Yield farming is the practice of staking or lending crypto assets in order to generate high returns or rewards in the form of additional cryptocurrency. This innovative yet risky and volatile application of decentralized finance (DeFi) has skyrocketed in popularity recently thanks to further innovations like liquidity mining. Yield farming is currently the biggest growth driver of the still-nascent DeFi sector, helping it to balloon from a market cap of $500 million to $10 billion in 2020.
In short, yield farming protocols incentivize liquidity providers (LP) to stake or lock up their crypto assets in a smart contract-based liquidity pool. These incentives can be a percentage of transaction fees, interest from lenders or a governance token (see liquidity mining below). These returns are expressed as an annual percentage yield (APY). As more investors add funds to the related liquidity pool, the value of the issued returns rise in value.
At first, most yield farmers staked well-known stablecoins USDT, DAI and USDC. However, the most popular DeFi protocols now operate on the Ethereum network and offer governance tokens for so-called liquidity mining.
Liquidity mining occurs when a yield farming participant earns token rewards as additional compensation, and came to prominence after Compound started issuing the skyrocketing COMP, its governance token, to its platform users.
The Seven Most Popular Yield Farming Protocols
Yield farmers will often use a variety of different DeFi platforms to optimize the returns on their staked funds. These platforms offer variations of incentivized lending and borrowing from liquidity pools. Here are seven of the most popular yield farming protocols:
1. Compound is a money market for lending and borrowing assets, where algorithmically adjusted compound interest as well the governance token COMP can be earned.
2. MakerDAO is a decentralized credit pioneer that lets users lock crypto as collateral assets to borrow DAI, a USD-pegged stablecoin. Interest is paid in the form of a “stability fee.”
3. Aave is a decentralized lending and borrowing protocol to create money markets, where users can borrow assets and earn compound interest for lending in the form of the AAVE (previously LEND) token. Aave is also known for facilitating flash loans and credit delegation, where loans can be issued to borrowers without collateral.
4. Uniswap is a hugely popular decentralized exchange (DEX) and automated market maker (AMM) that enables users to swap almost any ERC20 token pair without intermediaries. Liquidity providers must stake both sides of the liquidity pool in a 50/50 ratio, and in return earn a proportion of transaction fees as well as the UNI governance token.
5. Balancer is a liquidity protocol that distinguishes itself through flexible staking. It doesn’t require lenders to add liquidity equally to both pools. Instead, liquidity providers can create customized liquidity pools with varying token ratios.
6. Synthetix is a derivatives liquidity protocol that allows users to create synthetic crypto assets through the use of oracles for almost any traditional finance asset that can deliver reliable pricing data.
7. Yearn.finance is an automated decentralized aggregation protocol that allows yield farmers to use various lending protocols like Aave and Compound for the highest yield. Yearn.finance algorithmically seeks the most profitable yield farming services and uses rebasing to maximize their profit. Yearn.finance made waves in 2020 when its governance token YFI climbed to over $40,000 in value at one stage.
The Risks of Yield Farming
Yield farming can be incredibly complex and carries significant financial risk for both borrowers and lenders. It is usually subject to high Ethereum gas fees, and only worthwhile if thousands of dollars are provided as capital. Users also run further risks of impermanent loss and price slippage when markets are volatile. CoinMarketCap has a yield farming ranking page, which an impermanent loss calculator, to help you discover your risks.
Most notably though, yield farming is susceptible to hacks and fraud due to possible vulnerabilities in the protocols’ smart contracts. These coding bugs can happen due to the fierce competition between protocols, where time is of the essence and new contracts and features are often unaudited or even copied from predecessors or competitors.
Examples of vulnerabilities that resulted in severe financial losses include the Yam protocol (which raised over $400m in days before a critical bug was exposed) and Harvest.Finance, which in October 2020 lost over $20 million in a liquidity hack.
DeFi protocols are permissionless and dependent on several applications in order to function seamlessly. If any of these underlying applications are exploited or don’t work as intended, it may impact this whole ecosystem of applications and result in the permanent loss of investor funds.
There has been a rise in risky protocols that issue so-called meme tokens with names based on animals and fruit, offering APY returns in the thousands. It is advised to tread carefully with these protocols, as their code is largely unaudited and returns are whim to risks of sudden liquidation due to price volatility. Many of these liquidity pools are convoluted scams which result in “rug pulling,” where the developers withdraw all liquidity from the pool and abscond with funds.
As blockchain is immutable by nature, most often DeFi losses are permanent and cannot be undone. It is therefore advised that users really familiarize themselves with the risks of yield farming and conduct their own research.