What is yield farming and how they are the best passive income strategy?
Now that we know what’s DeFi and how liquidity pools work, let’s see what is yield farming and how people earn massive APRs (as much as 1000%)
Let’s see what is yield farming in laymen's terms! In centralized finance, we have an option to deposit gold or FIAT currency and earn rewards and interest on it. In DeFi, one can stake or provide liquidity and earn rewards on their investment. There are various projects and platforms that allow users to deposit tokens and let them earn high APRs or platform-native tokens or airdrops as well. Airdrops are considered as rewards while earning more tokens falls under yield farming. As we saw in the previous article, people deposit their tokens into liquidity pools, and in return, they are awarded governance tokens and a certain percentage of interest for locking their tokens and providing liquidity for others to trade. This whole process of depositing tokens into AMMs or DExs to earn interest is called yield farming.
Now, let us take an example for a better understanding. Tomb finance is one of the most recent decentralized platforms that gained massive attention for its unbelievably high APR which was as much as 1200% at a point in time. As tomb finance is built on the Fantom chain, people who hold Fantom tokens can provide liquidity into liquidity pairs of $Tomb-$FTM. We had learned why there has to be a pair of tokens while providing liquidity in the previous article. Based on the APR, people are rewarded with a percentage yield (interest). The percentage of returns is dynamic and keeps changing based on the TVL and the total value of tokens staked in the pool. People can withdraw their yield farming rewards into their wallets like metamask. We’ll learn about the distribution of yield rewards in the upcoming articles.
Note: Yield farming is generally done on DeFi platforms whereas staking requires the users to lock their tokens for a certain minimum amount of time to protocols that tend to support a bockchain for network activities.
If a platform is providing such high returns then why is everyone not staking/depositing their tokens for high returns?
The phrase “High return, high rewards” is very popular in the crypto space.
Yield farming has very high returns but it also has very high risks and that is why people do their own research and deposit only so much into these yield farms as much as they can afford to lose. Though losses have happened in the past, people have now started to place more trust in these yield farms because of the great developer team and the solution and security that the platforms provide.
Let’s see what are the different types of risks associated with yield farming.
- Impermanent loss
- Rug pull
- Bugs and Attacks
- Volatility
What is impermanent loss?
Let’s take a scenario to understand the concept of impermanent loss. Say, you are a liquidity provider and you have deposited a few XYZ tokens into a liquidity pool. Let us assume that the cost of these XYZ tokens while depositing in the pool is $1. Now, when you withdraw these tokens back to your wallet, there are 2 possible scenarios,
- The cost of XYZ token is higher than $1.
- The cost of XYZ token is lower than $1.
Irrespective of how many rewards and yield you earn from staking/providing liquidity,
if the price of a token while withdrawing it from the liquidity pool is less than the price of that very token while depositing it in the pool then it is called an impermanent loss.
Even if your rewards/yield add up to be more than your initial investment, your initial principle is depreciated which is a loss. This is one of the major risks with high yield liquidity pools, especially if the price of the token fluctuates a lot and you plan to provide for a shorter time frame.
What is a Rug pull?
This is the most common kind of risk that happens in the crypto space and it isn’t just limited to liquidity pools but also to other DApps and NFT projects.
A rug pull scenario: Say you promise your friend to pay him high interest if he lends you money. You make these promises very frequently and borrow money from him over and over again and then one day you finally decide to just leave the city/state and relocate to someplace where your friend cannot find you. You are the rug puller here and your friend just got rug-pulled. As the borrow/lending isn't actually official and completely based on “trust”, no official entity can help the one who just got scammed because of their actions.
This is what happens in the crypto space as well. There are tons of new projects and DApps that are being developed every day. It is the sole responsibility of an individual to find a reliable and trustworthy project to invest in. If the project team decides to collect tokens from individuals and then later just decides to close the project completely then it is called a rug pull resulting in a loss for individuals depositing their tokens into that project.
Bugs and Attacks?
Of course! there is always the risk of a bug in the code written for the Automated Market Maker/smart contract written for the liquidity pool. This might result in people leveraging the loophole and exploiting the funds available to take away. On the other hand, there is always a fear of an attack from a hacker to steal the funds from the liquidity pools. Even though the protocols/DApps are trying their best to make everything highly secure, the risk of attack from hackers is everpresent.
The volatility of the token price
Some projects/protocols require the tokens from users to be locked into the protocol for a defined period of time. Until this time period is not over, one cannot withdraw their tokens. Meanwhile, when your tokens are locked into a liquidity pool and the price of the token is extremely volatile and is possibly crashing to a very low price or even $0, you cannot remove your tokens and sell them to avoid even more loss. On the other hand, if the price of the token has increased exponentially and you believe that the price is about to go down, you will not be able to sell your tokens and take profits. This is one of the risks related to locked staking.
Having all these points in mind, DeFi staking and liquidity providing are the best-known strategies to earn huge returns. In order to avoid losses and minimize risks, it is very important for an investor to do thorough research on the project team and the project’s whitepaper to know everything about their ethics, background, and vision.
Here are some of the high returning DeFi protocols:
- Tomb Finance
- Anchor Protocol
- Reaper Farm
- Aave
Kudos! Now you know the basics of what yield farming is! I hope this article was insightful.
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