What is Yield Farming? How Does It Work?

Written by Steven WhiteUpdated: 21st Sep 2021
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During DeFi summer, yield farming was an incredibly active topic. People all over the world began staking their own assets in DeFi pools, bringing the total value of locked liquidity pools up to record highs.

This was unexpected, but more than welcome. Today, DeFi users are still staking and lending crypto assets to earn returns and rewards.

However, if you’ve never heard of DeFi summer or even yield farming, you’re probably asking yourself “what is yield farming and how does it work?”

What is Yield Farming?

Yield farming involves staking or lending crypto assets in order to generate profitable returns. It is an innovative application of decentralized finance (DeFi) that has become incredibly popular due to recent innovations.

For instance, yield farmers can rely on unique protocols to perform tasks like liquidity mining.

Liquidity mining is similar to yield farming, except liquidity miners are rewarded with fee revenue and the platform’s governance token.

How Does Yield Farming Work?

Yield farming protocols provide liquidity providers (LP) with the opportunity to stake their crypto assets in a liquidity pool that is operated using smart contracts.

The incentive for doing so is typically a percentage of any transaction fees that were processed. However, interest from lenders and governance tokens are also forms of compensation that you can earn through yield farming.

While yield farming can bring high returns rather quickly, it is important that you understand that issued return values will decrease as more investors add funds to the liquidity pool. Therefore, it often makes sense to focus on investment opportunities that are not too crowded.

What Started the Yield Farming Boom?

Modern innovations in the decentralized finance space allowed yield farming to grow as an effective means of earning passive income using cryptocurrencies.

As people began to understand how to navigate and leverage DeFi protocols, yield farming grew in popularity.

Today, we’re seeing more people yield farming than ever, and the market cap for the DeFi ecosystem has made it into the tens of billions.

Understanding Total Value Locked (TVL)

If you’ve taken an interest in yield farming, you’ve probably seen the term Total Value Locked (TVL) being used frequently. If you don’t know what TVL means, here is the answer.

TVL is essentially the amount of value that has currently been staked in any given protocol. That means, if there is a group of users investing in a protocol, the TVL will be equal to the total value of assets that are currently pooled in that protocol.

This information can be used to develop a better sense of the overall health of DeFi protocols and yield farming markets.

Many services allow users to track TVL, but it takes knowledge to effectively leverage the information provided through the TVL.

You need to consider a DeFi service’s market cap TVL ratio too, which requires calculating the supply, maximum supply, and current price.

By multiplying the circulating supply by the current price, you can find the current market cap. Divide that number by the TVL of the service, and you have the TVL ratio.

This information can be helpful when determining if a DeFi asset is currently undervalued or overvalued. Typically, if the ratio is under 1, the DeFi asset is likely to be undervalued.

As yield farming has grown into a booming industry, there have been many efforts to create protocols that have high returns and plentiful options for users. These are some of the most popular yield farming protocols to date.

Aave

This decentralized lending and borrowing protocol is used to create money markets, which allow users to borrow assets and earn compound interest over time.

The protocol is open source and non-custodial, meaning you have more control over transactions.

Aave has grown to have the highest TVL out of all DeFi protocols. As of August 2021, its TVL was more than $21 billion. This is likely because it is possible to earn as much as a 15% APR by lending on Aave.

Compound

Through Compound, you can lend and borrow assets. The protocol has an algorithmically adjusted compound interest rate, so passive income is possible.

You can also earn the governance token; COMP. Audits are performed regularly to ensure that the protocol and it’s governance tokens are entirely secure.

As of August 2021, the total supply of COMP has surpassed $16 billion. With this protocol, you can expect APY ranging from 0.21% to 3%.

Curve Finance

Curve Finance is the first decentralized exchange that we’ve featured in this list. Users and other decentralized protocols can exchange stablecoins using this exchange, allowing them to earn interest and income.

Curve Finance is the largest decentralized exchange as of August 2021. Their TVL is quite large, sitting at $9.7 billion locked.

People like using Curve Finance because stablecoins are generally safe, and rewards APYs can exceed 40% at times.

Uniswap

This massively popular protocol is a decentralized exchange and Automated Market Maker (AMM).

Through it, users can swap nearly any ERC 20 token pair without using any intermediaries. On this protocol, any liquidity providers who choose to get involved will need to stake both sides of the pool at a 50/50 ratio.

By doing so, they put themselves in position to earn returns in the form of a proportion of transaction fees and governance token rewards. The TVL for Uniswap is $5 billion as of August 2021.

Instadapp

Through Instadapp, users can develop DeFi infrastructure and build their own DeFi portfolio. As of August 2021, this protocol had more than $9.4 billion TVL. This is likely due to the flexibility and functionality of the protocol.

SushiSwap

Uniswap forked and caused a wave of users to engage in the liquidity migration process.

Today, SushiSwap has become a DeFi ecosystem, automated market maker, and lending and leverage market.

Decentralized apps have also been created on-chain, making this protocol a very unique option for DeFi enthusiasts. As of August 2021, the TVL of SushiSwap sits at $3.55 billion.

PancakeSwap

PancakeSwap is built on the Binance Smart Chain network, which allows for swapping of BEP20 tokens.

The protocol has an automated market maker model that allows users to trade against a liquidity pool.

Of all Binance Smart Chain protocols, PancakeSwap has the highest TVL. As of August 2021, the TVL was $4.9 billion locked. APYs can go extremely high with this protocol. In some instances, they have surpassed 400%.

Venus Protocol

Another protocol that is hosted on the Binance Smart Chain network. Using their algorithmic money market system, users can supply collateral to the network and earn interest for their investments.

Borrowers pay interest on these transactions, making it possible for yield farmers to earn income over time.

Venus protocol can also be used to mint synthetic stablecoins through over-collateralized positions. The TVl of Venus is $3.3 billion as of August 2021.

Balancer

Balancer offers flexible staking through its unique liquidity protocol. Lenders don’t need to add their liquidity to both sides of the pool equally.

Rather, they can create custom liquidity pools that have variable ratios. Currently, there is $1.8 billion locked in this protocol.

Yearn.Finance

This protocol is actually a decentralized aggregation protocol. It allows yield farmers to use a variety of lending protocols, such as Aave or Compound, to earn the highest possible yield.

Using algorithms, Yearn.finance seeks the most profitable yield farming services. Then, the protocol rebases to maximize profits for the user.

Through yearn, you can earn as much as 80% APY and the protocol currently has a TVL of $3.4 billion.

Yield Farming: Understanding Liquidity Pools

Liquidity pools are an essential component of the DeFi ecosystem. This is what you need to know about liquidity pools, liquidity providers, and related aspects of yield farming practices.

Liquidity Pool

When investors all pool their funds into a locked smart contract, they are creating a liquidity pool.

Through liquidity pools, DeFi users can perform decentralized trading tasks, lend assets to others, and more.

Liquidity Provider

Liquidity providers are users who add an equal value of two tokens in a pool. This creates a market, allowing others to perform transactions.

The liquidity provider typically has some incentive for staking their assets, such as a percentage of trading fees from transactions that occurred within the pool.

Automated Market Maker Model (AMM)

Traditional financial infrastructure relies on buyers and sellers actively performing transactions within a market.

The Automated Market Makers allow the DeFi system to remain liquid at all times. They work automatically and are normally permissionless.

The users supply the pool with tokens, then those tokens are priced based on an algorithm. The pools can be optimized depending on their purpose, making AMMs an incredibly useful tool for yield farming.

How to Calculate Yield Farming Returns

In most cases, yield farming returns are calculated annualized. Therefore, the estimate would refer to the number of returns that could be earned over the course of an entire year. APR and APY are common metrics used to this end.

APR doesn’t take into account the effect of compounding, but APY does. Though, you should be aware that APR and APY are sometimes used interchangeably.

Generally, you shouldn’t count too heavily on yield farming return calculations. They are just estimates, and the yield farming market is highly competitive.

Understand that some strategies only work for a limited amount of time. As one method grows in popularity, others will jump on it, making it less effective over time.

Bitcoin Yield Farming: Is It Possible?

Yield farming is not an option on the Bitcoinblockchain. This is because Bitcoin does not have the infrastructure necessary to host DeFi protocols. If you are interested in yield farming, protocols on the Ethereum chain are ideal.

However, some projects can “wrap” bitcoin and bring it onto the Ethereum blockchain in the form of wBTC.

What Are the Risks of Yield Farming?

Yield farming isn’t all sunshine and rainbows. There are also some risks associated with engaging in yield farming.

For example, when there is significant congestion on a chain, you may be required to pay much higher ETH gas fees.

Another issue is that ETH sometimes crashes. When this occurs, farming rewards may lose value quickly.

The foremost issue with yield farming is the fact that some people try to launch scams. When you engage in yield farming, make sure you are working with a trusted protocol.

You never want to end up staking your ETH for overvalued governance tokens that won’t be supported for long.

Is Yield Farming Safe?

While yield farming is risky at times, it is relatively safe. The security elements of most DeFi protocols ensures that users won’t have to give up private or personal information when engaging in transactions.

Yield Farming vs. Staking

Yield farming is the act of staking your assets in a liquidity pool. Staking means to invest assets into something. In the world of yield farming, you stake crypto assets in order to earn a reasonable return.

Staking plays a crucial component in the Solana ecosystem.

Bottom Line: What Is Yield Farming?

Yield farming is an exciting new opportunity to earn passive income. There are millions of people engaging in the practice currently, and as the finance industry moves more toward DeFi, we will likely see growth in the sector.

If you aren’t sure about whether yield farming is entirely safe and secure, you shouldn’t be overly concerned.

As long as you are cautious about which protocols you do business with you should have a positive experience.

Steven White
Steven White

Steven White is a SimpleMoneyLyfe authority on Cryptocurrency. He started his writing career producing content for higher education institutions. Steven worked frequently on content that was intended to encourage finance students to pursue Master’s level education. After moving on from that position, he has also held editorial roles for online cryptocurrency publications, like The Daily Hodl. Steven’s area of expertise is bitcoin, cryptocurrency, and financial technology.