Yield farming is when someone lends their crypto in order to make a profit from the interest rewards. It’s called farming because you are trying (farming) to get the best reward rate as possible, i.e. highest yield rate. Yield farmers will hop between lending pools to get the highest reward rate. Remember reward rates tend to be based on how many people are in the pool, so yield farmers will try to keep moving between pools in order to get the highest rates.
Simplified explanation:
Yield farming: finding the best place to store your crypto which will earn you the highest yields.
AKA farming (finding) the best place to maximize yield. = farming yield.
Yield farming is multifaceted compromising of several strategies/subtypes to make maximize your return on crypto investments. These include:
1. Liquidity provision
Provide liquidity to a liquidity pool through depositing tokens into the pool and received returns through trading fees on the liquidity pool.
Example:
- You put $500 of ETH and $500 of BAT into a pool, your friend does the same now there is $2000 in the liquidity pool.
- $150 of trading fees from people trading all day long, I earn $75 since I provided 50% of that liquidity to the pool.
- As more people contribute towards the liquidity pool, your cut of the trading fees becomes less and less. HOWEVER, the price of the assets in the pool is stable, as it will require more money to move the ratios of the assets in the pool. So if the total value of assets in the liquidity pool was $2000 ($1000 ETH + $1000 BAT) and someone came in and spent $500 to buy some ETH and exchange it for BAT, that would raise the price of ETH a lot compared to if the total value of the liquidity pool was $5,000,000.
2. Lending & Borrowing
Lending: lend crypto assets through a decentralised platform to earn interest like in normal finance. E.g. Aave, Compound
Leveraged Lending: strategy used to increase return on investment through borrowing and reinvesting.
Here’s how it works:
- Lend cryptocurrencies to platforms such as Compound or Aave.
- Deposit $100 worth of Basic Attention Token (BAT) into Aave. Aave will allow you to borrow against your deposit, say up to $60, but in another cryptocurrency called DAI.
- Your deposited BAT is earning an interest of 30% APR.
- You exchange your $60 in DAI for BAT and now deposit that $60 worth of BAT, so you are now earning an interest of 30% on $160 worth of BAT, instead of $100 worth of BAT.
Summary: you deposit $100 worth of crypto such as BAT into a DEX, and the DEX allows you to borrow against your deposit, so they give you $60 worth of another token such as DAI, and you exchange this $60 of DAT exchange it for $60 of BAT and then deposit this new BAT into the same DEX, now you are earning interest on $160 of BAT rather than $100 of BAT.
Borrowing: Borrow crypto assets through over-collateralization of your existing digital assets.
Here’s an example to illustrate how borrowing works in DeFi:
- In order to have the right to borrow funds, you must first deposit collateral. DeFi loans, tend to be overcollateralized, all this means is that you have to put more money in as collateral than what you want to borrow.
- For instance, you want to borrow $1000 of USDC, but you may need to deposit $1500 worth of ETH as collateral.
- The reason overcollateralization is essential in DeFi is because there are no intermediaries to ensure that you will receive your funds in the case of fraudulent events. Overcollateralization ensures that the creditor will not fall victim to fraud, as performing fraud on the debtor side, just doesn’t make economic sense.
3. Staking
Staking is technically a form of yield farming because you can buy coins, stake them, and then earn more free coins.
For example with Tezos, in 2021 you had a 6% APY, but you have to have the hardware and knowledge to set up your own staking node that would be reliable throughout the year. But if you want to avoid this hassle, you can go to a platform such as Coinbase, which stakes for you, but they take a cut of your 6% APY
4. Holding coins which have a redistribution fee
You want to hold coins that have the potential to increase in value. Most people invest in coins and tokens that have viability based on their use case potential, the team working on it, the tokenomics, etc.
But another facet to look at is to invest in coins which have a redistribution fee.
Some cryptocurrencies like Safemoon, charge a fee on transactions e.g. 10% transaction fee, this fee is not lost but used in ways that can benefit the remaining holders of the cryptocurrency. 5% is burned forever, and the other 5% is redistributed evenly to all other holders. The idea behind this is that the 5% of burned Safemoon, reduces the supply and should in theory increase the price (if demand stays constant). So just by holding the coin Safemoon, you will earn free Safemoon through everyone else’s transactions.
Example:
There is a total supply of 1000 Safemoon coins. A transaction of 100 safemoon occurs with a 10% transaction fee:
-5% Burned:
· Transaction amount: 100 coins.
· Burned: 5% of 100= 5 coins.
· Effect on Total Supply: total supply of Safemoon decreases by 5 coins from 1000 to 995.
-5% Redistributed :
· Redistribution: 5% of 100 = 5 coins
· Your share: since you own 10% of the total supply (100 out of 1000 coins), you get 10% of the 5 redistributed coins = 0.5 coins
After the transaction:
· Your New Holdings: 100 (initial) + 0.5 (redistributed)= 100.5 safemoon coins
· New total supply: 995 Safemoon coins (after burning 5 coins).
Summary:
After this single transaction scenario, I now have 100.5 safemoon coins, and the total supply of safemoon coins in circulation has been reduced to 995 coins.
5. Auto-compounding
PancakeBunny is a platform that optimises your earnings or yields from investments made on PancakeSwap, which is a decentralised exchange. When you invest in their token, PancakeBunny offers rewards. With the “auto-compounding” feature, PancakeBunny takes any rewards you earn and automatically reinvests them for you, thus boosting your investment growth without you having to manually reinvest your earnings.
Example to illustrate auto-compounding:
Imagine you invest $1000 in Pancake Bunny’s token, and you earn 10% rewards after a month, which would be $100. With Auto-Compounding:
1) Instead of taking that $100 reward out, PancakeBunny automatically adds it back to your initial investment. So now your investment is $1100.
2) The next time rewards are calculated, they’re based on this amount ($1100), not the original $1000. If you earn another 10% reward, that’s $110 this time, not just $100.
3) This process repeats, with each round of rewards being added to the last, causing your investment to grow more quickly over time because you’re earning rewards on top of rewards.
Risks of Yield Farming
- Rug Pulls: when developers pull out of a project
- Impermanent loss: when the value of one token vastly changes compared to the other token
Degen Yield Farms
Degen yield farms involve lending your cryptocurrency/ providing liquidity to a less-established (degenerate) DeFi project, with the chance of receiving rewards in the form of new tokens.
They are high-risk, high-reward investments, as they offer higher yields but also a greater risk on the investment.
What are the risks?
Hacks. The projects are untested so they may be vulnerable to hacks. And you may run the risk of the rewards you receive being worthless.
Insurance
With car insurance you pay $100 a month to protect your car, if you get into an accident, the car insurance company pays you what your car is worth and they use statistics to predict the price of their insurance per month by analysing how many of their drivers will crash their cars and uses this data to predict how much they would have to pay out each year to determine what the monthly price of the insurance is (insurance premium).
With DeFi, the insurance is CODE, so in the smart contract you could have a piece of code that says “Pay farmer Joe £100,000 if it’s 95 degrees or hotter 4 days in a row, however, he has to pay $2000 to initiate his contract”. The smart contract uses oracles to gain real-world up-to-date information i.e. to see if it was 95 degrees or hotter 4 days in a row.
Stablecoins
Stablecoins are coins whose value is pegged to the value of fiat currency. They are designed to have a stable value. For example, the USDC coin is pegged to the US dollar, meaning for every 1 USDC in circulation there is an equivalent 1 dollar held in reserves.
Another way stablecoins maintain their value is through algorithms. Some stablecoins like DAI will use smart contracts to manage their supply. If the value of DAI starts to rise above a dollar, then the smart contract will create more DAI to bring the price down. If the value drops, it will reduce the supply to push the price back up. This is called REBASING.
Collateral-backed stablecoins are stablecoins backed by other cryptocurrencies. For example, MakerDAOs DAI involves users depositing their crypto assets like ETH into a smart contract as collateral to generate DAI.
