Demystifying Yield Farming — The Risks Are Worth The Rewards

Over the last year, yield farming has become a common buzzword and an unstoppable force in decentralized finance.

So what exactly is yield farming? Various blockchain-based applications offer customers incentives for using or providing liquidity to their platform.

Yield farming is the intent to earn those incentives for a profit. It can be as simple as depositing funds to an application and waiting over a period of time to collect your rewards.

So instead of stagnantly holding ethereum in your wallet, yield farming is a way to make crypto work for you.

Incentivizing a collective “bank”

Decentralized applications (dApps) like an exchange are basically just computer code living on the internet. However, they lack a central group of financial backers to provide liquidity like a traditional bank does.

These decentralized exchanges (DEX) rely on individual users like you and me to deposit funds into liquidity pools. Through collectivization, those pooled deposits act as the “bank,” which the exchange can then use to perform automated swaps. To entice depositors, the application code has the ability to mint reward tokens as incentives. 

By providing a continuous incentive to depositors, the DEXs, in return, have a reliable source of liquidity without relying on a singular centralized entity like a corporation or government.

The benefit of aggregator platforms

Yield farming is diverse, and depending on the platform, there may be over 100 different farms to consider. For the new user, the simplest method would be using a digital dollar like USDC, which would not be impacted by market volatility. 

Using a fiat exchange, users can exchange their fiat currency to USDC. They can then withdraw the funds into a web-based wallet.

The user would then visit a farming application and deposit the USDC funds into the applicable farm. Over time your depositor rewards will accumulate, earning you a passive income on your digital dollar.

With yield farming, instead of your cryptocurrency sitting stationary in a wallet and only earning on the rises and dips of the market, it is instead being invested to earn you more tokens that you can repeatedly invest.

However, with so many options to choose from, users can easily get lost or fall into scams in such a complex ecosystem.

Aggregator platforms attempt to reduce these risks and automate the most lucrative farm strategies under one platform. Allowing users to relax and let the passive income stream in.

Automation as the best strategy

A yield farming strategy is a smart contract coded to execute commands to earn users rewards on their crypto assets. A single asset strategy is where only one crypto asset, like ETH, is used to deposit and earn yield.

More advanced strategies, like farming the Curve.Fi CRV token, requires you to deposit a mixture of tokens into the platform for a potentially more lucrative but more risky strategy. 

Users can leverage many applications for yield farming, and each has its own rules that determine these rewards.

Farming strategies may change by the day as new farms appear with new deposit requirements and payout amounts. Users can gain the most rewards by frequently managing their risks and strategies or let an automated platform handle them.

When farming, you also need to decide if you keep the reward tokens you receive, hoping they will go up in value over the long term, or sell the rewards to realize the profit immediately.

However, when visiting any particular farm, it is important to note the rate of return is generally displayed as an APY. This is a percentage based on compounding.

This means to achieve the high percentage displayed. You must sell the rewards and redeposit the profit back into the farm.

This compounding process can be costly and cost-prohibitive, forcing the user into holding the rewards and earning exponentially less than the displayed rate.

Using an automated platform can help with this problem. Since user funds are collectively pooled and acting as one large depositor, those previously prohibitive costs are shared across thousands of users, costing just pennies per user.

Putting your trust in developers

Each yield farming protocol develops its own strategies to attempt to maximize returns for its users.

Often core developers create and execute smart contracts which run the strategy. At the same time, community members aid in finding and proposing new strategies. This shows the truly collaborative nature of these decentralized organizations. 

These strategies can change by the day and by the hour as lucrative opportunities appear and developers move quickly to maximize returns. 

Developers look at security, liquidity, and yield within a pool as they are building strategies. Choosing to use a particular yield farming protocol means trusting the developers and community. You have to believe they will build and execute the safest strategies for their users.

Not only must developers ensure their own code is safe, but any project they connect a strategy to must also be deemed safe.

A risk versus reward toss-up

Everyone has a starting point for learning how to use their digital assets. The main reason why people aren’t yield farming is because of the volatility of crypto assets, combined with high Ethereum gas fees and the poor reputations of DeFi projects stemming from hacks and scams. 

A great analogy would be the American Wild West / Gold Rush. An opportunity to strike it rich and be a trailblazer in a new world, staking your claim on a new future.

However, with all of that potential came the risk of the great unknown filled with scams, robberies, and the potential to lose everything. The same can be said about cryptocurrencies and DeFi while still in this unregulated and trailblazing stage.

In my opinion, when you look at a meager .5% APY holding fiat in your bank account, compared to a standard 30-60% APY for putting your digital dollars in a yield farming pool, it almost seems trivial to doubt this new powerful way to store and earn on your digital assets. 

  • $5,000 x 64% APY (Yearly) = $8,225 < Yield Farming
  • $5,000 x .5% APY (Yearly) = $5,025 < Traditional Bank Account

On the horizon 

Opportunities to farm exist across multiple blockchains offering various pools and strategies to optimize your returns.

Millions of crypto enthusiasts passively hold crypto in their wallets. However, they have yet to do anything with their assets. In addition, there are billions more who have yet to discover cryptocurrency or this fertile ecosystem.

Decentralized finance and yield farming are available to anyone in the world with an internet connection. Users deposit their funds and then let the strategies do the hard work generating passive income.

Suddenly with automation, things like compound interest are accessible to an entirely new subset of the population. Collaborating to create strategies so the entire collective benefits is just the beginning of our decentralized financial future.