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Yield farming in crypto: Things you need to know about it

Money lending is a common thing to do, and you would see it present in multiple countries. This comes in the form of banks providing loans to their customers and people lending a helping hand to their neighbours. Through money lending, they earn a bit of profit because of the added interest.

In cryptocurrency, money lending is also present in the form of yield farming. Continue reading the rest of the article if you want to find out more.

What is yield farming in crypto?

In the simplest terms, yield farming is the process of lending crypto coins or tokens to receive a high return in the end. This phenomenon is present in Decentralised Finance (DeFi), which is a financial technology that strives to eliminate any intermediary or third party in transactions. 

Liquidity in crypto

To further understand what yield farming is, you need to know what crypto liquidity is first. This refers to the simplicity of the process of swapping tokens for another kind of crypto or fiat currency. DeFi platforms such as Curve Finance and Uniswap achieve this kind of convenience through liquidity pools. These are avenues that pool all crypto coins and tokens that people can buy and sell. Moreover, liquidity pools function because of smart contracts, which means that they would not need any intermediary.

Those who contribute to the pool’s liquidity are what you call liquidity providers (LP). They are the ones who would stake or lend coins and tokens to the pool and receive rewards in return. These rewards come from a portion of the transaction fees that DeFi collects from any trade among its network.

The inner workings of yield farming

Now that you know what liquidity pools and providers are, it is time to discuss how to yield farming works. 

A marketplace for people to buy, sell or exchange tokens and coins is created through the deposited or lent funds of liquidity providers. The pool generates income by charging the transaction fees that will be used to pay or reward the liquidity providers because of their shares. Aside from transaction fees, liquidity providers have the opportunity to get first access to a new token! 

Moreover, there are different types of yield farming, which are as follows:

  1. Liquidity provider – This is the process of depositing coins or tokens to pool in the hopes of improving trading liquidity. The fees from exchanges are what the liquidity providers will receive for their contribution.
  2. Lending – Coin and token holders have the opportunity to lend their assets to people by using a smart contract. Through this, the lenders will earn profit due to the added interest.
  3. Borrowing – Another type of yield farming is borrowing, which happens when an investor uses one token as collateral or security from a loan. The lender has an initial holding, and at the same time yields profit from the borrowed coins.
  4. Staking – In DeFi, you can stake your coins and tokens through proof-of-stake or liquidity pools. The former lets you stake your assets and contribute to the blockchain, while the latter lets you earn from contributing to the trading liquidity.

Calculation of yield farming returns

Your yield returns are calculated annually, which shows how much you can receive over a year. In this case, computational methods such as the annual percentage rate (APR) and annual percentage yield (APY) are used to calculate the supposed returns. However, it is also important to remember that the resulting numbers from these two computations are in no way fixed since they are just estimations. 

Understanding the importance of collateralization

Since yield farming is similar to fiat money lending, collateralization is included here as well. To minimise the risk of the lender, the borrower needs to treat an item of value as collateral. In other words, it serves as a repayment for the loan in the instance the borrower fails to uphold its end of the bargain on time.

In crypto, you need to be aware of the collateralization ratio of protocols. This is because your collaterals can be liquidated to the market, in case their value falls lower than the threshold of a protocol. To avoid this, most rules of any protocol involve over-collateralization which requires the borrower to pledge a value more than the amount they want to borrow. 

The pros and cons of yield farming 

With every detail combined, it is time to get down and see the pros and cons of yield farming to help you know more about it: 


  1. The chance of receiving higher returns

When the demand in a liquidity pool rises, interest rates can increase. Due to this, the liquidity providers can yield higher returns, which can motivate them to invest more and contribute to the well being of the coin or token.

  1. Yield farming can be a form of investment

Your farming and contribution to a DeFi protocol can benefit the future of the coin or token. This is because it can bring the possibility of the crypto doing well, which will attract more people to make transactions in the market. In return, your investment in the pools will also increase in terms of value.


  1. Yield farming is not easy

As promising and advantageous as it seems, you need to know at this point that yield farming is not easy. It has a highly volatile nature and the state of the liquidity pool erratically changes per day. As such, there is no constant, so you need to be smart in terms of when to become part of the liquidity pool.

  1. There is a risk of contributions falling apart

DeFi’s advantage for its users is that there is no third party involved, which means all the transactions are processed by the people through smart contracts. With this said, it shows that it heavily relies on the network operating seamlessly. In the event a bottleneck occurs, there is a chance that your contributions to the pool will fall apart.

Yield farming: Is it a yes or a no?

Should you get into yield farming? The answer to this question relies on how well you know the crypto universe and everything it involves. Doing some research on things you’re not sure of can be a big help in navigating the industry. If you happen to be knowledgeable about it, you can try yield farming to gain experience. 

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