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What is DeFi Yield Farming and How Can a Newcomer Safely Invest?

In the course of 2020 — the first year of DeFi — the total value locked (TVL) in decentralized finance protocols grew from a mere $700 million to an astounding $15 million. This expansion was, in great part, fueled by a yield farming boom.

For the first time in history, people could generate returns far greater than those offered by any banks or traditional financial institutions — and, quite unexpectedly, investors flocked to take advantage of inviting offers by the first yield farming protocols.

Since then, yield farming has undoubtedly become the most popular method to earn passive rewards on crypto assets. In this piece, we will define what yield farming is, explore how it works, define risks, and figure out where to start.

Explaining Yield Farming

Yield farming, or liquidity farming, is the backbone that supports multiple DeFi protocols. In its simplest definition, it is depositing crypto assets into a liquidity pool and earning passive rewards in exchange.

In many ways, yield farming is similar to using a traditional savings account: one deposits funds into an account and earns interest rates in return, while the bank uses the money to fund other ventures.

Functions of yield farming

Liquidity pools are, basically, a pile of crypto funds locked into a smart contract. DeFi protocols use them for various purposes, such as bootstrapping the necessary liquidity for loans and swaps, or maintaining the peg of algorithmic stablecoins like DAI and UST.

By allowing users to provide liquidity through yield farming, DeFi protocols can increase the total value locked and support the needs of their ecosystems. For one, as trades on DEXs are peer-to-peer (P2P), it is often difficult to find someone who wants to buy the same asset you are selling. By leveraging funds from a liquidity pool, DEXs can solve the compatibility issue and provide a fast service with lower slippage.

On top of that, yield farming is a common token distribution method. While most projects elect to pre-mine their tokens and conduct token sales for both institutional and retail investors, there is a viable alternative known as “fair launch”. It offers a more democratic approach, enabling communities to grow organically by allowing all investors, be they small or large, to participate on equal footing, and reducing the risk of price manipulation and whales holding large amounts of coins. One way to conduct a fair launch is to distribute freshly minted tokens as yield farming rewards.

How Does One Become a Farmer?

Yield farming is readily available on most exchanges and DeFi protocols, generally under staking/farming/earn. The Fringe Finance protocol, for one, is a good place to start. It provides a variety of yield farming products that allow users to grow their capital securely while incentivizing users to participate in its ecosystem.

Fringe allows users to stake a variety of different altcoins, even ones with low liquidity, and use them as collateral to issue loans in the protocol’s stablecoin, USB. The Fringe ecosystem also incentivizes users to become lenders by staking their USB, or other whitelisted stablecoins like USDC, and earning appealing rates and other rewards.

Yield farming is also available outside of DeFi, in protocols from emerging niches such as GameFi and SocialFi. Occasionally, some protocols also offer NFT farming, which enables users to either stake their NFTs in exchange for token rewards or stake their tokens and receive NFTs as compensation.

It’s important to note that users will need to give up access to their funds while yield farming. Before staking, they have to agree to a certain lock-up period: from a few days up to a whole year. Alternatively, liquid staking allows users to earn rewards while maintaining their funds accessible at all times in their wallets.

Exploring Risks

While yield farming is an excellent way to steadily grow your capital, there are a few risks to look out for before investing.

Hacking and exploits

According to a report, roughly 97% of all crypto assets stolen during the first three months of 2022 were taken from DeFi protocols. Currently, DeFi is the main target for cybercrimes: due not only to the amount of capital they hold but also to a general lack of expertise in smart contract coding.

One way to choose a secure protocol is to check for ones who’s undergone a successful audit by renowned firms such as CertiK or Hacken.

Falling APY rates

Typically, newly launched pools offer the highest yield. However, as more investors join and liquidity increases, the APY slowly goes less attractive.

Some investors look to maximize yield returns by constantly allocating funds to new pools. However, this strategy carries increased risk as new tokens and projects have a higher probability of failing, being a scam, or falling victim to hackers.

Impermanent losses

And finally, liquidity mining, a form of yield farming, carries the risk of impermanent losses. An impermanent loss occurs when one of the paired assets users lend to provide liquidity for DEXs has a drastic change in value.

Let’s imagine a user performs liquidity mining on an ETH/DAI liquidity pool and the price of Ethereum suddenly goes up. This will cause the Ethereum funds to be automatically sold for DAI, resulting in an impermanent loss for the user.

That is why certain users only perform liquidity mining on pools of stable assets, like USDT/DAI for example, as the risk of these assets fluctuating in value is negligible.

The Future of Liquidity Farming

While there are a few risks to be taken into account, yield farming remains the king when it comes to earning passive income.

Investors can earn anywhere between 2.5% and 250% APY, and sometimes more in the case of newly launched pools. Thus, it’s difficult for other services, both in the crypto industry and traditional finance, to compete with the returns offered by yield farming.

How sustainable are these rates? Will we start seeing diminishing returns, as the DeFi space grows more mature, or will new and more lucrative trends emerge? Time will show. In any case, we can expect yield farming to stick around and grow alongside the DeFi industry.