions, and your investment strategy play important roles in potential profitability.

Is Yield Farming Better Than Staking?
Whether staking or yield farming is better for you depends on your goals. Staking is generally considered less risky because it involves earning rewards for helping secure the blockchain. Yield farming, on the other hand, can offer higher returns, but it comes with more risk since you're providing liquidity rather than just securing the network. A portfolio could include both, but it’s important to carefully analyze the potential risks and rewards of each.
 

Yield farming represents an exciting frontier in decentralized finance, offering opportunities for significant returns through staking, lending, and liquidity provision. However, it's not without its complexities and risks. Beginners should consider starting small and using well-established platforms.
If you're ready to explore the DeFi and yield farming world, platforms like Ndax make it easy to get started. Sign up for Ndax here to discover how you can benefit from the evolving world of decentralized finance.