What is Yield Farming?

    Yield farming is the process of using decentralized finance (DeFi) to maximize returns. Users lend or borrow crypto on a DeFi platform and earn cryptocurrency in return for their services.

    Yield farmers who want to increase their yield output can employ more complex tactics. For example, yield farmers can constantly shift their cryptos between multiple loan platforms to optimize their gains.

    How does yield farming work?

    Yield farming allows investors to earn yield by putting coins or tokens in a decentralized application, or dApp. Examples of dApps include crypto wallets, DEXs, decentralized social media and more.

    Yield farmers generally use decentralized exchanges (DEXs) to lend, borrow or stake coins to earn interest and speculate on price swings. Yield farming across DeFi is facilitated by smart contracts — pieces of code that automate financial agreements between two or more parties.

    Types of yield farming:

    • Liquidity provider: Users deposit two coins to a DEX to provide trading liquidity. Exchanges charge a small fee to swap the two tokens which is paid to liquidity providers. This fee can sometimes be paid in new liquidity pool (LP) tokens.
    • Lending: Coin or token holders can lend crypto to borrowers through a smart contract and earn yield from interest paid on the loan.
    • Borrowing: Farmers can use one token as collateral and receive a loan of another. Users can then farm yield with the borrowed coins. This way, the farmer keeps their initial holding, which may increase in value over time, while also earning yield on their borrowed coins.
    • Staking: There are two forms of staking in the world of DeFi. The main form is on proof-of-stake blockchains, where a user is paid interest to pledge their tokens to the network to provide security. The second is to stake LP tokens earned from supplying a DEX with liquidity. This allows users to earn yield twice, as they are paid for supplying liquidity in LP tokens which they can then stake to earn more yield.

    Calculating yield farming returns

    Expected yield returns are usually annualized. The prospective returns are calculated over the course of a year.

    Two often-used measurements are annual percentage rate (APR) and annual percentage yield (APY). APR does not account for compounding — reinvesting gains to generate larger returns — but APY does.

    Keep in mind that the two measurements are merely projections and estimations. Even short-term advantages are difficult to forecast with accuracy. Why? Yield farming is a highly competitive, fast-paced industry with rapidly changing incentives.

    If a yeilarming strategy succeeds for a while, other farmers will flock to take advantage of it, and it will ultimately stop yielding significant returns. Because APR and APY are outmoded market metrics, DeFi will have to construct its own profit calculations. Weekly or even daily expected returns may make more sense due to DeFi’s rapid pace.