With yield farming, you let your crypto work for you in the world of Decentralized Finance (DeFi). Just as you could in a traditional savings account. Also, in DeFi you get interest (yield) in exchange for parking your money there.
So far, no difference. But in DeFi, the rates are higher, and the process is more decentralized - and as complicated as you want to make it. On top of that, everyone works from their own wallet (like MetaMask) and there's no helpdesk you can call.
In DeFi, all kinds of banking processes that normally go through a central body are spread among users. Traditionally it was banks that made money on the exchange of currency - now it is the users who make their capital available for other people's transactions. The users are rewarded for this. In this way, everyone becomes a market maker.
Liquidity pools and yield
Participants put their crypto, for example, into pools, so they jointly create a marketplace. After all, you need capital to have a functioning lending, borrowing and trading platform. And that capital in crypto is spread across hundreds of different coins. Meet: liquidity pools.
Suppose I bought (the fictitious) YippieCoin and believe in a long and prosperous future for that coin. Instead of simply holding my YippieCoins, I put them into a liquidity pool of a DeFi protocol. For example, in a pool that allows people to buy YippieCoin with a stablecoin, let's say USDT. So that's the YippieCoin/USDT liquidity pool: basically, a smart contract drawn up in the programming code, which locks up the coins. In exchange for the ability I give to other users to buy, borrow or lend YippieCoin, I get a reward. That reward is paid out in crypto of course. That is one of the multiple types of returns (yield) in DeFi.
In the below image you see a part of a pool of Avalanche's Trader Joe exchange.
So, what is the farm?
The simplest form of earning yield is simply making your coins available in a protocol like Aave or Compound. You get interest in return, paid in your own crypto. Very easy and the percentages, as mentioned, are higher – no surprise there - than with a traditional interest account. The percentages do fluctuate a lot more though.
But if you really want to farm, you go a step further. The real farmers carefully choose a DeFi protocol that offers the highest percentages on certain liquidity pools. Such a protocol seeks to raise capital quickly with double digit percentages. The yield is paid out in the protocol's own coins. These are so-called governance tokens, which give voting rights in the protocol. In Compound for example, a pioneer in this field, the token is COMP. The fact that the distribution is in the protocol's own coin is a way for the new DeFi platform to spread a kind of shared ownership among users and get a community off the ground. The farmers in turn hope that the value of these new coins will go up. They will then be the first to own the coins: at this early stage, they are not yet for sale on centralized exchanges like Coinbase, FTX or LiteBit.
Because the real farmer wants to put every bit of capital to work, he or she will also try to monetize these newly acquired governance tokens. For example, by depositing them with another protocol and getting paid another governance token in return. And so on and so forth....
Some DeFi lovers don't think this goes far enough and will for example pay high interest rates to borrow more, as long as they get the governance token of the protocol in return. This again in the hope that the new coin will go up in price much harder than the interest they are paying.
In the world of yield farming, users can try to make it as complicated and lucrative as they want - with, of course, the risks involved. For example, by using leverage from stacking loan upon loan. This works as follows in yield farming: users place their coins as collateral to borrow other crypto. That other crypto they in turn put up as collateral for another loan, etcetera. This creates a chain of token returns. But when prices fall dramatically, the house of cards collapses.
The number of protocols and combination of strategies is enormous. Hence the term DeFi Degenerate (DeFIdegen) that was coined (pun intended) for farmers who are totally addicted. For the more passive investors there are therefore applications designed to outsource the determination of a farming strategy. Yearn Finance, for example, has so-called Vaults for this purpose.
The main yield farming platforms
Some of the yield farming platforms that have been popular for a few years already are Uniswap, Pancakeswap, Curve Finance and Aave.
The biggest risk of the novice farmer is to try strategies that out of his league, such as the aforementioned leverage. Besides, stashing thousands of dollars or more of crypto in MetaMask or a similar app is a risk. These are simply browser extensions that are susceptible to hacks. Plus: if you lose the seed phrase and forget your password, you lose your money. That's perhaps the biggest risk: your own mismanagement of strategies and funds.
A tricky financial-technical obstacle, even for the more advanced, is the phenomenon of impermanent loss. This is the loss of your investment in a pool compared to if you had done nothing with it. Impermanent loss means something like unrealized loss. But the moment you withdraw your capital from the pool, it is all too real. Impermanent loss occurs when there are severe price fluctuations. For example, what happens to the liquidity pool of ETH and USDC if ETH rises sharply in value? Then ETH has to be sold for USDC to keep the ratio right. If you later withdraw your ETH and USDC from the pool, in this example you will get back less ETH and more USDC than you had put in. You did make a profit, partly because of the interest. But the profit could be less than if you had not put your ETH into the pool to begin with.
Apart from this practical problem, there are systemic risks. Certainly, beginning DeFi protocols have not yet been battle tested all that much. They are targets for hackers. Consequently, it occasionally happens that funds are stolen. Admittedly, users are often compensated by the investors behind the protocol. But still.
Having said all this, DeFi is a great playground to experience what it is like to be a market maker. Another way in which crypto deliver on the promise of crypto to become your own bank. As long as you accept the risks involved, you can also expect a nice crop of coins.