What Is Yield Farming?

The rapid growth of decentralized finance (DeFi) has been partially driven by interest in yield farming, also known as liquidity mining. Yield farming is the practice of maximizing returns on crypto holdings through a variety of DeFi liquidity mining methods.

While it can be lucrative, it requires a thorough understanding of DeFi protocols to be successful. In most cases, yield farmers enact complicated and evolving strategies, frequently moving crypto assets between lending marketplaces to maximize returns.

Because of this, acquiring knowledge of how yield farming works can be intimidating for newcomers. It’s important to be equipped with best practices before engaging in this new sector.

Decentralized Exchanges (DEXs) and Crypto Liquidity Pools

Within the DeFi ecosystem, decentralized exchanges (DEXs) have become some of the most widely used crypto protocols. Unlike centralized exchange (CEX) order books, DEXs utilize liquidity pools to facilitate peer-to-peer (P2P) trades. Structures known as liquidity pools help many DEXs maintain fair market values for the tokens they hold thanks to automated market maker (AMM) algorithms, which maintain the price of tokens relative to one another within any particular pool.

Crypto liquidity pools in different protocols may use algorithms that differ slightly. For example: Uniswap liquidity pools use a constant product formula to maintain price ratios, and many DEX platforms utilize models with varying degrees of similarity.

AMM liquidity pools used by today’s leading DEXs reduce or remove the need for a centralized entity, and as a result, they require a sustained outside source of liquidity to function properly. This is where liquidity providers (LPs) enter the equation. Liquidity providers are individuals who either create a liquidity pool of their own making or, more often, deposit tokens into an existing one so that traders can purchase tokens on a DEX.

Let’s use an example: On the PancakeSwap platform, an LP could deposit $100 USD worth of CAKE and $100 USD worth of BNB to the CAKE/BNB liquidity pool. As a reward for providing this liquidity to the PancakeSwap DEX platform, the PancakeSwap LP would receive FLIP (PancakeSwap's Liquidity Provider token) as a reward.

LPs earn a return on these tokens as long as they hold them, expressed as an annual percentage yield (APY). This return comes from the average trading fees generated by the CAKE/BNB liquidity pool. Earning LP tokens is a fundamental step in many DeFi yield farming strategies.

Yield Farming Crypto: DeFi Liquidity Mining Strategies

Acting as a LP is often an early step in establishing a yield farming strategy. However, liquidity providers are not bonafide yield farmers until their LP tokens are maximized by being staked into multiple protocols and/or pools. In many cases, liquidity miners deposit tokens across different liquidity pools and DEX protocols.

Let’s take a look at another example. A simple strategy for yield farming crypto might include the following steps:

1. Deposit CAKE and BNB to the CAKE/BNB liquidity pool on PancakeSwap.

2. Receive CAKE-BNB FLIP tokens.

3. Deposit CAKE-BNB FLIP tokens into the corresponding CAKE crypto liquidity pool, amplifying returns.

The DeFi liquidity mining space is abundant with this kind of staking or farming opportunity, and more pools and protocols emerge by the day. Those yield farming crypto can stake their LP tokens in various protocols and liquidity pools for as long as they may choose — from a few days to several months.

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The Crypto Yield Farming Ecosystem

Given the diversity of crypto yield farming strategies, there's no one way to yield the highest returns. In addition, the rapid pace of development creates an ecosystem that constantly evolves, requiring an ongoing assessment of DeFi yield farming opportunities. While not exhaustive, the list below includes some of the core yield farming platforms.

Aave: A decentralized, open source, non-custodial crypto lending and borrowing protocol. Users can create money markets, borrow assets, and earn compound interest in the form of AAVE tokens.

Compound: A money market protocol that facilitates crypto lending and borrowing utilizing algorithmically adjusted compound interest rates. Users can also earn COMP governance tokens by accessing the protocol.

Curve Finance: A DEX protocol that enables stablecoin exchange for users and other decentralized protocols. The Curve protocol uses a unique market-making algorithm to ensure low fees and minimal slippage.

Uniswap: A DEX and AMM that facilitates the exchange of almost any ERC-20 token pair.

PancakeSwap: A DEX and AMM on the Binance Smart Chain (BSC) that enables the exchange of BEP-20 tokens.

Venus Protocol: An algorithmic money-market platform that integrates lending and credit systems on BSC.

Balancer: An automated trading and portfolio manager that utilizes flexible staking for its liquidity protocol.

Yearn.finance: A decentralized, automated aggregation protocol for which user-generated algorithms find profitable crypto yield farming services.

What Are the Pros of Crypto Yield Farming?

As with any investment, there are pros and cons — and the truth is there isn’t one single way to be a successful investor. You need to consider your risk tolerance and the amount of time you have to manage your investments. Some prefer passive investments, while others have the time to be more hands-on with their investments. 

That said, here are some of the advantages of yield farming:

Potential for High Returns

One of the appeals of crypto yield farming is the potential for high returns. The crypto market is volatile, but this volatility can present opportunities. Many investors have profited—and continue to profit—from strategies like crypto yield farming.. This high return can come in the form of tokens or can be based on a percentage of transaction fees. 

With the right investment strategy and timing on your side, crypto yield farming can outperform the returns of traditional investments. During the crypto yield farming surge in 2020, some investors made enormous returns.

Passive Income

Although it’s not quite a “set it and forget it” strategy, crypto yield farming is appealing to investors for the passive income it produces. 

Crypto Yield Farming Provides Diversification

Yield farming not only provides a way to create passive income, but it also is enticing to some investors who desire diversification. 

Yield farming is expanding alongside the growing interest and momentum in the DeFi market. This is providing more investment options than ever, and many more than the critics of DeFi thought were possible. Investors can diversify traditional portfolios by participating in crypto yield farming, and they can also diversify within yield farming options, which are growing in popularity. 

Becoming Part of a Modern Investing Community

For some, the appeal of being a champion of DeFi is important, and crypto yield farming provides the opportunity to be part of a modern investing community, and helping to shape the future of DeFi. 

Having a true sense of ownership and governance is fulfilling for many crypto advocates. It’s something you can’t do with a traditional bank. 

Are There Downsides of Crypto Yield Farming?

With all of this in mind, it’s also important to be aware of some potential downsides of yield farming so you can make informed choices. Here’s what to know.

Volatility

It’s no secret that the crypto market can be volatile, but what makes crypto yield farming particularly volatile? There are a few things at play to consider. 

First off, there are various sizes of DeFi protocols and some have less liquidity than others. This can make the potential for gains exciting, but can also make the investment a bit more vulnerable. Because yield farming has many moving parts across multiple platforms, the assets are interconnected, and can cause larger swings than traditional crypto assets. 

Investment Loss via Impermanent Loss

Because liquidity ratios are constantly changing, the value of assets can change quickly when the ratios change. It’s not something you can control, but it is something you should be aware of. 

In fact, there have been market swings that have caused liquidity pools to be reduced by over 50%, and ratios have been quickly reduced. 

Bad Actors Creating Scams

It seems that wherever there’s a way to make money, there’s bound to be fraudulent behavior. Incidents in crypto, such as “rug pulling,” can happen, which is why it’s crucial to do your due diligence when researching any crypto investment. 

Essentially, rug pulling can happen after an investment has been promoted and there’s high interest. Once the money starts rolling in to fund the investment, the project is halted, and everything comes to a stop — including getting your money back. 

Rug pulling is the most common scam and crime in crypto. It can also be referred to as “getting rugged.” 

To avoid rug pulls, do your research, be sure to thoroughly check the security protocols, and get involved in crypto communities — word travels fast, and crypto investors tend to look out for one another. 

Now that we’ve covered some of the pros and cons of crypto yield farming, let’s discuss two concepts that often get confused with one another as one and the same — staking crypto vs. yield farming. 

Staking Crypto vs. Yield Farming

Although yield farming and staking crypto are two different practices, some mistakenly refer to them interchangeably. Yield farming — or liquidity mining — is a method of generating rewards with cryptocurrency holdings. The primary purpose of staking, on the other hand, is as part of the consensus mechanism of a Proof-of-Stake (PoS) blockchain network — a process for which stakers also receive rewards.

While acting as a staker also generates a return, it's typically much lower than the return on DeFi yield farming protocols. In general, staking yields pay out annually, ranging between 5% to 15%. In comparison, yield farming rates in crypto liquidity pools can exceed 100% and pay out on a continual basis, allowing for withdrawals at any time.

However, while crypto yield farming is typically more profitable than staking, it's also high-risk. For example, when yield farming on Ethereum (ETH), the network gas fees required to collect rewards can reduce earnings from APY rates.

In addition, if the market becomes volatile in either direction, impermanent loss can occur and drastically reduce profitability. This is when the value of tokens held in an algorithmically balanced liquidity pool lose value relative to assets in the open market. 

Finally, because liquidity pools use smart contracts, there's also a chance hackers could find and exploit vulnerabilities in the underlying code.

Yield Farming Crypto With Leverage

Leverage is the use of borrowed money to fund an investment. Just as leveraged trading can amplify returns and risks across traditional asset classes and crypto alike, yield farming crypto with leverage can amplify the returns issued by DeFi protocols.

The primary benefit of leveraged yield farming is that farmers can borrow more than the collateral they put up, further amplifying returns. For example: if yield farming with "X" yields "Y" returns, then yield farming with "10X" yields "10Y" returns. It’s imperative to keep in mind that losses work in a similarly amplified fashion if price targets are missed. Leveraged trading and crypto yield farming are practices best reserved for very experienced investors.

Leveraged yield farming platforms are a new but fast-growing sector of DeFi, and protocols utilize a varied methodology that brings together protocols, lenders, yield farmers, and liquidity providers to create opportunities to borrow and farm tokens in various liquidity pools and rewards-generating markets.

Some of today’s most notable leveraged yield farming crypto platforms include:

• Alpaca Finance (BSC): Marketed as the largest lending protocol to enable leveraged yield farming on the BSC. The protocol aims to deliver safe and stable yields to lenders while providing undercollateralized loans for yield farmers.

• Tulip (Solana): Operates as the first yield-aggregation platform built on Solana. The platform offers auto-compounding vault strategies and leverages the Solana blockchain's low cost and high efficiency.

DeFi yield farming protocols will continue to evolve even more complex strategies. Already, leveraged yield farming has introduced some of the first under-collateralized loans — managed by smart contract — in the crypto industry.

This functionality seeks to address several DeFi shortcomings, including capital efficiency and the providence of deeper capital markets. In addition to these systemic improvements, crypto yield farming is helping to establish more mature DeFi protocols and increase their earning potential, fueling growth across the entire ecosystem.

How To Get Started With Crypto Yield Farming

Before getting started with yield farming, it’s important to thoroughly research the process, understand key terminology, and assess potential risks. A fundamental understanding of smart contracts and how they function is essential, as they form the backbone of DeFi platforms.

Below is a quick guide to getting started with crypto yield farming: 

• First, you’ll need to select a DeFi platform. Be sure to check for one that offers yield farming, and do your research regarding security protocols. 

• Next, you’ll need a crypto wallet if you don’t already have one. Once you’ve secured a wallet, you can connect and associate it with your DeFi platform selected. 

• Once you deposit funds into liquidity pools within the platform, you can start earning rewards. 

The Bottom Line

Crypto yield farming is an evolving sector in decentralized finance (DeFi) that enables investors to earn rewards and interest on their digital assets. 

Unlike traditional investments, yield farming requires active participation, as investors often move their assets between platforms to optimize returns. Recent developments have also introduced leveraged yield farming, where farmers can borrow funds to enhance their earnings. 

Crypto yield farming offers a promising but complex investment opportunity in the DeFi ecosystem. By understanding its mechanisms, risks, and benefits, investors can explore yield farming and potentially earn significant returns while engaging with the evolving cryptocurrency community.

Learn more about crypto yield farming at Gemini.

The information provided in this article is for informational purposes only and should not be construed as financial, investment, or legal advice. Crypto yield farming and decentralized finance (DeFi) investments involve significant risks, including but not limited to market volatility, liquidity fluctuations, impermanent loss, smart contract vulnerabilities, and security risks such as fraud or scams. Past performance is not indicative of future results, and there is no guarantee of returns. Inv

Gemini does not endorse, guarantee, or assume liability for any third-party platforms, DeFi protocols, or investment strategies mentioned. Always verify security protocols, use reputable sources, and remain vigilant against potential risks when participating in the crypto market.