Yield Farming Explained

The concept of Yield Farming surely creates an imagination of agricultural activity to any mind new to cryptocurrency and the blockchain space. While yield farming may sound a bit obscure, the concepts that apply to farming crops to generate yields have a correlation to these two buzz words that have captivated the world of decentralized finance (De-Fi).

Yield Farming is the current hype of DeFi, and has hugely become popular among all DeFi protocols. Protocols that integrate yield farming or liquidity rewards enable user participation in cryptocurrency markets in a passive way. The main reason why it is one of the trending sectors is the promise of huge returns, whether real or imaginary, that are associated with it by many. Yield farming requires little experience and effort, a lot of people have found success in yield farming as a source of passive income. So, how does it really work and how on earth is there a farm in crypto? 

In its basic form, yield farming refers to any blockchain protocol that enables any person with some holding of crypto tokens to ‘lock-up’ those holdings with a custodian(the protocol) and in return, they distribute rewards; these rewards are typically distributed as protocol governance tokens. In order words, rather than just keeping one’s crypto assets idle in one’s wallet, one can choose to offer it to a service provider and earn some form of interest. 

A fundamental example of this is in lending protocols, creating a peer to smart contract lending/borrowing service. The holder lends his crypto assets to a platform, which in turn makes use of the assets in return for attractive interest payments. Stated simply, to yield-farm in cryptocurrency you must handover custody of your crypto assets to a particular DeFi platform.

In doing so the protocol rewards users, the platform does this as they have some system of benefiting from having token custody. Another common example of yield farming is through providing liquidity to an AMM  in return for liquidity incentives -- tokens allotted to liquidity providers. These projects require liquidity to facilitate swaps and bootstrap growth, so it is a win-win for both parties.

DeFi started on the Ethereum network, so it is no surprise that yield farming from the outset was exclusive to the  Ethereum blockchain, with the rewards being in the form of Ethereum-based tokens. The DeFi space has continued rapid innovation, as other blockchain platforms with yield farming capability have been created and are competing strongly with Ethereum, especially the Binance Smart Chain (BSC).  

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Origins of Yield Farming

One of the very earliest forms of Yield Farming appeared in 2018 when a Chinese Exchange, FCoin,  created its native token FT, tied its value to the transaction fees of its users, and issued the FT coins as rewards to its users. A portion of FCoin’s revenue was also distributed to her users in proportion to how many FT tokens each user held. 

Those were the early days of Yield Farming, but the practice became prominent in early 2020 when a  blockchain credit platform, Compound Protocol, began issuing its native COMP tokens as a reward to early users. These rewards were allocated to bootstrap growth to the platform in addition to the default interest payments users received.

The very wide acceptance of Compound Protocol’s approach set off a chain reaction of platforms incorporating similar liquidity incentives into their strategy. Ultimately, this lead to the very fast proliferation of platforms offering yield farming opportunities in an effort to capture the market. A perfect example of this is what is coined as De-Fi summer (June-July 2020), where the first explosion of DeFi platforms occurred.

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The Hype Around Yield Farming

Two reasons account for this. First is the attraction of good returns on investment. Many new projects offer yield farming opportunities, with rewards in the form of the project’s native tokens. Lots of people aspire to be early farmers in the hope that the tokens will swiftly increase in value such that they can trade their earnings and make a good profit.  

Secondly, lots of Yield Farming platforms offer interest rates far higher than traditional fiat banks. Hence more and more people are going into yield farming rather than keeping money in the bank.  

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What are the Risks of Yield Farming?

Despite all the promises and glitter that yield farming is, it has some very notable downsides and risks worthy of mention. 

Users who adopt Ethereum-based DeFi projects  (the majority of DeFi users) face very expensive transaction fees, especially in high congestion periods. It is not uncommon to experience transaction fees of tens of dollars and sometimes, hundreds. In fact, a ridiculously high amount of $486 was once registered as a transaction fee in 2020! This creates implications for the average DeFi investor, those who go into yield farming with a small deposit may discover that it will take them a long time before they can earn enough to be in profit after the deduction of transaction fees. This issue is not so much of a problem these days as blockchains such as the BSC boast much lower transaction fees in comparison to the Ethereum Network.

Another risk for yield farmers is the highly volatile nature of cryptocurrencies. There could be situations where a platform’s reward token falls so much in value over time that a farmer may never be able to recoup his investment.  

Smart Contract Risks

Again, it is not a pleasant experience to lose your hard-earned money to thieves, but this is a very real possibility as far as yield farming and crypto are concerned. Lots of scam projects have entered the market aiming to capitalize on hype and fraud investors. They set up their platforms, and after investors have committed their funds, the operators shut down their channels and disappear with investor’s funds. It is extremely wise to tread carefully when choosing a yield farm to invest in. 

Finally, the software programs that power digital currencies often have loopholes that can be exploited by hackers. This possibility is high with projects whose codes have not been audited by a credible third-party.  If there are loopholes in the smart contracts, investors’ funds are at high risk because once the loophole is discovered by malicious parts the entire funds in that farm can be siphoned in a moment. A classical case is that of  Harvest.Finance that lost more than $20 million in a hack. 

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Concluding Thoughts on Yield Farming

In conclusion, the concept of Yield Farming is gaining great traction and attracting much attention from the crypto community and even venture capitalists. There are many platforms that a prospective yield farmer can consider. These include yield farming networks such as Synthetix, Curve.Finance, Compound Finance, MakerDAO, Balancer, Pancake Swap etc. In the final analysis, the key to finding the right farm that will suit you is to carefully Do-Your-Own-Research (DYOR).

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