A Beginner's Guide to DeFi Yield Farming

DeFi yield farming is becoming one of the most popular ways to earn passive income with cryptocurrency. At first glance, yield farming may seem like a risk-free investment strategy for users to put their tokens to work. Still, the rules change often, and there are numerous risks. Even so, the rewards are usually more than enough to incentivize people to stake their tokens.

How does DeFi yield farming work?

Yield farming projects allow users to lock their cryptocurrency tokens for a set period to earn rewards for their tokens. Yield farms use smart contracts to lock tokens and pay interest with rates from a few percentage points to triple-digits. In many cases, the locked tokens are lent out to other users. The users borrowing tokens pay interest on their crypto loans, and some of the proceeds go to the liquidity providers.

In other cases, the locked tokens provide the liquidity needed for the decentralized exchange to facilitate trading. This type of decentralized exchange often uses an automated market maker that needs locked tokens to fulfill buy and sell orders. In this case, the yield farmers earn passive income through transaction fees. In addition to trading fees, users often earn other liquidity incentives such as governance tokens and newly minted tokens.

DeFi platforms like Curve Finance allow users to yield farm numerous types of tokens on various blockchains such as Ethereum, Bitcoin, and Polygon. Curve utilizes a unique algorithm that only moves price when the loss is smaller than the profit. That allows it to create more liquidity than the average platform.

What are the risks?

On the surface, yield farming might seem like an easy way to profit from the crypto markets with your tokens. Still, yield farming isn’t without risk. There are numerous ways to lose money when yield farming. Understanding these risks in this relatively new form of decentralized finance is the first line of defense in protecting yourself.

Volatility

Newer digital assets with low liquidity often have extreme price fluctuations. Although volatility can be a good thing, it can also cause users to lose money. Since yield farm platforms often require users to lock their cryptocurrency tokens for a predetermined period, there is a chance the price will drop significantly before users can sell their tokens.

Impermanent loss

Impermanent loss is easiest to understand when looking at liquidity pools where users deposit two types of tokens. For example, if a user wants to support a liquidity pool that allows other users to trade ETH for HBAR, they’ll need to deposit both types of tokens.

When someone buys HBAR from this liquidity pool, they’re essentially depositing ETH into the pool and removing an amount of HBAR equivalent to the value of the deposited ETH. When this happens, it shifts the ratio of HBAR and ETH, so there is more ETH and less HBAR in the pool. This raises the value of HBAR and lowers the value of the ETH. Since the pool comprises funds deposited by various liquidity providers, it also shifts the ratio of tokens they have locked, leaving them with less of the token that increased in value. In many cases, this presents a situation in which the total value of their tokens would be greater if they had held their tokens.

Rug pulls

Rug pulls are a scam in which someone creates a new cryptocurrency token, promotes it to find buyers, and exits the project without returning funds to the buyers. In many cases, these scams involve people holding a large sum of the token and selling it into the liquidity pools, draining the provided liquidity and making the token worthless.

Liquidity pools drying up

Because various users worldwide supply liquidity, the amount of liquidity can change as people pull their tokens from the pool. Low liquidity leads to higher slippage, meaning people will receive less money than expected when selling their tokens into the pool. Many exchanges allow users to set slippage tolerances to limit low-liquidity risk. Still, there may be scenarios in which liquidity is low enough that users lose money when trying to exchange their tokens. Yield farming may increase the risk of low liquidity since the tokens have to be locked for a set period and can’t be sold.

Not being able to stay on top of shifting conditions and strategies

Yield farming payouts can change dramatically from day to day. In some cases, users may lock their tokens in a pool with a high payout, only to find the pool dropped the rewards later in the week. In the time it takes before users can unstake their tokens, other pools may increase their rewards, leading to situations in which the liquidity provider could have earned more if they had waited and deposited their funds in the new pool. Keeping up with the various pools’ rewards and developing a yield farming strategy can be a challenge.

How are returns calculated?

Return calculations vary depending on the platform. In some cases, the creator of the pool determines the annual percentage rate (APR) manually and can change it at any time. The protocol uses a smart contract to determine and alter the APR in other cases. Some protocols, such as Yearn Finance, look at various yield farming platforms to assess APRs and deposit tokens in the pool with the highest APR. In many cases, the liquidity provider also earns tokens from transaction fees, meaning pools with more trading volume pay more.

How do I get good returns?

Many DeFi protocols allow users to withdraw their tokens at the click of a button. However, there is usually a defined period for whicih funds must be locked before a withdrawal is possible. Because APRs vary from day to day, many users search for yield farms that only lock their funds for short periods so they can redeposit assets in a pool with higher earning potential.

Conclusion

Yield farming can be a lucrative way to earn passive income, although it isn’t risk-free. Hedera is committed to providing new avenues for developers to build decentralized applications that offer retail users the opportunity to yield farm. Stader Labs, a non-custodial liquid staking platform that enables staked assets to be used for lending, yield farming, and other opportunities has recently gone live on the Hedera network.

Hedera, an open-source public distributed ledger, uses the fast, fair, and secure hashgraph consensus. Its network services include EVM smart contracts, native tokenization, and a decentralized messaging service, called the Hedera Consensus Service, to build decentralized applications.