What Is Yield Farming in Decentralized Finance (DeFi)?
Yield farming is a way to make more crypto with your crypto. It involves you lending your funds to others through the magic of computer programs called smart contracts. In return for your service, you earn fees in the form of crypto. Simple enough, huh? Well, not so fast.
Yield farmers will use very complicated strategies. They move their cryptos around all the time between different lending marketplaces to maximize their returns. They’ll also be very secretive about the best yield farming strategies. Why? The more people know about a strategy, the less effective it may become. Yield farming is the wild west of Decentralized Finance (DeFi), where farmers compete to get a chance to farm the best crops.
The Decentralized Finance (DeFi) movement has been at the forefront of innovation in the blockchain space. What makes DeFi applications unique? They are permissionless, meaning that anyone (or anything, like a smart contract) with an Internet connection and a supported wallet can interact with them. In addition, they typically don’t require trust in any custodians or middlemen. In other words, they are trustless. So, what new use cases do these properties enable?
One of the new concepts that has emerged is yield farming. It’s a new way to earn rewards with cryptocurrency holdings using permissionless liquidity protocols. It allows anyone to earn passive income using the decentralized ecosystem of “money legos” built on Ethereum. As a result, yield farming may change how investors HODL in the future. Why keep your assets idle when you can put them to work?
So, how does a yield farmer tend to their crops? What kind of yields can they expect? And where should you start if you’re thinking of becoming a yield farmer? We’ll explain them all in this article.
What is yield farming?
Yield farming, also referred to as liquidity mining, is a way to generate rewards with cryptocurrency holdings. In simple terms, it means locking up cryptocurrencies and getting rewards.
In some sense, yield farming can be paralleled with staking. However, there’s a lot of complexity going on in the background. In many cases, it works with users called liquidity providers (LP) that add funds to liquidity pools.
What is a liquidity pool?
It’s basically a smart contract that contains funds. In return for providing liquidity to the pool, LPs get a reward. That reward may come from fees generated by the underlying DeFi platform, or some other source.
Some liquidity pools pay their rewards in multiple tokens. Those reward tokens then may be deposited to other liquidity pools to earn rewards there, and so on. You can already see how incredibly complex strategies can emerge quite quickly. But the basic idea is that a liquidity provider deposits funds into a liquidity pool and earns rewards in return.
Yield farming is typically done using ERC-20 tokens on Ethereum, and the rewards are usually also a type of ERC-20 token. This, however, may change in the future. Why? For now, much of this activity is happening in the Ethereum ecosystem.
However, cross-chain bridges and other similar advancements may allow DeFi applications to become blockchain-agnostic in the future. This means that they could run on other blockchains that also support smart contract capabilities.
Yield farmers will typically move their funds around quite a lot between different protocols in search of high yields. As a result, DeFi platforms may also provide other economic incentives to attract more capital to their platform. Just like on centralized exchanges, liquidity tends to attract more liquidity.
What started the yield farming boom?
A sudden strong interest in yield farming may be attributed to the launch of the COMP token — the governance token of the Compound Finance ecosystem. Governance tokens grant governance rights to token holders. But how do you distribute these tokens if you want to make the network as decentralized as possible?
A common way to kickstart a decentralized blockchain is distributing these governance tokens algorithmically, with liquidity incentives. This attracts liquidity providers to “farm” the new token by providing liquidity to the protocol.
While it didn’t invent yield farming, the COMP launch gave this type of token distribution model a boost in popularity. Since then, other DeFi projects have come up with innovative schemes to attract liquidity to their ecosystems.
What is Total Value Locked (TVL)?
So, what’s a good way to measure the overall health of the DeFi yield farming scene? Total Value Locked (TVL). It measures how much crypto is locked in DeFi lending and other types of money marketplaces.
In some sense, TVL is the aggregate liquidity in liquidity pools. It’s a useful index to measure the health of the DeFi and yield farming market as a whole. It’s also an effective metric to compare the “market share” of different DeFi protocols.
A good place to track TVL is Defi Pulse. You can check which platforms have the highest amount of ETH or other cryptoassets locked in DeFi. This can give you a general idea about the current state of yield farming.
Naturally, the more value is locked, the more yield farming may be going on. It’s worth noting that you can measure TVL in ETH, USD, or even BTC. Each will give you a different outlook for the state of the DeFi money markets.