Yield farming has risen to prominence in recent years with the advent of decentralized finance services. The activity is designed to help users of such platform earn on their available digital assets, while providing the market at large with a source of liquidity.

Yield Farming Explained

The process of yield farming, or liquidity farming, as it is often called, is the act of users party to a decentralized finance service providing, or lending their cryptocurrencies into a specialized repository called a liquidity pool. The users provide their assets in trading pairs with others and receive passive income in return in the form of interest or commissions from the services using these funds to process their operations. The process of yield farming is very similar to staking and is often compared as a source of passive income.

The rewards users receive are usually paid in native platform liquidity pool tokens, which can be redeemed for the originally lent assets if the user decides to withdraw their share of the liquidity pool. The rate of return users can expect to receive is measured in APY, or Annual Percentage Yield, which outlines the return users can expect to receive over the course of a calendar year.

Many liquidity pool services rely on compounding, which is the process of placing the rewards users earn onto their balance in the liquidity pool to increase the share. This process, often called auto-compounding, can offer significant rewards, as many of the liquidity pool platforms incentivize users to do so by offering additional rewards.

The assets users provide into a liquidity pool are then offered to exchanges and other services that require liquidity. Automated Market Makers, also known as AMMs are the services operating the liquidity pools, giving permissionless trading and liquidity tapping to all participants of the system.

Potential Rewards

The phenomenon of yield farming emerged during the summer of 2020 as an alternative to bank savings accounts and as a measure for supporting people locked indoors by the Covid-19 pandemic. The cryptocurrency industry quickly leveraged the advent of liquidity farming by rapidly growing in terms of capitalization and giving rise to an entirely new subsection of the industry.

Though highly profitable at the outset, the yield farming industry has since dilapidated and lost much of its appeal, especially after the collapse of such giants as LUNA and others. The risks of investing in liquidity pools are many and include high volatility, rug pulls, and even the shutdown of the hosting platform. However, the rewards are usually within the 4-6% range, as that is the highest potential APY users can expect to receive when pooling their funds into a liquidity service.

Still, many users will face the risk of impermanent loss, which is the loss of value of the pooled assets resulting from price changes of the assets between the period of their deposit and withdrawal from the platform. Many users continue to pool and auto-compound their assets despite such risks, believing that APY will rise in the long term. However, practice has shown that yield farming is a short term undertaking that should be rotated across services and platforms if users expect to receive higher revenues from their available liquidity.

Potential Risks

Among the most common risks of liquidity farming is volatility of cryptocurrencies, which results in impermanent losses. The volatility factor can also force users to withdraw their assets from a liquidity pool prematurely, giving the platform reason to charge either the interest or a penalty fee for such a move. In this case, users will be left with a considerable loss and will not be able to sell their asset upon price drops with a profit.

Rug pulls are another risk that involves the possibility of the platform founders essentially running off with the funds accumulated in the liquidity pool. This risk is impossible to foresee and can result in thousands of users being left with liquidity pool tokens instead of their assets. The pool tokens will be worthless if the platform is shut down.

Another major problem with many yield farming platforms is their inherent lack of security, which is the result of pool initial development. Many of the platforms were developed using template smart contracts, which were ridden with bugs and exploits that hackers can resort to in order to steal funds.

Key Takeaways

Yield farming is a potentially profitable venture in the cryptocurrency space if the user manages to find a reliable platform that they can place their assets into. However, they should be prepared for average returns and a high risk of incurring losses as a result of rug pulls, impermanent loss factors, and inherent cryptocurrency volatility. Considering the given issues, yield farming should be considered as a dynamic investment strategy that would require a high degree of diversification of assets and constant migration across liquidity pools in order to reap the benefits of changing APYs and trading pair value.