What is Yield Farming?
TLDR: When Decentralized Finance users make deposits in a Platform’s Smart Contract, and “pool” their assets with other users in order to earn not only transaction fees but also special tokens, that sometimes confer specific privileges to holders, they are said to be engaged in a strategy known as Yield Farming.
The eye-watering rates offered by banks on cash deposits provide a rather powerful incentive to find better alternatives. Surely, one can do better than the 0.5% offered by the Goldman Sachs online Saving Account, or than the paltry 0.40% offered by the American Express High Yield Savings Account.
This is where Decentralized Finance (DeFi) comes in.
DeFi protocols, today, offer a solid alternative for users looking for higher yields on deposits. Yield Farming is a DeFi Strategy that is particularly cherished by the crypto community.
Yield Farming is a process that allows users to provide liquidity, that is, lock-up assets for a certain period of time in Smart Contracts – and be rewarded for doing so. Deposited funds are normally Stablecoins linked to the US dollar, such as DAI, USDC or USDT.
It is important to understand how Yield Farming distinguishes itself from Staking.
Staking has a specific purpose: it is a method of securing blockchain networks. Certain tokens, such as ATOM, Algorand (ALGO) and Ontology (ONT), can be staked. For locking up their tokens for a specific amount of time, and for contributing to the security and stability of a blockchain network, token holders earn rewards.
Yield farmers, in addition to the transaction fees that they receive, earn special tokens (such as Compound’s COMP and Curve’s CRV). These tokens, in addition to conferring certain privileges (such as the right to vote and to make governance proposals to implement changes to Protocols), can be used as assets in the wider DeFi ecosystem. The amount of tokens a Yield Farmer receives is a function of the amount deposited in a platform’s Smart Contract.
Yield Farmers are known to sometimes reinvest the tokens they earn, thus creating complex chains of investments. For example, Bob, after making a deposit of 10 000 USDT on Compound, receives 10 000 cUSDT back, which can be redeemed 1:1 for USDT at any time. Bob can then take those cUSDT and make a deposit in a liquidity pool in another protocol, in order to earn interest there also.
Yield farming, as we have seen during DeFi summer (summer of 2020), is not without risks. Many DeFi protocols, some of them bearing names of fruits, vegetables and animals (such as Yam or Dorayaki), promising unbelievable returns to investors, are largely unaudited and can turn out to be convoluted scams (“Rug Pulls”). To “Rug Pull Risk”, we also need to add Smart Contract Risk. Smart Contracts are always at risk of being exploited and Liquidity Pools drained – such as in the case of Harvest, a protocol with 350 million US dollars in Total Value Locked, which lost over 24 million dollars due to a Smart Contract exploit.