How Yield Farming Works
The Automated Market Maker system (AMM) has revolutionized the decentralized finance. It allows anyone to independently provide liquidity for the crypto markets of decentralized exchanges (DEXs) to facilitate trades. AMM system is widely used by most DEXs that allows users to fund the liquidity pools to earn rewards. Yield farming not only encompasses the liquidity mining, but also lending and staking or the combination of all. In some DeFi platforms, the yields you earn can come from a combination of transaction fees and the interest generated by lending. Harvest finance is an example of such yield aggregator platform.
In the process, users deposit their crypto assets in a liquidity pool which is basically a smart contract which fuels AMM system. As a result, they receive LP tokens which represent how much liquidity they have provided. When trade occurs through the assets in the pools, a portion of trade fees is granted to liquidity providers. In some cases, users can also stake their LP tokens to earn even more rewards. Afterwards, they can also compound the rewards by reinvesting them into other liquidity pools – the process can be automatic in some platforms. The most common risk it carries is the market volatility of crypto assets. If price decreases, the value of their rewards can decrease leading to a loss.
Earning Potential
Yield farming is beyond just providing liquidity and earning transaction fees. The earning potential varies depending on the employed strategy. In simple yield farming, you deposit crypto assets in a specific pool and earn a portion of transaction fees. Some pools also provide incentive rewards which can increase the APR rate from 50% to more than 100%.
Some platforms provide auto-compound strategy in which rewards are automatically reinvested into new pools. This strategy gives better returns but also has risks like impermanent loss. The auto-compound can increase the APR rate by 10-30% compared to non-compound yield strategies. Yearn Finance and Beefy Finance are some of the platforms that provide this feature.
Another great strategy is to use yield bots which are algorithms or tools that automatically invest assets in various pools to maximize the rewards for users. These bots can give better returns compared to manual yield farming. The yield bots can provide APR up to 200% or above. This is made possible by dynamic allocation of crypto across multiple liquidity pools, lending platforms and other yield farms based on predefined rules and market conditions. The bots can adjust the current investments in real-time to maximize profit. Interestingly, these bots rely on APIs and oracles to access real-time information about various DeFi platforms and markets. That’s how they identify the best possible yield opportunities across the DeFi ecosystem. These bots can also auto-compound.
Risks
One of the major risks is the price volatility of the assets that you deposit in liquidity pools. This also exists in case of staking and lending. That’s why, assets with stable price movements are better to be used in staking and yield farming. Even if this risk is ruled out, investors can face impermanent loss. This occurs when value of assets in the pool changes compared to simply holding them. This can be mitigated if you invest in pools with high trading volume and incentive rewards.
Other risks are present at the platform level. Bugs or errors in the smart contract code can lead to unauthorized access or loss of users’ funds. Additionally, while encryption and network security protocols (like firewalls) provide security, vulnerabilities can still exist. However, the platform-level risks can be mitigated by choosing a secure and reputable DeFi platform.
Top 3 Strategies
- Stablecoin Yield Farming
This strategy involves the use of stablecoins which are stable assets pegged to real-world assets. You can deposit popular stablecoins like USDT or USDC in yield aggregator platforms or DEXs to earn stable or predictable yields. The risk of impermanent loss and price fluctuations is minimal. Whether this strategy is better than the one involving normal cryptocurrencies depends on various factors such as risks, and profitability. The risk of impermanent loss is ruled out, but stablecoin pools offer lower APR rates due to reduced risk and high trading volume. Specifically for this strategy, yield aggregator platforms like Yearn Finance can be good option.
- Liquidity Provision
Liquidity Provision means depositing coins in liquidity pools in decentralized exchanges to earn transaction fees and other incentive rewards. Pancake Swap is a good platform for earning boosted yields because it also allows staking of LP tokens. It has diverse range of pools known as Farms. You can earn up to 300% APR. The impermanent loss can be a major risk in this strategy. Pools with high trading volume and additional incentive rewards can help reduce that risk.
- Yield Aggregation
Yield aggregators have become popular in the recent years. These are platforms which use algorithms to find the best yield opportunities across multiple DeFi platforms by utilizing the real-time information through APIs and oracles. The process is mostly automatic and supports auto-compound. The impermanent loss is also reduced through this strategy because the algorithms monitor the performance of investments and adjust asset allocations. Yearn Finance and Beefy Finance are some of the best yield aggregators in 2024.