What is yield farming?

Yield farming, which is sometimes referred to as liquidity staking, is a way to earn interest on your cryptocurrency assets in much the same way you might earn interest on conventional cash that’s just  sitting in a savings account. It lets you put your cryptocurrency tokens to work in the hope that they earn a profit (more crypto tokens) while you’re holding them.

Yield farming, which usually requires users to “lock” tokens into a liquidity pool, comes with a greater risk than standard staking, in which tokens are used to validate cryptocurrency transactions using the proof-of-stake (PoS) consensus method. But to make up for the increased risk, yield farming offers greater rewards, which is what makes it so attractive.

In this AAG Academy guide, we’ll teach you all you need to know about yield farming before you start contributing your own cryptocurrency tokens, including all the benefits and risks — and we’ll look at why yield farming is so important to the cryptocurrency industry.

If you’ve invested in a promising cryptocurrency project that looks set to carry out all of its promises, holding onto your tokens for a prolonged period of time is one way to increase your chances of earning a profit. But what if those tokens could earn you even more tokens, instead of just sitting in your wallet, doing nothing? That’s where yield farming comes in.

Yield farming gives investors the opportunity to increase the number of tokens they hold, simply by putting their existing tokens to work. One of the most common ways to do this is with a process called liquidity staking, but there are other yield farming methods available — such as lending tokens to borrowers, and even playing play-to-earn games.

How does yield farming work?

No matter which yield farming method you choose, the farming process is similar. You start by putting your tokens into whatever farming method you’ve chosen, and then leaving them there for a period of time so that they can generate interest — usually in the form of more tokens — or other rewards. It’s important to bear in mind, however, that a return is not guaranteed.

Every yield farming method has its risks, and those with the highest returns rates tend to be the riskiest. When investing into a liquidity pool, for instance, there is a possibility that you will eventually get back more than you invested, but there’s also a possibility you will get back fewer tokens, depending on what each token is worth when you withdraw your stake.

You might choose to offer your tokens to cryptocurrency borrowers through a DeFi lending platform. In this scenario, the lender pays interest on their loan repayments, so you should end up with more tokens once the loan has been repaid. However, there is a risk that the borrower won’t pay back their loan at all, in which case, your tokens will be lost.

Yield farming through play-to-earn games is one of the least riskiest methods — and one of the most fun! — but, as you might expect, the potential returns aren’t as high. In this scenario, you start by investing cryptocurrency tokens into in-game assets or to access certain features, and then complete missions, challenges, or quests in an effort to earn rewards.

You might be interested in: Things to look for before investing in crypto assets

What are the benefits of yield farming?

Like putting your spare cash into a savings account, one of the biggest benefits of yield farming is that you have the potential to earn interest and rewards on the cryptocurrency tokens you already own. If you leave them sitting in your wallet, they may rise in value, but the number of tokens you hold stays the same. Yield farming gives you a chance to increase that number, as long as you’re aware of and willing to accept that there are risks.

Some liquidity farming systems also give you governance rights when you contribute your tokens. This allows you to have a say in the project’s future. Those with governance rights get to vote on development and operations decisions. In most cases, the more tokens you contribute, the more power you have, though most projects put a limit on this to prevent the possibility of a single user, or a small number of users, from having too much power.

What are the risks of yield farming?

As we touched upon earlier, there are risks associated with yield farming, and you should be aware of these before you start contributing your cryptocurrency tokens. Here are some of the most common risks to take into consideration:

Composability risks
Composability risks aren’t exclusive to the cryptocurrency industry. Every time you trust a third party with your money, you have to accept that there are composability risks of some kind. For instance, it’s possible (albeit unlikely), that a company like PayPal could be hacked or go bust, and any money sitting in your account could be difficult to recover. Even banks can go bust.

When you start yield farming, you must accept that similar risks are involved. However unlikely it may be, it’s not implausible that a blockchain could suffer an attack, that a bug in a smart contract’s code could cause catastrophic failures, or that other serious issues could occur. In any of these scenarios, losses are a possibility.

Impermanent loss
Impermanent loss is perhaps the biggest concern in yield farming since it is so common. This is when the tokens you’ve contributed to a liquidity pool change in value compared to how much they were worth when you first deposited them. The more significant the change, the more you could lose when it’s time to withdraw your stake.

Rug pulls
We have another AAG Academy guide that looks at rug pulls in-depth, so we won’t go into too much detail here, but in a nutshell, a rug pull is what happens when a project’s creators take all the funds from a liquidity pool and leave investors with nothing but a pile of tokens that are now worthless. When this happens, anything you’ve contributed to the project is lost.

You might be interested in: Rug pull in the crypto world and how to avoid it

What yield farming protocols are there?

There are lots of yield farming protocols to choose from in the cryptocurrency industry today. Some of the biggest and most popular ones are:

• PancakeSwap
• Uniswap
• SushiSwap
• Aave
• Curve
• Yearn Finance

References

• Yield farming vs staking vs liquidity mining
• Staking vs yield farming vs liquidity mining
• Impermanent loss explained
• Yield farming