Yield farming blew up in 2020 as a way for crypto investors to use their holdings to generate returns in a different way than mining or trading.
In this article, you’ll learn what yield farming is, how it works and how you can get involved.
The Savings Account Model
Before we look at yield farming, it’s worth taking a big step back.
For most people, lending money to businesses in exchange for a return is a popular way to generate income. In fact, we do it all the time with our banks. If you have a savings account, you’re already part of the lending model.
When we open a savings account with our bank, we agree to leave a certain amount of money in the account for at least a year. In return, the bank then promises us an interest rate.
But the money that is deposited into a bank account doesn’t just sit there. Instead, the bank actually borrows it and moves it around between you and the other clients within their system, generating income for itself.
In exchange for this, the bank pays you interest on the money that you lended – the money in your savings account.
The logistics of the whole system are complex, but the main thing here is that a savings account is really a glorified lending agreement between you and the bank where you have lent the bank money.
Crypto and the savings model
Cryptocurrency is a great way to make extra returns on your money outside of a savings account at your bank.
You can generate returns on your investment in multiple ways in the cryptocurrency world whether it’s staking, mining, or investing. There‘s no right choice as to which option is the best – it really depends on factors like how much you want to invest, what returns you’re aiming for, and what your appetite for risk is.
One thing to remember is that cryptocurrency is a money system that doesn’t need a 3rd party middleman, like a bank, to facilitate transactions. As such, there’s no direct equivalent of a savings account.
However, there is now another option available in the cryptocurrency world – yield farming.
So what is Yield Farming?
Before we get into the definition of ‘yield farming’, it’s worth explaining what ‘yield’ is.
In the world of investing, ‘yield’ is the earnings generated by an investment over a particular period of time. It’s expressed as a percentage based on the invested amount and can include the interest earned or dividends received.
‘Yield farming’ is the process of using cryptocurrency to generate earnings without waiting for the price of the underlying crypto asset to increase.
It’s basically a bank account in the cryptocurrency world, except, instead of lending money to a bank, it is instead lent to cryptocurrency projects.
In exchange, these projects agree to pay you back your initial amount plus some interest.
With that said, each opportunity for a return comes with pros and cons. Let’s take a look at what they are for yield farming.
Advantages of Yield Farming
Higher returns than traditional channels
Yield farming gives you an opportunity to generate higher returns than the traditional investment channels, like investing in real estate, stocks or bonds.
Let’s take a look at the potential returns
Before we begin, it is important to understand the differences between simple and compound interest.
Simple interest is often used to calculate a base return on investment (ROI) that a borrower pays to a lender. For example, if you lend someone R1,000 with an agreed annual interest of 6%, then you will be paid back R1060 at the end of the loan period.
When compared to simple interest, compound interest has the potential for slightly higher returns.
Compound interest allows you to not only earn a ROI on the amount that you lent, but to earn a ROI on both the amount that you lent plus the interest earned on the loan.
For example, if you loaned the same person R1000 but agreed that the amount would be compounded semi-annually (twice a year) at the same interest rate of 6%, you would earn R1060.90. Not too much of a difference, but over a longer period of time and a larger amount lent the difference becomes apparent very quickly.
So why compound interest over simple interest?
Compound interest was created as an incentive to attract investors for the long term. If you only invested for a year in either a compound or simple interest rate then you wouldn’t really see the benefits. However, if you were to invest for five to ten years then compound interest starts generating higher returns for you than simple interest would. This is a win for both the lender and the borrower since the lender gets a higher ROI and the borrower has money to use for longer periods.
So, how are returns calculated on yield farming?
Calculating the returns of yield farming can be tricky as returns are indicated by the borrower ‘Annual Percentage Yield’ (APY) – basically a fancy way of saying compound interest.
So, for instance, if you were to lend cryptocurrency at 4 APY you would have a return on investment of 4% on the amount lent and any interest gain throughout the year.
Important: every project has different forecasted returns on investment, and some projects might compound your money less or more frequently than other projects. To get a better estimate of your returns, do your research to find out how frequently a project compounds your money.
Finding the APY of a project
Let’s take a look at the markets page of the popular decentralised finance platform, Compound:
As you can see from the snapshot above, the supply APY is the amount that you should focus on. This is the return that someone would earn yearly if they lent money to the corresponding project.
Note: the APYs listed here are subject to change. This is mainly due to supply and demand in the market. Yield farmers use complex strategies to maximise their returns. This involves shifting funds between different projects at appropriate times to leverage off of high returns at certain times.
Farmers (the name given to people who are taking part in yield farming) have an opportunity to turbocharge their returns through a process called liquidity mining.
With this, farmers not only receive the high returns that come with yield farming, but also get rewarded in utility tokens. These tokens are an extra incentive from the lender to say thank you. We’ll take a look at some liquidity mining examples later on in this article.
Risks of yield farming
Open source apps
The open source model of programming makes computer code belonging to a project publicly available for anyone to see.
Teams make use of this model so that the open source community can flag potential security threats in the code before the project is launched, allowing the development team to make the necessary changes to their project before the launch.
The only problem with this model is that the code is also publicly available to potential hackers. Hackers will see the final version of the code that is launched, and could be able to develop a strategy to hack the project.
Most yield farming projects are open source, which could leave them vulnerable. However, there are way too many open source projects for hackers to target all of them. The teams behind the projects also have to approve all changes made to the project before the final launch. Apart from that, there are a lot of other safety practices that are standardised for any project that is made open source.
So, rest assured that just because the code is made publicly available before it is published, does not mean that it is vulnerable to security threats. It really depends on the team behind the project and whether or not they have implemented the correct safety protocols.
ICO trend is emerging in a different form
The initial coin offering (ICO) craze was a trend that gained a lot of traction in 2017 and 2018 because it was a great way for cryptocurrency projects to raise funding and also a great way for early fans of a project to invest in it.
ICOs followed the same model as yield farming, except that the incentive then was not utility tokens and the traditional ICO incentive would be merchandise from the project, like a T-shirt, or a cup, on the premise that you would achieve a healthy return as the project grew traction.
The risks of an ICO were the following:
- Some of the projects were not legitimate and were just scams that utilised ICOs to scam people out of money
- Some of projects had no intrinsic value to offer the market
- Groups of people used ICOs to raise money but didn’t adhereto the project’s roadmap, resulting in the project dying and investors losing their money
Something concerning is that yield farming in projects does not only share the same level of craze that ICOs had back then, but they also share all of the risks. Yield farming can really be seen as another form of an ICO.
An important thing to remember is that your returns are paid in the cryptocurrency that you are farming in. So if you are in Ethereum, your returns will be paid for in Ethereum. The same applies for any other cryptocurrency that you farm.
An important factor to consider when looking for projects to invest in – the price of the cryptocurrency that you’re farming. The price is directly influenced by supply and demand, and is subject to fluctuations. This has a direct effect on your returns.
Sure, you may have a great strategy that is generating a great return. But this return is in cryptocurrency. So while you might achieve an annual return of 40%, the price may drop overnight and stay low – putting a dent in your realised profits when it comes to fiat currency.
However, this can also work in your favour. If the cryptocurrency increases in price over the long term then your gains increase exponentially.
Should I still yield farm?
As with any investment, there are risks involved and, like any other investment, it is important to do your due diligence before investing.
Much like there are still some ICOs that are legitimate, there are also projects in yield farming that you can invest in.
An extra layer of security when yield farming
The great news about yield farming is that investors deposit funds using a smart contract into a liquidity pool.
A liquidity pool is a smart contract where funds are pooled and utilised for either lending, borrowing, or decentralised trading.
Smart contracts are pieces of code that represent a legal agreement between two parties. This code is run on the blockchain and cannot be taken down or changed once it is launched on the blockchain.
This adds an extra layer of security when you yield farm, as the smart contract guarantees that the pool will deliver on its obligations.
If the conditions, as stipulated in the agreement between you and the borrower, are breached, your funds will be returned.
Let’s take a look at some of the most established players in yield farming.
Major players in yield farming
Compound was the first platform to introduce yield farming to the market in mid-summer 2020. Yield farming is similar to staking crypto in many ways. Users lock their cryptocurrency into large farming pools. You receive rewards based on the amount of crypto you lock and for how long you participate in the pool.
Aave is perhaps best described as a system of lending pools. Users deposit funds they wish to lend, which are then collected into a pool. Borrowers may then draw from those pools when they take out a loan. These tokens can be traded or transferred as a lender wishes.
How can someone start yield farming
The first step in yield farming involves adding funds to a liquidity pool, which are essentially smart contracts that contain funds. These pools power a marketplace where users can exchange, borrow, or lend tokens. Once you’ve added your funds to a pool, you’ve officially become a liquidity provider.
But how do you deposit funds into a liquidity pool? Let’s walk through it
Buy the cryptocurrency that the smart contracts require for you to make a deposit.
In order to know which cryptocurrencies are required to make a deposit, let’s focus on the DeFi (decentralised finance) platform, Compound. For demonstration purposes, we will take a look at two different liquidity pools.
Each of the liquidity pools that we are going to discuss are a bit different in terms of how deposits are made – one is a bit more complex than the other.
The simple deposit
The simplest liquidity pool to get into is Ethereum. This is because Compound has a Rand to Ethereum exchange and vice versa. So you can purchase and sell Ethereum relatively simply.
You can purchase Ethereum on any available exchange in South Africa, be it Luno, VALR, Binance, or Ice3.
Once you have purchased Ethereum, you then need to deposit it into a liquidity pool.
This is a bit of a complex part, but we’ll walk through it step by step.
First you’ll need to open an Ethereum wallet that supports Compound’s liquidity pool. At the time of writing, these wallets are Coinbase Wallet, Ledger, and MetaMask. We’ll take a look at the most popular one: MetaMask. (Click here to install a Metamask wallet: you will need to have one to access the Compound Finance app.)
Once you’ve downloaded and created the MetaMask wallet, you need to deposit funds (your newly bought Ethereum) into it.
A quick overview of MetaMask:
MetaMask is an Ethereum wallet that also provides support for all cryptocurrencies created on the Ethereum blockchain, also known as ERC20 tokens.
Back to liquidity mining…
Once you’ve successfully deposited your Ethereum into your MetaMask wallet, click here. The link will take you to Compound’s app.
Click connect wallet, and then select MetaMask.
A prompt will ask for you to enter the password to your MetaMask wallet. Enter your password and click “connect” to connect your MetaMask wallet:
You should now see your wallet address at the top right corner of your screen in the Compound app.
Navigate and select Ether from the supply menu. Then click on the Ether link.
A prompt will now appear asking you how much you’d like to supply. Enter your amount, making sure that you have enough Ether to match the amount that you want to supply. Once done, click the supply button at the bottom of the prompt and click confirm in the MetaMask prompt:
Congratulations! You’ve successfully lent your first Ethereum on Compound and are part of the liquidity mining gang. Now you can sit back and let your profits come in.
The more complex deposit
Choosing a different token than Ethereum can mean that higher returns can be accesed. But different tokens can require a more complex deposit. For example, you may want to lend another ERC20 toke to access a higher APY (Annual Percentage Yield).
Before we take a look at the complex deposit, let’s first take a look at what an ERC20 token is.
What is an ERC20 token?
ERC20 tokens are defined as the token standard for any projects that are developed on the Ethereum blockchain. Meaning, if any team wants to create a token on the Ethereum blockchain then they will have to follow the ERC20 token template.
This template consists of a set of rules that every token developed on the Ethereum blockchain must follow.
These rules stipulate how the tokens are transacted between users, how the tokens are bought and sold, as well as some security practices that the token must implement.
Back to the complex deposit…
Before you can lend an ERC20 token, you will first need to purchase Ethereum or Bitcoin and then exchange it for the token that you want to lend.
Once you have your token, you deposit it to MetaMask and lend it to Compound’s app the same way you did in the simple deposit steps listed previously. This is not recommended for beginners, but if you’re a veteran in cryptocurrency then try it out. It will open up more possibilities for you, such as the possibility to diversify your investment portfolio to hedge some risk, or the possibility to implement more complex farming strategies to maximise returns .
Cash out at any time
The great thing about yield farming is that you can cash out at any time. There is no contract binding you to the loan and there are no associated penalties for cashing out prior to the expiration of the loan.
Of course there will be fees when cashing in and cashing out, but these are minimal compared to penalties that a bank would charge.
So, if you feel like you have made a decent return, even after fees, then feel free to cash you farming profits out by sending them to your Ethereum wallet, and exchanging it for Rand on a local exchange.
What the future holds for yield farming
The future of yield farming is uncertain as it is still in its infancy.
However, one thing can be agreed on, and that is that the ICO boom taught the decentralised finance community a valuable lesson: that a lack of due diligence will inevitably lead to a loss of funds.
Post ICO craze, the cryptocurrency community as a whole, from developers to cryptocurrency holders, has weeded out the scams of the time. Developers have learned what the common exploits used by hackers at the time were and have removed them from their applications that are in the market today.
The developer community has grown wiser and has designed security practices that make decentralised finance applications a lot more secure and less vulnerable to hacks and exploits.
These practices form the foundation of the decentralised finance applications that are in the market today, including yield farming. The occasional scam will still pop up in the yield farming space, but the cryptocurrency community is able to spot them much faster than before – limiting the collective financial losses.
For this reason, yield farming can be regarded relatively safe. With this said, it is still advised that you do your own due diligence before sending cryptocurrency funds out