What is DeFi Yield Farming? A Beginner’s Guide on the Risks and Rewards of Earning Yield in Crypto

For example, when the crypto markets are volatile, users can experience losses and price slippage. The easiest way to become a staker and start earning staking rewards is the profitability of ethereum cryptocurrency mining has halved in a week through a crypto exchange like Coinbase using its wallet. In June 2020, the Ethereum-based credit market known as Compound began offering COMP, an ERC-20 asset that empowers community governance of the Compound protocol, to its users. Note that you may see the proportion of your trading pair shift over time, especially with more volatile cryptocurrencies.

The power of DeFi’s permissionless composability has led to many new financial primitives that previously couldn’t exist due to the inefficiencies, opaqueness, and counterparty risk present in today’s traditional financial system. With interest rates on traditional bank savings accounts remaining extremely low, yield farming offers a way for those participating in the decentralized finance ecosystem to generate better returns on their holdings. The first step in yield farming involves adding funds to a liquidity pool, which are essentially smart contracts that contain funds.

These projects have benefited from creating a network of early users who actively bootstrap the project’s liquidity and participate in the protocol’s governance. The initial implementations of yield farming, however, were employed to directly boost the liquidity of a specific asset. If you’re a long-term buy-and-hold crypto investor, you may want to look into yield farming. You can keep your risks low with simple staking, or you can enter the world of DeFi by participating in lending or liquidity pools. There are a lot of options to explore, and it’s possible for you to benefit greatly by boosting the returns on your crypto holdings.

What Is Yield Farming?

In return for locking up your finds in the pool, you’ll be rewarded with fees generated from the underlying DeFi platform. Note that investing in ETH itself, for example, does not count as yield farming. Instead, lending out ETH on a decentralized non-custodial money what is bitcoin and should i invest in it market protocol like Aave, then receiving a reward, is yield farming. While some yield farming projects are well-established and draw in the bulk of collateral, new DeFi algorithms are constantly popping up. Some DeFistartups use copied and unaudited smart contracts, posing risks for unexpected operations and effects.

1. Liquidity pools provide the financial backing behind these algorithms, enabling a customer’s transaction to be fulfilled upon request.
2. It’s worth noting that this effect works similarly in the inverse scenario—if less and less liquidity is available in a protocol, the fewer users it attracts, which in turn generates even less liquidity, and so on.
3. This guide will explain everything you need to know about taxes on crypto trading and income.
4. Some protocols will work to stabilize interest rates for lenders seeking more consistent returns.
5. These projects often raise huge amounts in a short period of time and are then forgotten about.

However, the democratization of access shouldn’t distract away from the fact that it requires a high degree of scrutiny and responsibility– it can be far riskier than its traditional finance counterpart. Yield farming has similarities to some established concepts in traditional finance. Another is selling stock options, a way to earn money on stocks you own by lending them to others.

Even if you are yield farming on reputable DeFi protocols, smart contract risk, and hacks could still lead to a complete loss of funds. These tokens are locked in a smart contract, which programmatically rewards users with tokens as they fulfill certain conditions. Uniswap pays out the fee it collects from exchanges to liquidity providers.

Daily Debrief Newsletter

For instance, DeFi tokens are not considered securities, and the US Securities and Exchange Commission hasn’t taken any decisive actions against them. Cryptocurrency lending entered a phase of functional maturity largely due to two behemoth projects – Maker DAO, and Compound. Yield Farming helps stimulate the flow of value within the decentralized ecosystem system,. This may influence which products we review and write about (and where those products appear on the site), but it in no way affects our recommendations or advice, which are grounded in thousands of hours of research.

Fair Token Distribution

One of the earliest pioneers of yield farming was Synthetix, a synthetic asset protocol powered by Chainlink Price Feeds. Users who acquired sETH could then enter the Synthetix ecosystem and acquire other synths that provided exposure to other assets. Over time, Synthetix’s yield farming program shifted to begin providing SNX rewards to users who deposit sUSD (Synthetix’s stablecoin) on Curve Finance, alongside other popular stablecoins. The token rewards from yield farming are an addition to any built-in revenue streams inherently generated by the protocol, such as trading fees within a decentralized exchange or interest from lending in a decentralized money market. Yield farming has enabled countless projects to bootstrap their growth at a quicker pace to secure hundreds of millions to billions in user funds. Decentralized finance (DeFi) has experienced a period of rapid growth in the last few years, with its aggregate Total Value Locked (TVL) reaching upwards of a quarter of a trillion dollars.

How yield farming works with liquidity pools

Yield farming has some parallels to staking and the two terms are often used interchangeably. Staking is a term used to describe the locking up of tokens as collateral to help secure a blockchain network or smart contract protocol. Staking is also commonly used to refer to cryptocurrency deposits designated towards provisioning DeFi liquidity, accessing yield rewards, and obtaining governance rights. As such, yield farming and staking may refer to a similar user action—depositing tokens into a smart contract—but can widely differ as well. With that said, protocols commonly refer to depositing tokens into a liquidity pool as “staking”.The term “yield farming” is also used to refer to the execution of automated yield-generating strategies in the DeFi ecosystem. Developers can create sophisticated yield farming strategies that generate returns through an interconnected loop of deposits into multiple protocols.

Users will pay fees to transact on the Ethereum network, and how to buy utrust due to heightened interest, those fees may rise rapidly or make the network too congested to be able to participate successfully. Yield farming is a method of using cryptocurrencies like Ethereum and USDC to earn interest (distributed in that coin’s denomination) through DeFi mechanisms such as staking and lending. The term “yield farming” might conjure images of a passive, relatively risk-free scenario comparable to growing crops, but it’s a fairly risky endeavor.