DeFi yield farming, explained

What is yield farming?

Yield farming is the practice of staking or locking up cryptocurrencies in return for rewards. While the expectation of earning yield on investments is nothing new, the overall concept of yield farming has arisen from the decentralized finance sector. The general idea is that individuals can earn tokens in exchange for their participation in DeFi applications. Yield farming can also be called liquidity mining.

The popularity of yield farming has become a self-fulfilling prophesy comparable to the initial coin offerings boom of 2017 due to the laws of supply and demand. As each new project that emerges offers new tokens or ways to earn rewards, users have been flocking to it, hoping to get a cut of the yield on offer. In turn, this creates a demand that pushes up the value invested in the project and the tokens.

How does yield farming work?

The precise mechanics of yield farming depend on the terms and features of the individual DeFi application. The practice started out by offering users a small share of transaction fees for contributing liquidity to a particular application, such as Uniswap or Balancer. However, the most common yield farming method is to use a DeFi application and earn the project token in return. 

This practice became popular early in the summer of 2020 when Compound announced it would start issuing its COMP governance token to lenders and borrowers who use the Compound application. It was an instant hit, pushing Compound to the top of the DeFi rankings. 

Since then, several projects have followed suit by creating DeFi applications with associated governance or native tokens and rewarding users with their tokens. These copycat tokens have replicated COMP’s success like, for example, Balancer’s BAL token, which gained 230% immediately after launching. The continued success of each new project fuels more innovation, as projects compete fiercely for users.

The most successful yield farmers maximize their returns by deploying more complicated investment strategies. These strategies usually involve staking tokens in a chain of protocols to generate maximum yield.

Yield farmers typically stake stablecoins, such as Dai, Tether (USDT) or USD Coin (USDC), as they offer an easy way to track profits and losses. However, it’s also possible to farm yield using cryptocurrencies such as Ether (ETH).

What are the benefits and risks of yield farming?

The benefits of yield farming are immediately apparent — profit. Yield farmers who are early to adopt a new project can benefit from token rewards that may quickly appreciate in value. If they sell those tokens at the right time, significant gains can be made. Those gains can be reinvested in other DeFi projects to farm yet more yield.

Yield farmers generally have to put down a large value of initial capital to generate any significant profits — even hundreds of thousands of dollars can be at stake. Due to the highly volatile nature of cryptocurrencies and particularly DeFi tokens, yield farmers are exposed to a significant liquidation risk if the market suddenly drops, like it did with HotdogSwap. Furthermore, the most successful yield farming strategies are complex. Therefore, the risk is higher for those who don’t fully understand how all the underlying protocols work. 

Yield farmers also take risks on the project teams and underlying smart contract code. The potential for gains in the DeFi space attracts many developers and entrepreneurs who bootstrap projects from scratch or even copy the code of their predecessors. Even if the project team is honest, its code is often unaudited and may be subject to bugs that make it vulnerable to attackers.

There have been several examples of this risk playing out as yield farming has grown in popularity. One is bZx, which suffered a series of hacks early this year and, most recently, lost another $8 million, which were later returned, due to a single misplaced line of code.

YAM Finance was another high-profile example. The project’s YAM token went from zero to $57 million in value locked in only two days after its launch in August — then crashed when the founder admitted a major flaw in the underlying code. A subsequent audit revealed several more issues related to security and performance.

What are the key challenges and opportunities for yield farming?

Most DeFi applications are currently based on the Ethereum blockchain, creating some critical challenges for yield farmers. Ahead of the Ethereum 2.0 upgrade, the network is struggling with a lack of scalability. As yield farming becomes more popular, more transactions clog up the Ethereum network, leading to slow confirmation times and spiraling transaction fees. 

This situation has led to some speculation that DeFi could end up self-cannibalizing. However, it seems more likely that Ethereum’s woes will ultimately work to the benefit of other platforms. For example, the Binance Smart Chain has emerged as an alternative option for the yield farmers that flocked to the network to take advantage of new DeFi DApps, such as BurgerSwap. 

Furthermore, Ethereum’s existing DeFi operators are also attempting to alleviate the issue with their own second-layer solutions for the existing platform. Therefore, assuming that the problems with Ethereum aren’t fatal to DeFi, the practice of yield farming could end up being around for some time to come.