What is Yield Farming: Risks and Strategies Explained

Key takeaways

• In yield farming, token holders lock their crypto assets in smart contracts of DeFi protocols.
• In return, they may receive more tokens as rewards, a regular passive income, or a share of transaction fees.
• Some yield farming strategies include lending, staking, providing liquidity, compounded yields, and others.
• Although yield farming sounds attractive for a passive income, it also brings along a few risks.

In decentralised finance (DeFi), yield farming is a commonly used strategy for traders to derive returns from their crypto holdings. These returns, termed ‘yields’, have often grown to very high levels but also carry some quantum of risks. Various DeFi protocols, operating as yield farms, offer multiple yield farming strategies that can be indulged into. 

The DeFi protocol Compound was instrumental in promoting yield farming after its advent in 2020. The platform’s governance tokens, $COMP, were offered as rewards to those who participated in its marketplace activities of lending and borrowing on the Ethereum blockchain. Over the years, yield farming has evolved, with several protocols associated with it. In this blog, we will dig into the concept, and explain its various strategies, potential, and risks.

In decentralised finance (DeFi), yield farming is a commonly used strategy for traders to derive returns from their crypto holdings. These returns, termed ‘yields’, have often grown to very high levels but also carry some quantum of risks. Various DeFi protocols, operating as yield farms, offer multiple yield farming strategies that can be indulged into.

The DeFi protocol Compound was instrumental in promoting yield farming after its advent in 2020. The platform’s governance tokens, $COMP, were offered as rewards to those who participated in its marketplace activities of lending and borrowing on the Ethereum blockchain.

Over the years, yield farming has evolved, with several protocols associated with it. In this blog, we will dig into the concept, and explain its various strategies, potential, and risks.

What is yield farming?

The term ‘yield farming’ became prominent in 2020, with the surging popularity of decentralised finance in that year. As we mentioned, a few DeFi platforms, such as Compound, had significant roles to play in shaping the DeFi sector and attracting new users to yield farming. 

The core concept behind yield farming involves depositing one’s crypto holdings in a protocol and thereby receiving regular percentage returns from it. There are various strategies like lending and staking that can be used by yield farmers to maximise returns.

Yield farming is primarily common in liquid staking protocols, decentralised exchanges (DEXs), and money markets in DeFi. Liquid staking protocols like Lido Finance and DEXs like PancakeSwap are notable yield farms. But how do these platforms facilitate yield farming? We’ll go through that in the next section.

How does yield farming work?

Yield farms enable users to lock their crypto assets for a certain period in return for rewards in the form of APY (Annual Percentage Yield). This is done in a decentralised manner with the help of smart contracts, which facilitate the locked assets for lending, liquidity, or other purposes. In theory, since smart contracts remove the requirement for an intermediary in these financial services, decentralised finance has the potential to exponentially improve efficiency.

DeFi protocols serving as yield farms usually enable the peer-to-peer interactions between protocol users and yield farmers. The locked assets of yield farmers help in the smooth conduct of operations like token swapping or leverage trading, where liquidity is essential.

Yield farmers are rewarded in various ways. It can be in the form of regular interest payments from their locked assets, a share of transaction fees of the DeFi protocols, or even through governance tokens. For example, Curve Finance is a DeFi protocol that allows yield farming on various blockchains and rewards yield farmers with a share of trading fees from swaps.

Yield farming strategies

Here are some strategies that can be applied:

• Lending: This strategy involves lending crypto holdings to others through the smart contract of a DeFi lending protocol. The yield is derived from the interest paid for the borrowed crypto holdings. Protocols like Aave use this strategy.
• Staking: The procedure of locking one's crypto assets in a blockchain network to secure its operations is known as staking. Blockchain protocols, like Figment and Lido.fi, may offer a regular yield for staking the assets. This is prominent in proof-of-stake blockchains, which usually offer a yield on the staked assets.
• Provision for liquidity: This strategy is common for decentralised exchanges and lending borrowing protocols like Uniswap and PancakeSwap, where yield farmers deposit their tokens to provide liquidity. They receive a share of the exchange's transaction fees in return.
• Due diligence: Yield farming returns can also be maximised with the required research and due diligence of a particular yield farm. Tokenomics, security, and governance are some of the important factors that can help choose the best yield farms and reduce the risks of yield farming.
• Reinvesting rewards: Yield farmers can also earn compounded yields by adding their yields to the already staked or lent assets and, as a result, maximising their future yields.
• Optimise capital efficiency: Capital efficiency can be used by yield farms that offer attractive yield rates and better risk management strategies. Metrics like transaction fees, liquidity pools, and trading volumes are important here.
• EigenLayer restaking: The EigenLayer protocol has established the concept of restaking. This strategy allows already staked ETH and liquid stake ether from other protocols to be restaked, leading to additional yields.

Risks of yield farming

There can be a few risks of yield farming, which are listed below:

• Rug pulls: Rug pulls are a kind of scam in the crypto sector, which commonly occurs in liquidity pools. After yield farmers deposit their holdings in a particular liquidity pool, a rug puller with a majority stake in the pool may dump their holdings and abandon them, which could lead to massive value erosion for the yield farmers. For example, yield farming a coin worth $10, with 25% APY and a locking period of 3 months, will be of no use if its price falls by 90% within that period.
• Volatility: Massive volatility in the crypto market, leading to frequent price swings in crypto tokens, could also affect yield farming in a negative way.
• Flash loans: DeFi protocols are extremely vulnerable to uncollateralised loans called flash loans, where scammers might use the borrowed funds to manipulate token prices or simply steal the money from the protocol.
• Cyber attacks: When crypto tokens are locked in a DeFi protocol, they may be susceptible to cyber-attacks. These cyber attackers may steal the locked assets from a smart contract.
• Regulatory risks: Since DeFi protocols are decentralised, they could be subject to frequent regulatory policy changes or new laws. Hence, these regulatory risks are constant in yield farming. Countries are also amidst continuous deliberations on DeFi regulations. For instance, in 2023, a Senate Bill in the US aimed to regulate the industry.
• Scam tokens: Fake tokens or DeFi protocols promising more utility or yields to holders are also one of the most common risks.

Yield farming: the future potential

As this blog pointed out, yield farming is a great way of maximising returns in crypto, provided the underlying crypto is fundamentally strong and is supported by sound tokenomics. One needs to remain careful of token inflation since crypto tokens promising high yields often inflate their supply very quickly, resulting in extreme drops in prices. 

Yield farming on tokens such as Ethereum, Bitcoin, or stablecoins is much more sound and promising than on new tokens. In the case of newer tokens, it is not advisable to lock your collateral for long periods of time, such as six months or more. Once key risk mitigation methods evolve with the growth of this sector, it can become a widely used growth option for crypto holders!

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