What Is Yield Farming?
Welcome to Soldex Academy, your number one source for Crypto and DeFi content. Today, we will discuss what yield farming is, how it is done, and some of the benefits and risks involved. However, to better understand yield farming, we recommend watching our videos on DeFi, Proof of Stake, Liquidity pool, and Automated market makers.
What is Yield Farming?
Yield farming, also called liquidity mining, simply means staking or locking up your crypto assets to earn more crypto.
How does yield farming work?
Recall that a liquidity pool is a collection of funds locked in a smart contract. And liquidity providers deposit their funds in a liquidity pool, and these funds facilitate lending, borrowing, trading, and other functions.
Liquidity providers are usually incentivized with:
- Transaction fees of trades that occur in the pool
- Interest from lenders
- A governance token
So instead of letting their crypto lie idle in a wallet, liquidity providers stake them to earn rewards. Let’s say you wish to stake your crypto and join in yield farming; you’d follow all or some of the following processes:
Supply funds to a liquidity pool
First, you’ll supply a pair of tokens to a liquidity pool.
Earn and reinvest your LP tokens
After supplying funds to a liquidity pool, you’d automatically be awarded some LP tokens that you can reinvest.
Stake LP tokens
You can also stake the LP tokens you’ve received for more rewards.
You can lend your crypto assets to some protocols to earn rewards.
Unlike traditional finance, you can also make money from borrowing crypto assets. Say you have some $SOLX that you don’t want to sell yet because you believe in the project. You can lock up your $SOLX as collateral to borrow other crypto assets.
Say you have some $SOLX lying around. You can lend it to a crypto platform to earn rewards in the form of other crypto assets. Let’s say you earn USDC as a reward. You can go ahead to lend your USDC on another platform to earn more rewards, say more $SOLX. You can still lend the rewarded $SOLX for more USDC, and so the circle continues.
APY and APR in Yield Farming
APY or Annual Percentage Yield and APR or Annual Percentage rate are two commonly used metrics used to calculate yield farming returns. They estimate what you could get as returns for a year. The difference between them is that APY considers the effects of compounding while APR doesn’t. Also, note that yield farming is a fast-paced marketplace and the returns are often volatile. So, APR and APY may not be accurate calculations metrics. This is because a highly profitable yield farming strategy may stop being profitable if many farmers adopt it.
Yield Farming Platforms.
There are many yield farming platforms with their own rules and risks. Some of them are:
Curve finance etc.
Risks involved in Yield Farming
Although yield farming comes with high rewards and incentives, there are also some risks to take note of.
Although we have explained yield farming in simple terms in this video, it can get very complex. Some of the most profitable strategies of yield farming are difficult to grasp and recommended for advanced users only. You’d easily lose your money as a newbie if you don’t fully understand what you’re doing.
While yield farming, you also run the risk of an impermanent loss. That is the loss in the total value of your assets when you provide liquidity compared to when you simply hold your assets in your wallet.
A rug pull happens when developers abandon a project and run away with investors’ money. The risk of rug pull is higher with new projects, especially those that promise incredible returns.
Smart contract risks
Yield farming protocols are governed by smart contracts built on the blockchain. Suppose there is a bug or a vulnerability on the smart contract of the protocol you locked your funds into. In that case, you stand the risk of losing your money, especially if a hacker takes advantage of this vulnerability.