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A Beginner's Guide to Yield Farming

November 12, 2020

People who've been keeping up with developments in the cryptocurrency space have probably heard the buzz about yield farming. Many of them may want to add this option to their crypto-related activities but feel they need more information first.

This guide gives a breakdown of the key topics related to yield farming. After reading it, investors will be in better positions to decide whether to pursue it in more depth.

What Is Yield Farming?

Yield farming lets people put their cryptocurrencies to work for them. They do so by providing liquidity, which is commonly associated with assets and markets. Liquid assets are those that get bought and sold quickly and easily without affecting their value, and a liquid market is one with a lot of trading activity.

When yield farmers contribute liquidity, that's called staking. They give it to specialised cryptocurrency websites categorised as protocols, many of which facilitate borrowing and lending.

Most people who are participating in yield farming stake stablecoins, which are tokens linked to a reserve asset or basket of assets. For example, USDC is a cryptocurrency token that is pegged to the U.S. dollar, making it less volatile than many cryptos, hence the name stablecoin. However, staking cryptocurrencies like Bitcoin is also possible.

What Is a Protocol?

A protocol is a base layer of computer code that tells a site or its associated applications how to function. Most of today’s websites — from Amazon to Facebook — have them. Those protocols handle necessities like traffic routing and data transfer. Some application protocols also offer secure connectivity that allows authorised professionals to share their customers’ permissioned data with designated third-party apps.

The majority of internet protocols have thousands or even millions of applications running through them. They’re defined as “thin.” However, cryptocurrency protocols — such as those that allow people to add funds to a digital wallet or make the non-reversible transactions that Bitcoin allows — are called “fat.”

They have relatively few applications on each protocol compared to internet and application protocols. Many of them specify how people can use the cryptocurrency or the digital distributed ledger known as the blockchain.

The protocol’s code works in the background, so site users don’t see it. However, when cryptocurrency enthusiasts talk about protocols, they often expand the definition to include the site or platform that lets them work with their digital currencies and not just the underlying code.

How Does Yield Farming Provide Mutual Benefits?

People who take part in staking via protocols get rewarded in return, usually through tokens or portions of fee payments made by a protocol’s users. Yield farmers often receive native tokens, which activate different applications on the same protocol that distributes them. For example, Musicoin is a music streaming platform that issues native coins that people redeem to hear musicians’ songs or watch their videos.

Yield farming also offers advantages to the various protocols, most of which are in the early stages of existence. Having an active and growing base of enthusiastic users makes it easier for protocols to bootstrap their early activities and attract stakeholders' attention.

What's the History of Yield Farming?

People have varying opinions about when yield farming started, but many say it began in 2018 when FCoin — a now-defunct Chinese exchange — started rewarding people for trading with cryptocurrency. The FCoin team invented what is called the trans fee mining model. In short, the platform returned users’ transaction fees the next day through its FT tokens. FCoin also distributed 80% of its revenue to those people each day, giving them amounts proportional to the number of FT tokens held.

Yield farming rose to popularity more recently thanks to a protocol called Compound and its associated cryptocurrency tokens called cToken. Compound arrived on the cryptocurrency scene in 2017, but people only began receiving the tokens in June 2020. Once that happened, yield farming became an especially hot topic among crypto investors.

Compound is a lending platform that allows borrowers to take out loans. Lenders provide these loans by locking their cryptocurrencies into the company protocol. The corresponding interest rates paid or received depend on the supply and demand related to specific crypto assets given by the lenders. Although there are other crypto-based borrowing and lending platforms, Compound stands out because it rewards lenders with ERC-20 tokens.

An ERC-20 token is a type of cryptocurrency designed solely for use on the Ethereum platform. Once a person locks their cryptocurrency into the Compound protocol, they receive an equivalent amount of cTokens that earn interest for them. They can redeem them at any time to receive the original cryptocurrency back, plus any interest.

How Does Yield Farming Work?

When someone locks their funds to a protocol, those cryptocurrencies stay in a digital wallet and enable a transaction on the blockchain. Then, those locked digital assets earn rewards, including interest (or a yield).

Yield farming arrangements most commonly involve smart contracts called liquidity pools. A smart contract is an agreement existing on the blockchain that functions automatically as long as all parties uphold particular parameters. For example, one concerning work carried out by a contractor would pay that person after the job is completed, without requiring intervention from a person.

A liquidity pool's smart contract contains funds added to it by providers. People are rewarded in return, either in user fees associated with the platform or reward tokens. Some protocols also provide payouts via multiple cryptocurrencies, allowing people to diversify their assets. They can then lock those cryptocurrency rewards in other protocols to maximise their yields.

One of the reasons behind Compound's popularity boom was a decision to award $COMP tokens to liquidity providers, which allowed governance rights over the protocol. Once Compound began offering those, it soared to the top of the DeFi rankings and made more people take notice. Unlike the cTokens, $COMP tokens do not have yield. People are nonetheless interested in them because they see a promising future for Compound and think governance rights may prove valuable.

Yearn Finance is another protocol offering governance tokens to yield farmers. However, the specifics associated with how many rewards people get for locking their cryptocurrencies in protocols and what currencies they receive for doing it vary. That's a primary reason why many yield farmers frequently move their assets between multiple protocols, always in search of the biggest rewards.

How Popular Is Yield Farming?

Many people who are feeling curious about yield farming may wonder if it's just a topic making the news recently or if a growing number of people are genuinely taking part in it. One accurate way to gauge the reality is to watch a metric called total value locked (TVL). It represents the total assets locked into lending platforms or protocols associated with this crypto activity.

As the TVL goes up, it indicates increasing participation in yield farming. Looking at the TVL shows a person the aggregate value of cryptocurrencies put into these protocols. People can also study the TVL to see the relative market share of various protocols before deciding to get involved with them.

An online destination called DeFi Pulse is a widely cited authority for showing the overall activity associated with yield farming. To get an idea of how much yield farming is on the rise, people should consider that there was a TVL of more than $4 billion in the top three protocols listed on DeFi Pulse at the time of this writing.

However, something to keep in mind is that yield farming is far from entering the mainstream. Thus, it enjoys popularity with crypto enthusiasts, but not yet with the wider public. Only time will tell if that will change.

What Are the Benefits and Advantages of Yield Farming?

Today's investors use numerous apps to track their investments. A person familiar with using those will find there's almost no learning curve with yield farming applications. They have user-friendly interfaces that allow people to see the available projects that need staking, then choose the amount of cryptocurrency to contribute.

Another perk of yield farming is that people don't need much to get started with it. The two primary requirements are that someone has Ethereum and a cryptocurrency wallet. The low barrier to entry appeals to people who want to explore what yield farming offers without going through a complicated process. It also helps that there are many directories and regularly updated lists of yield farming opportunities.

The profit potential is another major advantage. People who decide to stake their cryptocurrencies into protocols early could see significant returns.

Annual percentage yield (APY) is the main calculation used to show what someone could earn from a particular yield-farming platform. It’s a percentage representing the rate earned on an investment over one year, accounting for compounding interest. Some of the most successful yield farmers earn an APY of up to several hundred per cent.

Some yield farmers, including those using Compound, get tokens that give them governance rights over a platform that could become hugely popular one day. Yield farmers can also reinvest their gains into other protocols or projects, opening the chance for ongoing profitability.

What Are the Risks and Disadvantages of Yield Farming?

Calculating short-term rewards for yield farming is a challenging task. Yield farming is a competitive and fast-paced market, and the outcomes may not stay consistently lucrative. Another thing to be aware of is, although it's easy to get involved, figuring out the most profitable strategies is not so straightforward. People should not consider yield farming a guaranteed route to riches.

The high Ethereum gas prices seen this year are another downside to yield farming. Gas is the transaction fee or pricing value that someone must pay to carry out a transaction on the Ethereum blockchain. Gas prices have climbed steeply in 2020, and they reached $500,000 in one hour during a day in September.

Thus, although people can start yield farming with a small deposit, it may not be worth it to get involved by contributing less than a five-figure investment. Otherwise, the gas fees will be higher than the yield.  

A recent analysis also suggests that the people who have the highest amounts of cryptocurrencies to use — a group commonly known as "whales" — are the most likely to profit from yield farming. In one example, a whale locked more than $97 million of stablecoins in a protocol and made $800,000 in three weeks. Another whale put $40.6 million in it and earned $500,000 in the same amount of time.

That's not to say people can't still get good results from investing less. However, they should be aware that the ultra-lucrative outcomes may most likely happen for people who have access to tremendous amounts of cryptocurrencies.

Jason Lau, the chief operating officer of OkCoin, also pointed out that the APY associated with most protocols shows the expected return for an entire year. However, most yield farming projects last for mere weeks. He said, "The actual calculation of yield percentages are not transparent, and farming for any particular reward often only lasts a few days to weeks, with projects often reducing the reward over time."

Is Yield Farming Safe?

Yield farming is like many other investment options in that it can be dangerous for people who don't understand the pitfalls. One practical way investors can make it as safe as possible for themselves is to moderate the risk/reward ratio associated with their decisions. One man lost $5,000  when token prices fell overnight by declining 100 times their original value.

A recent survey also found that 40% of people involved in yield farming do not know how to read smart contracts. That inability could mean they can't spot potential red flags that could make an arrangement overly risky or even an outright scam. Also, if a person relies on an outside party to interpret the smart contract, they must place a great deal of trust in that individual.

Yield farming can also become unsafe due to its technical reliance on smart contracts. Mistakes in the code can cause unexpected consequences. One recent issue concerned a bug in a smart contract for the Yam Finance protocol. The error caused unintended growth in the token supply, which would eventually reduce the value of everyone's tokens over time. This issue came to light after people had staked millions into the protocol.

The team behind Yam Finance also admitted it had not audited its code before releasing it to the world. Problems with smart contracts can crop up at any time due to the potential for human error. However, investors can make yield farming safer for themselves by choosing protocols that go through regular checks to spot and resolve issues.

Even people heavily involved in yield farming describe it as risky, with some admitting the full risks remain unknown in these early stages. However, as most investors know, it's sometimes necessary to go outside of a comfort zone for the sake of making investment decisions pay off.

Taking the time to get as informed as possible about the protocols, and the general pros and cons of yield farming, will put people in a better position to decide how to move forward.    

Ready to Try Yield Farming?

After reading this guide, you might be interested in giving yield farming a try, but concerned about the risks involved.

This is why SwissBorg has built a Smart Yield account that automatically scans the market to connect you to a range of DeFi and CeFi programs to find the best yield for the lowest risk. They also mitigate the risks involved in yield farming with a Safety Net Program, where they reserve 25% of all revenues earned to offset the risk involved with smart contracts.

Ready to get started? Sign up to be notified as soon as their Smart Yield accounts launch!

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