What is Yield Farming - yield farming explained

Yield farming has become a popular buzzword in the world of cryptocurrencies and DeFi.

In this article, we’ll explore what yield farming is, how it works, and the opportunities and risks associated with it.

What is Yield Farming?

Yield farming, also known as liquidity mining, is a process where investors provide liquidity to a DeFi platform in exchange for rewards. These rewards come in the form of tokens that may be the project's governance token which may offer potential voting rights or monetary benefits.

The goal of yield farming is to earn a higher return on investment (ROI) than would be possible by simply holding a cryptocurrency. When yield farming, you typically take on some level of risk in return for a higher potential return.

How Does Yield Farming Work?

Yield farming works by providing liquidity to a DeFi platform through a process called staking. Staking involves locking up cryptocurrency in a smart contract for a set period of time, in exchange for rewards.

When you stake your cryptocurrency, you provide liquidity to the DeFi platform, where the platform sources ample liquidity for more efficient trading and borrowing.

In exchange for providing this liquidity, you receive rewards in the form of crypto tokens that represent your contribution to the ecosystem.

The amount of rewards you receive depends on the amount of liquidity you provide and the duration of the staking period. Generally, the longer you stake, or the larger amount of liquidity you contribute, the higher rewards the yield farming rewards.

Opportunities of Yield Farming

Yield farming presents various opportunities to make money, and sometimes, significant amounts of money.

Higher returns on investment

Yield farming allows investors to earn higher returns on their cryptocurrency holdings than would be possible by simply holding the cryptocurrency. This is because investors are rewarded for providing liquidity to the DeFi platform, which allows for more efficient trading and borrowing.

For example, investors yield farming into Curve's 3pool can earn CRV tokens for providing stablecoin liquidity - up to 5% APY for their contribution.  

Rewards for early adopters

Early adopters of DeFi platforms who yield farm at the early stage are able to stake their cryptocurrency and earn rewards before the platform becomes widely adopted. This can result in significant returns for early adopters when the token price rises and the project gains adoption.

Risks of Yield Farming

While yield farming presents opportunities for high returns, it also comes with several risks.

Impermanent loss

Impermanent loss occurs when the value of the cryptocurrency provided as liquidity changes relative to the value of the other cryptocurrency in the liquidity pool. This can result in a loss of value for the staked cryptocurrency, even if the rewards received are higher than the loss.

Smart contract risk

Yield farming involves staking your crypto into a smart contract. If the smart contract has a bug or is hacked, you could lose 100% of your investment.

There have been several high-profile smart contract hacks over the past several years from DeFi for a total loss of US$6.4B. According to DeFillama's tracking, several projects like Euler Finance have lost investors' funds from protocol logic issues that have resulted in an exploit.

Market volatility and price risk

Yield farming rewards are often paid out in the form of new tokens, which can be highly volatile. If the price of these tokens drops significantly, the rewards earned from yield farming could be worth less than the cryptocurrency staked.

Conclusion

Yield farming presents an opportunity for investors to earn a higher yield on their cryptocurrency holdings by providing liquidity to DeFi platforms. However, yield farming also comes with several risks, including impermanent loss, smart contract risk, and market volatility.

As with any investment, it’s important to thoroughly research and understand the risks and rewards associated with yield farming before getting involved. Yield farming can be a powerful tool for earning returns on cryptocurrency holdings, but it’s important to approach it with caution and a solid understanding of the mechanics.

For updates and special announcements, follow our Instagram (@stakingbits) and join our community on Telegram.