What Is Crypto Yield Farming?
Crypto yield farming is a carefully set up system allowing crypto holders to deposit their crypto into a pool for investment purposes. In other words, it’s an investment strategy of lending or staking your holdings into a liquidity pool through DeFi, hoping to reap the additional benefits of your investment.
Liquidity pools gather deposits from various users, who essentially borrow their money on a DeFi platform and earn interest or more crypto in return for their investment. Once borrowed, users’ crypto ends up locked into a decentralized app (dApp) for token rewards. That could be anything from a crypto wallet to a decentralized exchange.
In most cases, crypto holders rely on the decentralized exchange to borrow, stake, or lend the coins that will, in return, allow them to earn interest on that deposited or borrowed sum.
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Yield farms are DeFi tools relying on smart contracts. Unlike traditional finance systems, smart contracts allow us to erase the middleman, such as a centralized bank, from the picture. However, since yield farms rely on smart contracts, users always know the terms and conditions of their agreements.
Yes, smart contracts are excellent tools for preventing scams, but fraudulent crypto yield farms unfortunately still exist on the market. So, not only is crypto yield farming a risky investment due to market volatility but also because not all yield farming projects are credible. But more about that later.
Employing smart contracts allows anyone to contribute to a liquidity pool as long as they have a cryptocurrency wallet. That is both good and bad, but such is the beauty of decentralized ecosystems.
How Does Yield Farming Work?
We could compare liquidity pools to the standard savings account you’d typically open in your local bank. When savers make regular deposits, they earn interest, which is the bank’s way of saying thank you for letting us borrow your money to meet the needs of our other clients. Of course, that doesn’t mean you’re losing money from the account. It just means that the cold hard cash you deposit doesn’t sit in the vault but rather circulates and benefits the economy.
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However, decentralized systems work a bit differently than the standard, centralized ones. In this particular example, instead of using your deposited crypto to finance a client’s mortgage, cryptocurrency deposited into a yield farm is used to finance a smart contract app.
So, when crypto holders put their digital coins into a staking pool through a dApp lending protocol, their liquidity is in, meaning others can borrow said liquidity and use it to finance their own investments. That said, yield farms might hold your investments for a pre-arranged amount of time to keep the ecosystem alive and thriving. More importantly, your crypto might also be used as collateral, depending on the terms and conditions of your arrangement.
What Are Potential Yield Farming Rewards?
Yield farming usually rewards early investors the most. The most lucrative reward in this ecosystem is the governance token.
Now, governance tokens offer various privileges, such as giving the holders a say in managing the project. The more governance tokens you have in your possession, the more power you have to change the project’s trajectory. With that in mind, governance tokens are the bread and butter of every Decentralized Autonomous Organization (DAO) that operates under no influence of a central authority.
So, in a way, governance tokens also represent how much they’ve contributed to a liquidity pool. For example, let’s say you’ve invested around $1,000 into your liquidity pool. If the total investment or total pool’s worth is $10,000, you’d own 10% of that pool.
And then, of course, there’s interest. Crypto holders, or liquidity providers in this case, can earn a percentage of each transaction for investing in a liquidity pool.
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Depending on the project, some other rewards may be involved. More importantly, remember how I mentioned that early investors get governance tokens as a reward? Well, rewards will change depending on the reward protocols, hierarchy, and contribution to the pool.
Yield Farming Types
If you want to become a crypto yield farmer, you must first familiarize yourself with the yield farming types. So, here are your options:
- Lending: This yield farming type allows crypto holders to lend their assets to borrowers. This is done through smart contracts, and lenders earn yields from the interest borrowers pay on their loans.
- Borrowing: Borrowing in crypto yield farming refers to taking a loan of a coin by providing other tokens as collateral. This is a common yield farming method, as it allows farmers to keep their initial coins while farming yield on the coins they’ve borrowed. The value of both coins can increase over time, so you can imagine why this yield farming type is trendy.
- Staking: When we talk about staking crypto, we usually refer to taking part in validating blockchain transactions. When crypto holder stakes their coins, they initially put their crypto into a staking pool. The pool then earns rewards for solving complex mathematical problems and adding another block onto a chain. The prizes are split between staking pool contributors. However, staking is often applied in yield farming, too. Yield farmers who stake their crypto holdings pair their tokens with a platform, supplying it with liquidity. This allows them to earn extra income. That is because they earn rewards for supplying liquidity, but they can also stake those rewards to earn more yield.
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Pros and Cons of Crypto Yield Farming
Similarly to leverage in trading, crypto yield farming can be pretty lucrative. However, it’s a high-risk, high-reward opportunity to make money. Some say it’s as risky as leverage, but for different reasons. So, let’s see if dipping your toes into crypto yield farming is really worth it.
Some of the yield farming pros include:
- High interest rates: Investing in a yield farm could reward you with high interest rates. A yield farm could potentially earn you returns over 100% APY. Still, keep in mind that that’s not always the case. Still, even lower returns are profitable.
- Maintaining custody of lucrative assets: Yield farming allows you to keep all invested assets in your custody. Even if you have to keep them in a pool for a certain period of time, at the end of the day, they’re still yours to spend, sell, or borrow.
- Smart contracts: Smart contracts are both a blessing and a curse. While they allow anyone to join a farming pool, smart contract bugs can jeopardize all your holdings. Still, they are the foundation of decentralization, and they improve efficiency and transparency in a decentralized ecosystem.
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Crypto yield farming cons:
- Market volatility: When the crypto you put in a liquidity pool is staked or locked into the said pool for a specific timeframe, the value of those coins still follows the real-time market value. That said, if the price significantly drops, you wouldn’t be able to just take them out of the pool and sell them, meaning you could lose a lot more than you would receive by keeping your coins in a staking pool and earning interest. However, it’s also possible that you wouldn’t panic-sell those coins anyway, so it’s not necessarily a devastating outcome. Furthermore, if you’re considering crypto yield farming for saving purposes, keep in mind that you need to invest in a stable currency, preferably one that is pegged to the US dollar. Some crypto farms will offer you a 15% interest on Bitcoin, but if the BTC value crashes, so will your savings.
- Rug pulls: Rug pulls are crypto scams. In most cases, scammers sugarcoat the story about their projects only to attract investors and run off with their assets. However, a rug pull also occurs when developers abandon crypto projects without announcing the decision to the public. This prevents crypto holders from selling their assets before it’s too late. In this scenario, crypto holders would get to keep their coins or tokens, but those digital assets would be utterly worthless, so they wouldn’t get a chance to sell them and recoup their losses.
- Potential losses: If the coin value skyrockets and you can’t take it out of the staking pool, the interest you earn might not match the profit you could have made from selling the asset.
- Taxes: Crypto may not be a profitable investment after all, depending on the country you live in. For example, if crypto payments aren’t regulated in your country, you might have to pay taxes on your profits and the initial investment. Let’s say you invest $1,000 in crypto and make a $100 profit. When you exchange that crypto for fiat and transfer it to your bank account, your bank might disregard the fact that only $100 of that sum is your profit. The bank will have a record of an additional $1,100 to your name, and since crypto isn’t regulated, you wouldn’t be able to separate profits from your investments and therefore cut your taxes in half. In other words, your earnings may go down the drain.
Crypto Yield Farming Protocols to Consider
As mentioned earlier, many scammers profit from crypto yield farms, making it imperative to invest in credible projects that have been a part of the market for some time now.
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Some of the most popular and credible crypto yield farming protocols are:
- Coinbase– Coinbase is a good option because it’s a prominent and regulated broker.
- Uniswap– Uniswap is the largest decentralized exchange on Ethereum, and it’s one of the most popular platforms offering crypto yield farming.
- DeFi Kingdoms: It’s a game, a liquidity pool, and a decentralized exchange, all in one.
- MELD– MELD is a new startup project on the Cardano network. According to the founders, it’s the first DeFi, non-custodial banking protocol.
Now that you know what it is, is crypto yield farming worth the time and effort?
While it can be profitable, crypto yield farming poses certain risks. If you aren’t comfortable with taking those risks, it’s always best to move on and find another project that will allow you to stay in your comfort zone.
