What’s Yield Farming in Crypto & How Profitable Is It?

Photo by Towfiqu barbhuiya on Unsplash

Crypto yield farming is a decentralized finance (DeFi) concept that allows cryptocurrency holders to earn passive income, wayyyy beyond any interest they could have gotten from their traditional bank savings.

In this article, we give a non-technical explanation of its background, how it works, the risks involved, and most importantly, how profitable it really is.

How It All Started

Yield farming was the hot new craze that powered the DeFi Summer of 2020. This was a period of explosive growth in DeFi, fueled by a combination of factors like low interest rates, excess liquidity, and the allure of sky-high returns through “yield farming.”

Imagine a gold rush, but instead of panning for nuggets, people were rushing to lock their crypto assets in lending protocols and decentralized exchanges, earning double-digit, sometimes triple-digit, annual percentage yields (APYs) in the form of newly minted project tokens.

It was a heady time, with the total value locked (TVL) in DeFi protocols soaring from $1 billion to over $15 billion in just a few months. But some investors learned that not all that glittered was gold; the summer also saw its share of scams, hacks, and volatile price swings, reminding everyone that the Wild West of DeFi comes with its own set of risks.

How Yield Farming Works

Yield farming involves users lending or staking their cryptocurrencies in smart contracts to facilitate various financial activities, such as trading, lending, or borrowing. The yields (returns) offered by DeFi protocols during DeFi Summer of 2020 were often incredibly high, sometimes exceeding 100% per year.

Here’s what goes into yield farming:

1. Investors deposit their crypto assets into a DeFi protocol. This could be anything from a stablecoin lending pool to a decentralized exchange.
2. The protocol uses the deposited assets to provide liquidity for its users. This means that the assets are available to be borrowed, loaned,or traded.
3. In return for providing liquidity, users receive rewards in the form of the protocol’s native tokens.

Where Do Yields in Yield Farming Come From? (BONUS SECTION)

In case you’re wondering, the returns in yield farming come from multiple sources, depending on the specific type of farming you’re doing, for example:

• Trading fees: In liquidity pools on decentralized exchanges (DEXs), your crypto is used to facilitate trading for others. When people trade on the platform, a small fee is charged, and a portion of that fee is distributed to liquidity providers (LPs) like you, contributing to your yield. It’s like earning a commission from every transaction happening in your crypto market stall.
• Lending interest: In lending protocols, your crypto is loaned out to borrowers who pay interest on the borrowed amount. This interest is then distributed to lenders like you, generating your yield. Think of it as lending out your crypto shovel and rake, earning rental income from those who need them for their crypto gardening.
• Protocol token rewards: Many DeFi protocols distribute their own governance tokens as incentives to encourage participation. When you farm on these platforms, you may earn additional tokens alongside other rewards. It’s like getting bonus seeds and fertilizer for participating in the community garden.
• Transaction fees: Some yield farming strategies like flash loans or arbitrage trading involve exploiting temporary price discrepancies across different platforms. The profits generated from these actions can contribute to your yield, but these strategies are often complex and carry higher risks. Think of it as finding valuable herbs and spices in hidden corners of the crypto market, but requiring advanced foraging skills.
• Inflationary rewards: In some cases, platforms distribute newly minted tokens as rewards to incentivize participation. This can contribute to your yield, but it’s important to be aware of potential inflationary risks, as the value of these newly created tokens may decrease over time. Think of it as receiving freshly baked bread as a reward, but considering the possibility of it going stale quickly.

How Much Can You Earn From Yield Farming?

A rough gauge of profitability in yield farming looks something like this:

• Moderate APYs (5–15%): This is a more sustainable range for long-term yield farming. Several established platforms offer this range for well-established crypto assets.
• High APYs (15–50%): These farms often involve riskier assets or more complex strategies. While potential rewards are higher, so are the chances of things going south.
• Extremely high APYs (50%+): These might sound tempting, but be extremely cautious. They often involve experimental platforms or less-liquid assets, significantly increasing the risk of losing your principal.

However, the profitability of yield farming depends on several factors, including the interest rates in lending protocols, trading fees, and the performance of the associated tokens. It can be highly lucrative, but returns are subject to market volatility and the specific dynamics of each platform.

To break it down in greater detail, it really depends on:

• The specific platform you use: Different platforms offer different types of farms and pools, each with its own potential APY (annual percentage yield). Some platforms might entice you with sky-high APYs, but remember, higher risk often comes with higher potential rewards.
• The crypto assets you choose: The APY can vary greatly depending on the specific cryptocurrencies you invest in. Some may offer consistent, low APYs, while others might have high but very volatile rates.
• Market conditions: The overall crypto market can significantly impact your earnings. Rising prices generally lead to higher returns, while down markets can eat into your profits or even cause losses.
• Your own farming strategy: How you choose to combine different platforms, pools, and assets can affect your overall yield.

While some farmers have documented incredible gains (think triple-digit APYs!), it’s crucial to understand that these are not guaranteed and can be fleeting. Many platforms adjust reward rates regularly, and losses are always a possibility.

3 Biggest Risks in Yield Farming

The key risks involved in crypto yield farming include:

• Smart contract risks: Yield farming relies on smart contracts, and vulnerabilities in these contracts could lead to exploits or hacks, resulting in the loss of funds.
• Impermanence loss: When providing liquidity to a pool, users are exposed to impermanent loss, which occurs when the value of the deposited assets diverges from the value of the assets in the pool. This can lead to a reduction in overall returns compared to simply holding the assets.
• Rug pulls: This is a type of scam where the developers of a DeFi protocol abandon the project and take all of the investors’ money with them.
• Market risks: Cryptocurrency markets are highly volatile. The value of the deposited assets and rewards can fluctuate significantly, affecting the overall profitability of yield farming.

Remember, yield farming is not (always) a get-rich-quick scheme. It requires research, careful planning, and a healthy dose of risk tolerance. Don’t invest more than you can afford to lose, and always prioritize understanding the risks before jumping in.

What’s the difference between yield farming and staking?

Yield farming and staking are both ways to earn additional crypto, but there are some key differences. Here’s a breakdown:

Mechanism:

• Yield farming: Think of it as a complex, multi-layered garden. You can deposit your crypto in various “fields” like liquidity pools, lending protocols, and margin trading platforms. Each field has its own rules and risks, but generally involves actively moving your crypto around to maximize rewards. It’s like constantly tending to your crops and switching fertilizer types depending on the weather.
• Staking: This is more like a low-maintenance orchard. You lock your crypto in a designated “stake” on a specific platform, often supporting blockchains that use the Proof-of-Stake (PoS) consensus mechanism.By staking, you contribute to the security and validation of the network,and in return, earn regular rewards. It’s like planting a fruit tree, watering it occasionally, and watching it grow steadily over time.

Complexity:

• Yield farming: Requires significantly more research and technical knowledge. You need to understand different platforms, pool mechanics, and tokenomics to make informed decisions and navigate the ever-changing landscape. It’s like being a seasoned gardener with a deep understanding of soil science and pest control.
• Staking: Generally easier to get started with. You choose a platform and a staking pool for your preferred PoS cryptocurrency, and the rewards start accruing automatically. It’s like planting a familiar tree and relying on basic gardening knowledge.

Risks:

• Yield farming: Carries higher risks due to its complexity and potentially experimental nature. Impermanent loss (losing value due to price changes), smart contract vulnerabilities, and rug pulls (scams) are just some of the dangers lurking in the crypto garden. It’s like venturing into uncharted territory with less-established crops.
• Staking: Risks are primarily associated with price volatility and potential platform hacks. While generally safer than yield farming, your staked crypto can still lose value, and choosing unreliable platforms can lead to losses. It’s like tending to a fruit tree during a storm, hoping it survives the harsh weather.

Rewards:

• Yield farming: Offers the potential for significantly higher returns compared to staking, sometimes reaching triple-digit APYs. However,these rewards are often fleeting and come with high risks. It’s like harvesting a bumper crop overnight, but with the possibility of it spoiling quickly.
• Staking: Provides lower but more consistent and predictable rewards, typically ranging from 5% to 15% APY. It’s like regularly picking ripe fruit from your orchard, knowing you’ll have a steady supply in the long run.

Check out CoinW Earn’s on-going staking promotions to put your idle crypto to work.

Ultimately, the best choice depends on your risk tolerance, knowledge level, and financial goals. If you’re a beginner, staking might be a safer entry point. If you’re comfortable with higher risks and actively managing your crypto, yield farming could potentially offer larger rewards but requires a lot more care and vigilance.