Yield Farming: What Is Yield Farming and How Does It Work?
By | Updated January 7th, 2022
What does yield farming mean?
Yield farming is a way of turning crypto into more crypto. It often involves staking crypto in a liquidity pool over a certain period of time in exchange for transaction fees or some other reward. A yield farmer will strategically stake in multiple liquidity pools to maximize their return.
What Is Yield Farming?
Yield farming is also known as liquidity mining, because yield farmers are attempting to extract value out of liquidity pools.
Liquidity pools are comprised of tokens that are held in smart contract. Liquidity pools are necessary because decentralized exchanges (DEXs) operate at too fast a pace for traditional market makers to facilitate them; without them, the rate of slippage would become unacceptably high.
Liquidity providers lend tokens to a liquidity pool so the automated market maker can facilitate trading and other DeFi activities. In consideration of lending their tokens to be held in smart contract, a liquidity provider is paid a share of the fees that are generated when other investors use their liquidity pool (in proportion to their contribution to it). Liquidity providers may also receive novel tokens, which are often hard to purchase elsewhere.
A liquidity provider becomes a yield farmer when they begin strategically selecting which liquidity pools they will lend to. Their aim is to maximize their payout by locking up their tokens in the highest yielding pools they can access.
This involves exploiting multiple pools simultaneously, a series of pools, or both. But yield farming can only become immensely profitable because it carries certain risks!
Why Is Yield Farming Risky?
A yield farmer’s goal is to maximize their annual percentage yield (APY), which measures their ROI while taking compounding interest into account. It is a comprehensive way of tracking ROI while investing in multiple different liquidity pools.
But maximizing an APY is not easy. The yield farmer’s ideal strategy includes investing in liquidity pools that share very few liquidity providers, as these provide the highest ROI. As more liquidity providers enter a pool, the lower its returns become.
Recognizing the right time to exit a pool with an increasing number of providers is key to successful yield farming. This is why successful yield farming strategies are so fiercely guarded – they become less effective as more people use them.
Furthermore, smart contracts and the other building blocks that comprise a DeFi system are not 100% reliable. If any element that your liquidity pool is reliant on bugs out, your only recourse for losing your funds may be punching your computer screen.
Yield farming can be a great crypto investment strategy – but not if you go into it blindly. It takes a serious knowledge of DEXs to formulate a sound plan, and your chance of success becomes greater when you are a whale. But there are stories of savvy newcomers who turned a few tokens into a fortune through yield farming!