- Important definitions:
APY - Annual Percentage Yield, amount of yield you would get on your principal annualised
APR - Annual Percentage Rate, it’s similar to APY but it doesn’t consider compound interest
LP - Liquidity Providers, users locking their funds into Liquidity Pool
Liquidity Pool - a smart contract containing funds, powering a marketplace where users can exchange, borrow or lend tokens. Click here for more information
Liquidity mining - process of distributing LP tokens to Liquidity Providers
Collateral - a borrower’s pledge of specific property to a lender, to secure repayment of a loan
In a nutshell, yield farming is a reward scheme. Farmers(users) can lock up their funds in liquidity pools and gain fixed or variable interest in exchange.
Imagine you are a real farmer. You sow grains in your field and wait for them to grow, then you reap the crop or yield.
Now compare it to our situation - the farmer is the user, grains are tokens, the field is a liquidity pool, and yield is profit.
Users put tokens into a liquidity pool, wait for the interest to grow, and then gain profit.
Investing in cryptocurrency is not yield farming.
Why do we even need yield farming?
Moving funds between different protocols or swapping coins could be likened to a crop rotation. That’s a farmer’s practice of growing a series of different types of crops in the same area on rotation, which maximises yield as a result.
Supplying to liquidity pools: You can provide liquidity to a liquidity pool and gain commissions from token swaps that happen in that pool.
Staking LP tokens: Some protocols allow you to stake LP tokens and reward you in their own LP tokens, which could be further stake in yet another protocol. To put this in other words, you could stake funds in pool A and get Atokens in return, then stake Atokens in pool B and get Btokens in return and so on. This way, you get commissions from different pools at the same time.
Lending and borrowing: You can supply funds to a lending protocol for the purpose of earning a percentage on their capital or borrow from a lending protocol to leverage (i.e. borrowing funds to invest).
Please remember that yield farming strategies could potentially become unprofitable in a matter of days or even hours. Keep an eye on your locked funds and react quickly.
When Carl provided liquidity into the pool (for more information, see the example: provide Liquidity) he added 2000 USD, but he wasn’t satisfied with his percentage share in the pool. So, he borrowed 1 ETH for 1000 USD and added it into the pool, now making it 2 ETH and 2000 FVT.
Thanks to this move he now has a larger share in the pool than before and thus gains higher commissions.
over-collateralize to prevent the collateralization ratio from dropping below the threshold amount
use less volatile assets like stablecoins (the more volatile the asset is, the higher are the chances of liquidation)
Risks of yield farming
Liquidation. As mentioned above, liquidation causes losing collateral.
Asset losses caused by smart contract bugs. Yield farming relies on smart contracts which, like any software, is exposed to potential attacks and suffer from random errors. Thankfully, doesn’t occur frequently but users should be aware of these kinds of potential risks.
Value of tokens changing. The desirable outcome is for token value to increase, but sometimes it is the other way around which leads to fund loss.
Block malfunction. Whenever a block experiences a malfunction, the entire ecosystem suffers. Within the ecosystem, every block is connected with one another. This idea helps make it permissionless, but it demands collective responsibility.