Yield farming is a cryptocurrency investment strategy that holds out the hope of bigger returns than most conventional investments are offering these days. It could be a chance for the bold to win big — or for the holders of new currencies to manipulate prices. The U.S. Securities and Exchange Commission has notified the industry that it has reservations, particularly over whether the practice should be regulated as a securities offering.
What is Yield Farming?
When you deposit money in a bank, you’re effectively making a loan, for which you get interest in return. Yield farming, also known as yield or liquidity harvesting, involves lending cryptocurrency. In return, you get interest and sometimes fees, but they’re less significant than the practice of supplementing interest with handouts of units of a new cryptocurrency. The real payoff comes if that coin increases rapidly. It’s as if banks were luring new depositors with the gift of a tulip — during the Dutch tulip craze. Or a toaster, if toasters were the object of wild speculation and price swings.
It may sound strange, but you have to remember that, unlike established currencies that have lots of money in circulation, cryptocurrencies have to perform a tricky balancing act to grow. A new currency only has value if enough people use it, so there’s an incentive to issue new units to grow a user base. But flooding the market would make the currency less valuable. (Remember, so far cryptocurrencies are sought after more for their value as a commodity whose price may rise with demand than for their usefulness in making real-world transactions, which is the main function of the dollar, euro, or yuan.)
Interest rates or rates of return are often measured in APY, which is the annual return on an asset, including compounding. The more common the compound interest, the greater the difference between the APY and the APR of the investment.
Banks and other more traditional investments usually stick to a flat APR. Revenue farming is often seen as the equivalent of Silicon Valley startups like Uber, which offer huge incentives to early investors on the platform. New blockchain applications need liquidity to support the platform and ultimately grow, which is where yield farming comes in.
So How does Yield Farming Work?
First, do you know what a dApp is? That’s shorthand for a decentralized app. Ethereum co-founder Vitalik Buterin explains the concept through this analogy: if Bitcoin is a pocket calculator, platforms with dApps are smartphones, but ones on which automated programs run without a central operating system or server. Many of them make use of the Ethereum blockchain, a digital ledger.
The most basic approach is to lend digital coins, such as DAI or Tether, through a dApp such as Compound, which then lends the coins to borrowers who often use them for speculation. Interest rates vary with demand, but for every day’s participation in the Compound service, you get new Comp coins, interest, and other fees. If the Comp token increases– and it’s more than doubled in value since mid-June — your returns skyrocket as well.
How does Yield Farming work with Staking?
If you believe in the long-term potential of a proof-of-stake blockchain project, then you might be interested in buying a native token and staking it to get more rewards. The way cryptocurrency staking works is that you pledge your tokens to a blockchain protocol like Solana.
The protocol then selects one of the stakes to confirm the next block in the blockchain. The more effort you put in, the more likely you will be selected. The person who gets selected will get a reward for confirming the block. In practice, the easiest way to start earning staking rewards is to bet through your exchange like Coinbase. The exchange will take care of all the technical details and add any rewards you earn to your balance.
How does Yield Farming work in Liquidity Pools?
Another way to generate more returns from your crypto assets is to become a liquidity provider for a decentralized exchange. If someone goes to Uniswap to exchange their Ether for DAI, for example, Uniswap will take some DAI from the liquidity pool and add the Ether that the user exchanged. This allows Uniswap to offer exchanges for almost any cryptocurrency pair you can think of without actually holding the cryptocurrency.
Uniswap pays the fees it collects from exchanges to liquidity providers. The amount each provider receives corresponds to their share of the protocol’s total liquidity pool. For example, let’s say you put $100 in Ether and $100 in DAI ($200 total) into a liquidity pool of $20,000 in total. Your share of the fund is 1%. If the amount of fees collected in exchanges between Ether and DAI per day is $100, you will earn $1.
Note that you may see the share of your trading pair fluctuate over time, especially for more volatile cryptocurrencies. This can lead to a non-permanent loss, which is a decrease in the value of your assets compared to when you would have just kept your cryptocurrency from the liquidity pool.
What are the Best Platforms for Yield Farming?
Commonly used platforms for Yield Farming are all well-known decentralized exchanges that support dApps. Good examples are:
Advantages of Yield Farming
The benefits of growing crops are quite simple. If you are already planning to hold cryptocurrency for the long term, you can also look at increasing the return you get from these assets. Betting and lending provide a low-risk way to generate additional income earned on the same cryptocurrency you own. Participating in a liquidity pool can generate higher returns, but carries more risk. As mentioned above, participating in crop growing activities also supports the entire crypto-ecosystem.
Yield Farming can also increase their yields by mining liquidity. They receive tokens from the company that loaned them the funds, in addition to high interest on the loan.
What Other Kinds of Coins are Involved?
Compound, launched in June, is one of the largest such services and currently has about $11 billion in funds, according to tracker DeFi Pulse. Other major players in this game are Balancer, Synthetix, Curve, and Ren. Synthetix pioneered the idea. Today, these services hold more than $90 billion in locked user funds, which are funds that are used in lending. Supposedly, the holders of coins like Comp can participate in the governance and improvement of these networks. But the vast majority of people using them currently are speculators, trying to earn fairy-tale-like returns.
What are the Risks?
Beyond regulatory crackdowns, there’s theft, for one. The digital money you lend out is effectively held by software, and hackers seem to always be able to find ways to exploit vulnerabilities in code and make away with funds. Some coins that people are depositing for yield farming are also only a few years old at most, and could potentially lose their value, causing the entire system to crash.
What’s more, early investors often hold significant shares of reward tokens, and their moves to sell could have a huge impact on token prices. Lastly, regulators are yet to opine on whether reward tokens are or could become securities — decisions that could have a big impact on the coins’ use and value.
While revenue farming can be considered an alternative to keeping cash deposits in a savings account, it is not very safe. Here are a few reasons:
No insurance for your belongings. Banks in the United States include federal deposit insurance up to $250,000 per account.
Smart contracts used for crops can be prone to errors or can be attacked by bad actors.
If you’re using a less reliable protocol, you could be a victim of a scam, which is unattractive due to little regulation in the industry.
What else could go wrong?
Many high-yield harvesting strategies also carry the risk of liquidation. To maximize returns, many users are adapting complex strategies. For example, some investors have been depositing DAI tokens into Compound, borrowing DAI using initial tokens as collateral, and lending out the borrowed funds. The idea is to get a greater portion of the allocated rewards: Comp tokens. A move in the wrong direction in a token’s value could wipe out all gains and trigger liquidations.
What’s New About This?
People have been able to earn interest by lending their cryptocurrencies for several years through apps like BlockFi, as part of a trend of decentralized finance, or DeFi, in which middlemen like banks are replaced with the automated protocols of dApps. What’s different about new ventures like Compound are the tokens handed out to lenders and borrowers, often with implied future rights to cash flows. The idea was to give people who use these apps some “skin in the game,” by creating an incentive to participate in governing and improving the networks.
What about market manipulation?
When someone who has lent a cryptocurrency through a DeFi service like Compound then borrows it back, they’re creating artificial demand for the coins — and thereby inflating the coins’ prices. That’s raised concerns that early adopters who have accumulated large holdings, often called whales, are manipulating price movements, a common accusation in a range of crypto markets. Small traders should beware that yield harvesting “has become a game for whales who are capturing the vast majority of rewards,” according to crypto research firm Messari.
Why did Yield Farming get so Popular right now?
A couple of reasons: Amid the Covid-19 pandemic, all cryptocurrencies — generally viewed as an uncorrelated asset in the long term — have seen a surge of interest in light of high volatility in many traditional assets. What’s more, many of the yield-harvesting products only debuted this summer, offering highly attractive tokens as rewards and boasting of high-profile backers like Andreessen Horowitz and Polychain.
Is farming for you?
If you’re a long-term buy-and-hold cryptocurrency investor, you might want to look into yield management. You can keep your risks low with simple staking, or you can enter the world of DeFi by participating in credit or liquidity pools. There are many options to explore and you may benefit greatly by increasing the return on your cryptocurrency holdings.
Yield farming provides a great opportunity to quickly earn a large profit on your cryptocurrency, although extraordinary returns are often accompanied by high risk. The smart move is to reduce your exposure to a company that offers security, regulatory oversight, and consistent token valuation, all while generating an unmatched return on your initial investment.