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In the summer of 2020, yield farming was arguably the most talked about topic of conversation. Meanwhile, in 2021, the TVL of liquidity pools in the decentralized finance (DeFi) ecosystem continued to hit new highs. However, many people do not currently understand what yield farming is or how it works, so this article’s purpose is to answer all of your questions. Let us begin with defining what the phenomenon actually is.
Yield farming is a common practice in the decentralized space that involves lending crypto assets with the intent of generating high returns. Returns are usually generated in cryptocurrency and not in physical cash. Furthermore, the popularity of this application has increased lately due to liquidity mining, but this practice is risky. Currently, yield farming is the biggest factor driving the growth of the DeFi sector, catapulting it from $500M to a market cap of $10B as of last year.
How Does Yield Farming Work?
Yield farming platforms incentivize liquidity providers to stake their crypto assets or lock them up in a liquidity pool. This way, the protocol can lend to those intending to borrow from the liquidity pool. The incentives provided could be a percentage of transaction fees, interest, or the protocol's native token, and these returns are clearly detailed as an annual percentage yield or APY. The catch here is that as more investors add to the liquidity pool, the percentage given on returns decreases.
The APY is the annual estimated returns over a year on a specific investment; compounding interest is also factored into this. Depending on the number of investors in the liquidity pool, APY on an investment could be as high as 20%–25%, and it is sometimes much higher. Nevertheless, it is important to note here that these protocols are risky and prone to rug pulls. In any case, the rewards are earned in tokens, which are susceptible to price swings.
Before now, yield farmers staked USDT, USDC, and other popular stablecoins, yet the rise in popular DeFi protocols has paved the way for more native tokens to be given as rewards for their investment. Tokens are farmed in these liquidity pools in exchange for providing liquidity for DEXs, and native or governance tokens can be traded on centralized and decentralized exchanges.
At the moment, there is no yield farming for Bitcoin. However, there is a wrapped Bitcoin (wBTC), which is a forked Bitcoin token that solves the problem of connecting this specific cryptocurrency and the Ethereum blockchain. wBTC is an ERC-20 token that delivers liquidity to DeFi protocols on Ethereum’s network. By utilizing wBTC, Bitcoin holders can earn a few rewards on their cryptocurrency.
Yield Farming Risks
Yield farming is complex and financially risky for both borrowers and lenders. First, it is subjected to high gas fees and can only be beneficial if thousands of dollars are offered as capital. Slippage could also occur when the market becomes volatile. Apart from that, yield farming is prone to hacks and is extremely vulnerable due to the presence of bugs in smart contracts. Some smart contracts are unaudited and utilized immediately due to time constraints; as a result, Harvest Finance lost more than $20M in liquidity in one go. These protocols are dependent on other applications to function comfortably. If these applications are exploited, this may affect the protocol, resulting in the loss of investors’ funds.
You should tread carefully when seeing protocols offering good returns on liquidity investments in the form of some unknown tokens. Most of their codes are unaudited, and the returns are a form of bait to facilitate absconding with investors’ funds. Most of these funds are never recovered, so conduct proper research before investing. Nonetheless, this does not mean there are no reputable protocols out there. Indeed, many investors are taking advantage of yield farming protocols to maximize their profits.
