Yield Farming 101

Yield farming is crypto-speak referring to allocation of capital to DeFi protocols in return of yield, analogous to investing in traditional interest/yield-bearing capital market products like bonds and dividend-yielding stocks, with some key differences.

Yield Farming 101
Photo by Raphael Rychetsky / Unsplash

Introduction: Yield farming vs traditional capital market products

  • Definition: Yield farming is crypto-speak referring to allocation of capital to DeFi protocols in return of yield, analogous to investing in traditional interest/yield-bearing capital market products like bonds and dividend-yielding stocks, with some key differences
  • Yield farming is decentralized i.e. there are no banks / other intermediaries involved which means the yield earned accruing to the lenders (you!), 100% belongs to you (minus very small amount of protocol fees). Yield farms are executed 100% by smart contract, requiring very little action from lenders and borrowers other than entering and exiting a farm
  • Yield farms are executed on Web3.0, in which individuals are responsible for their own private keys, and are free to interact with whatever protocol they wish, can participate on either side of liquidity pool e.g. you can be the person who swap tokens, or be the liquidity provider, the lender / the borrower or even both
  • Protocols that facilitate yield farming are typically non-custodial which means the assets that are invested in the farms do not actually go to the protocol itself, but instead it goes to the smart contract wallet. Unlike banks, the protocol could not repurpose the funds into some other use case, unless specified by the smart contract
  • The content of the smart contract is public and can be reviewed by anyone. Reputable protocols usually have their smart contract audited for security and vulnerabilities

Different types of Yield Farming

There are some different ways in which you could yield farm, such as follows:

  1. Liquidity Provider pool for Automated Market Maker (”AMM”) pools: AMMs are decentralized exchange without any orderbook as assets inside AMM are priced in terms of the reserves of one another. For example, 100 $ETH and 1000 $ACYC means that 1 $ACYC is priced at 0.1 $ETH, but when there are changes in reserves for example 200 $ETH and 900 $ACYC, 1 $ACYC’s price is now changed to 0.22 $ETH). Prices are calculated depending on the AMM model which is outside of the scope of the article, but due to the potential slippage, AMMs require considerable liquidity on either side to operate optimally. You can earn the portion of fees that traders pay when they use AMM by acting as the Liquidity Provider (”LP”) of the AMM pool. The fees may range from 0.30% — 1.0% per transaction depending on the assets and the protocol. Note that in most pools (Uniswap in Ethereum and PancakeSwap in BSC, for example), the transaction fees that are levied are added back into the pool, and when you remove the liquidity to redeem your investments, you will be entitled to proportionate amount of the fees accumulated by the pool. As such, your rewards are also denominated in the assets that you provide the initial LP in e.g. for USDT/USDC pool, the rewards are also denominated in USDT and USDC
  2. Stake farms: Stake farms typically accept single asset deposits in return of some yield. The use of proceeds from the staked assets can range from facilitating collateralized or non-collateralized borrowing, to treasury management, as incentives for holding an asset, and others. Unlike LP for AMMs, your deposit may or may not be locked depending on the protocol. If it’s locked, typically you will receive an LP token which represents your proof of ownership of the pool — but this may not be the same with all protocols (for example, staking $SUSHI in SushiSwap will provide you with the LP token $xSUSHI, staking $TIME in Wonderland rewards you with LP token $MEMO). The LP token usually trades at a slight discount vs the asset being staked, but it functions as your exit liquidity in the event of emergency / if you need to liquidate ahead of the unlock date. In some other cases, you may also stake your LP token to amplify the returns of your asset. Stake farms typically reward its stakers with the asset itself, although it may vary on case-by-case basis.
  3. Insurance farms: This is not very common, but it does exist. Insurance farms typically accept single-asset deposit, and its use of proceeds would be to pay claims to insurance buyer / claimants white it continues to accumulate premiums from them. While you may be required to deposit stablecoins or some other currency, the rewards may be in form of the native protocol token itself. For example, providing $LUSD into the Liquity Stability Pool will reward you with $LQTY tokens instead of the LUSD stablecoin itself. It is important to take note of which currency your rewards will be denominated in before making any investment decisions
  4. Others: There are other varieties of yield farms which may be the variation of the above-mentioned types of yield farms, with varying use of proceeds, mechanism and risk-return profile

What is Liquidity Mining?

  • Note that some protocols will also offer Liquidity Mining (”LM”) program which is designed to quickly bootstrap liquidity by rewarding stakers and LPs with extra incentives
  • LM refers to the practice of providing additional rewards to stakers and LP in form of native currency of a certain protocol, in return of their “business” interacting with the protocol, either as LP or as traders, arbitrageurs, borrowers, or others. For example, Compound firstly offers the LM program by rewarding $COMP tokens to its users, a strategy that was replicated by Sushiswap with $SUSHI
  • Most native tokens allow users to share in the protocols’ fees and it also usually carry some governance / voting power in relation to the protocol itself. Native tokens can usually be staked for governance rights (usually denoted by “ve”, or short for “voting escrow”). Some native tokens also must be staked for a period of time to be whitelisted to receive a share of the protocol fees, or to receive rebasing
  • It has a lot of variety and it’s important to be aware of the various utility of native tokens. Note that APYs for liquidity mining can be very high, but it is important to understand that the APYs are calculated in terms of the native token, not in terms of its dollar value. Value of native tokens can be very fluctuative as it may be highly inflationary depending on its rate of emissions