Crypto yield farming became the hottest topic in the DeFi summer of 2020. It has since remained one of the most sought-out crypto investment strategies by many who look to earn rewards on their crypto holdings.
Its emergence saw the total value locked (TVL) across all DeFi platforms reach an all-time high of $256 billion, recorded on December 2, 2021. Despite the current market condition and risks, which have likely resulted in TVL dropping to around $112.33 billion, crypto yield farming is still one of the most profitable strategies crypto investors can execute today.
This article explains the various strategies you can adopt to earn on your assets and the risks to look out for before investing.
What is crypto yield farming?
Yield farming is a crypto investment practice that allows you to generate crypto rewards in return for your crypto holdings. In other words, it will enable you to earn passively when you agree to lock up your crypto assets over some time.
The concept is similar to traditional banking systems, which give interest on the amount you agree to lend out. For yield farming, ROIs are being rewarded with additional cryptocurrency.
The most notable cryptocurrencies that support yield farming include stablecoins such as USDC, USDT, DAI, and BUSD. Other popular cryptocurrencies include Bitcoin (BTC), Ethereum 2.0 (ETH), Chainlink (LINK), Polkadot (DOT), Tezos (XTZ), Polygon (MATIC), and SwissBorg (CHSB), among others.
How does it work?
Yielding is a complex strategy that requires the involvement of liquidity providers (LP) to add funds to liquidity pools. As a liquidity provider, when you add funds to the pools, you'll be incentivized with cryptocurrencies for locking up your assets.
What then is a liquidity pool? Basically, it's a smart contract-based protocol where funds are kept. This decentralized platform ensures that all transactions are verified and are seamlessly executed among all involved parties following a preset algorithmic condition. In essence, the pools provide the funding infrastructure, which allows DeFi users to perform various transactions, including borrowing, lending, and swapping.
Rewards distributed to liquidity providers are generated from transaction fees charged to users who trade on DeFi platforms or other sources such as interests from lenders or a governance token.
What APY and APR stand for in yield farming
Annual percentage yield (APY) or annual percentage rate (APR) are the rates of return that come to you as an investor over the course of a year. In simpler words, it's a way you can calculate or track how much interest you'll accumulate over time. Compounding interests, which are interests you receive both on your principal amount and accrued interest over time, is also factored into the APY.
It would help to keep in mind that some projects' APY or ARR (whichever one is used) can change depending on the number of participants, token distribution schedule, and trading fees.
Nonetheless, suppose your investment strategy is basically to make a return on investment for simply holding your crypto. In that case, a cryptocurrency savings account with APR/APY may be all you need.
Different yield farming strategies
There's no one-size-fits-all when it comes to yield farming crypto investments. We recommend considering factors peculiar to your needs and circumstances, judged mainly by your risk appetite, commitment level, and payout preference.
Now, let's break down some different yield strategies you can consider as you look to get on board.
Staking
Crypto staking is one of the most popular ways for long-term crypto holders to invest in yields using decentralized or centralized protocols. It's a low-risk, capital-protection investment plan that allows you to earn passive rewards by simply holding your cryptocurrencies. It is another way, your crypto assets can work for you, bringing you some interests without you needing to sell them.
You can think of staking as the crypto equivalent of government bonds, popularly known as treasuries. When you deposit your funds into an interest-based savings account, you agree to lend it out to the government for a period of time. In return, you're paid a set level of interest corresponding to your investment funds.
Similarly, when you stake your digital assets, you lock them up to participate in maintaining the security of the blockchain and keep it running. In turn, you get your incentives calculated in percentage yields for allowing the blockchain to make use of your capital.
The proof-of-stake consensus mechanism is widely used on the blockchain to select honest individuals who'll participate in the system and ensure no one can mint additional cryptocurrencies they didn't earn. The mechanism also helps increase transaction speed and is done efficiently while lowering fees.
DeFi Lending
DeFi lending is an innovative way of using decentralized protocols to participate in a wide range of lending activities. It is the equivalent of investing in AAA corporate bonds like Apple, Facebook, etc. Generally, AAA bonds are viewed as the least likely investment to default.
DeFi lending is relatively similar to staking, but the difference is in the way your crypto is being used, and the period you can lend out your funds. Instead of locking up your assets to benefit only the blockchain, DeFi lending allows you to lease it out to other crypto borrowers. The decentralized platform charges borrowers certain interest rates, out of which your reward is giving out to you.
Elsewhere, while staking locks up your crypto for a preset time, many lending platforms allow you to withdraw your funds whenever you need to.
DeFi Strategy
DeFi strategy is a key tool for advanced traders. It basically involves the mixing of various options by increasingly employing strategies to get leverage and higher yields.
It can be compared to how traditional investors use various ways to satisfy their insatiable thirst for yields. For example, a traditional investor might purchase real estate for income generation, buy high dividend-paying stocks, or even trade OTC bespoke yield-enhanced notes in order to reach its yield objectives.
Likewise, many crypto investors realize their yield objectives by using a variety of approaches including lending on decentralized money markets, staking on a protocol’s native token, or simply collecting trading fees by depositing passive liquidity into an automated market-maker.
Parachain Auction
Parachains are advanced layer-1 blockchains comprised of independent platforms that run parallel within the Polkadot and Kusama ecosystem. Parachain use cases transcend various customizable industries, including gaming and NFTs, DAOs, IoT, DeFi, and others.
Parachain auction is a way of distributing available slots equitably to determine the number of parachains that will gain access to the Polkadot and Kusama network. When a Parachain auction is held, Polkadot (DOT) or Kusama (KSM) holders can participate by pledging their respective tokens to the project they think deserves the parachain slot.
Once the auction starts, the project that garnered the most slots may commit to airdrop tokens or use other forms of reward structure to compensate their supporters.
The risks of yield farming
Like every other investment plan, crypto yield farming comes with its risks. Some are benign, and sometimes, they can be severe issues.
Getting liquidated on your holdings
Liquidation in crypto happens when there's a drop in collateral price that goes below the loan price. And since cryptocurrencies are known to be notoriously volatile, it could be a real challenge to know when to pull out of a pool and when to stick to it. When a liquidation occurs, the liquidated fund is not enough to cover the loan amount, resulting in a loss.
You can reduce your chance of getting liquidated by implementing the “stop-loss” or “stop-market order” strategy, especially if you're using leverage. This will ensure you’re able to limit potential losses.
Risk of impermanent loss
The net difference between the value of two cryptocurrency assets in a liquidity pool-based automated market maker is known as impermanent loss. During a sharp market move, you can lose all your funds committed to the liquidity pools.
You can minimize your risk when you take the time to understand everything about the pool, how it works, reviews from other users, and whether the protocol offers a solution to mitigate impermanent loss risk.
Issues with the smart contract
The risks associated with DeFi smart contract are in the computer codes inputted by the developers. Seemingly minor errors could lead to hackers taking advantage of the protocol, resulting in capital loss.
To reduce your risk, check if the contract is audited. Go through the audit report to see how the contract was audited and follow up on any updates if bugs were found.
High gas fees
Unfortunately, if you're a participant with small funds, you could lose money due to Ethereum's high gas fees. When that happens, you might realize that the gas fees to withdraw funds are greater than your actual earnings.
Your own strategy
The way you approach your investment strategy could make or mar your yielding. It's important to understand that yield farming strategies change with time. You have to be constantly in the know based on different market conditions. For example, you have to be sure when to jump into a pool or whether you should approach it with a long-term plan in mind.
Conclusion
Yield farming crypto is a viable means that allows you to earn passive rewards on your cryptocurrency assets using various strategies. To get the best out of your investment, you should educate yourself on what methods would work for you and how you can manage the various risks associated with yielding.