What is Yield Farming in DeFi?

Yield farming involves users depositing and locking their crypto assets in liquidity pools or other DeFi protocols to earn returns.  

Crypto assets deposited and locked by participants serve multiple purposes across different DeFi protocols:

• Decentralized Exchanges (DEXs): In AMM-based DEXs, these funds provide liquidity, enabling seamless token swaps and trading.
• Lending Protocols: In money market DeFi platforms, locked assets facilitate borrowing, allowing users to take out loans against their collateral.
• Staking Protocols: In proof-of-stake blockchains, staked assets help validators secure the network and maintain consensus.

Liquidity providers (participants who lock up their crypto assets) earn returns through transaction fees from trades, interest on loans, or rewards in the form of newly minted governance tokens.

 

 

How Yield Farming Works

In yield farming participants known as liquidity providers deposit assets into liquidity pools of DeFi protocols powered by smart contracts these pools require yield farmers to lock their crypto assets for a set lockup period to earn returns on their tokens.

Fee sharing is based on APR, APY, and liquidity provided

 Depending on the protocol the fees or interest generated by these protocols are used to pay these returns to liquidity providers based on the amount of assets they contributed to the pool and the APR or APY. 

 

Yield Farmers could also earn tokens

Some protocols emit governance tokens to liquidity providers in additional incentive to fee sharing or pay rewards with tokens, for instance, liquidity staking protocols issue LSTs, yield farmers can redeploy them to other liquidity pools to earn additional returns concurrently.

Thus, yield farmers are always looking for attractive returns and typically move their funds around different protocols and multiple blockchains in search of the highest yields. 

 

Yield farmers employ various strategies to take advantage of yield farming opportunities some farmers also provide liquidity to qualify airdrops while getting returns  

It is not uncommon to see DeFi protocols support numerous blockchains for instance DeFi protocol can support multiple EVM-compatible chains such as BNB, and Arbitrum offering an assorted range of token combinations across different liquidity pools on all supported chains.    

 

APR and APY In Yield Farming 

In yield farming, returns and potential earnings are typically expressed in Annual Percentage Rate (APR) and Annual Percentage Yield (APY). Farmers use these figures to estimate their potential earnings before contributing to a liquidity pool or staking their assets. 

 

Annual Percentage Yield (APY) represents the interest rate earned with compounding within the course of one year.

It reflects the maximum possible yield, assuming that returns are reinvested. The more frequently the interest is compounded, the higher the APY. 

Some protocols distribute rewards in tokens, requiring users to manually claim them at maturity, sell them, and reinvest them to achieve compounding. This means actual earnings may vary depending on how many compounding periods the pool or protocol has within a year and whether returns are reinvested.

 

Calculating APY can be complex, but fortunately, there are several online calculators available that can provide accurate estimates with just a quick Google search.

 

Annual Percentage Rate (APR) represents the simple interest earned over one year on assets locked or provided as liquidity in a DeFi protocol, without compounding. APR is a straightforward measure of returns. 

 

For example, if you deposit $100 worth of assets into a liquidity pool with a 5% APR, you would earn $5 worth of assets after one year, assuming the asset price remains constant.

Source: Trust Wallet

 

Risks Associated with Yield Farming

Smart Contract Vulnerabilities

DeFi protocols rely on smart contracts to automate transactions such as lending, swapping, trading, and liquidity provision. These smart contracts often hold millions or even billions of dollars in crypto assets, making them prime targets for hackers and malicious actors. Any bug or flaw in the code or logic of a smart contract can lead to security breaches, resulting in significant financial losses.

Impermanent Loss

Impermanent loss occurs when the value of deposited assets in a liquidity pool shifts due to price fluctuations. This happens because automated market makers (AMMs) adjust token ratios to maintain balance.

If the token price changes significantly after depositing funds, withdrawing them may yield fewer assets than if they were simply held in a wallet.

Market Volatility

The cryptocurrency market is highly volatile, and yield farming returns fluctuate based on supply and demand. 

• Tokens earned as rewards may decrease in value before they can be claimed or sold.
• Some pools may offer attractive APYs temporarily, but rewards can decrease as more liquidity providers join.

Rug Pulls and Exit Scams

Rug pulls occur when developers create a new token, attract liquidity providers, and then drain the pool by selling off their holdings, making the token worthless.

 

Ways to Mitigate Risks in Yield Farming 

 

Assess Total Value Locked (TVL)

Total Value Locked (TVL) is a crucial metric that measures the total value of assets staked or locked in a DeFi protocol. A higher TVL often indicates a platform’s popularity and trustworthiness, as more funds are committed. However, a high TVL does not always guarantee security, so yield farmers should use it as a reference rather than a sole deciding factor.

Verify Security Audits

Security audits help identify vulnerabilities in a DeFi protocol’s smart contracts. While an audited protocol is generally safer, it does not eliminate risks entirely, especially when new features or upgrades are introduced. Investors should check whether a protocol has undergone independent security audits and monitor updates to ensure continued security.

 

Watch Out for Extremely High APRs

While high APRs can be attractive, they often signal high risk. Some protocols use inflated rewards to attract liquidity, only to later reduce yields or experience token devaluation. Investors should approach extremely high returns with caution and evaluate the protocol’s sustainability before committing funds.

 

Here is a comprehensive list of DeFi yield farming protocols spanning multiple blockchains.

Closing Thoughts 

Yield farming offers lucrative opportunities but comes with significant risks, including smart contract vulnerabilities, impermanent loss, and market volatility. To mitigate these risks, farmers should assess TVL, verify audits, and be cautious of overly high APRs. Success lies in staying informed, diversifying strategies, and managing risks effectively to maximize returns while protecting assets. 

 

‍‍[Author’s Note: This article does not represent financial advice, everything written here is strictly for educational and informational purposes. Please do your own research before investing.] ‍ 

 

Author: Godwin Okhaifo 

 

Also Read: Introduction to Liquidity Pools