In the world of decentralized finance (DeFi,) yield farming can be extremely lucrative. But if you want to succeed, you’ll need to understand the ins and outs. So we’ve broken down some of some common strategies – and pitfalls – that you should be aware of before you pick up your plough.
1. What exactly is yield farming?
Yield farmers try to earn the highest possible income – or yield – on their digital capital by switching between different DeFi platforms and strategies. Think of this like a farmer rotating crops on a field to get the most output from the soil.
There are a number of different ways to “farm yield”, so to speak, but the idea behind them is the same: to earn a return on your crypto by locking it up in the smart contracts of DeFi platforms. Let’s now look at some common yield farming strategies.
2. Providing liquidity
When you deposit coins and tokens on a decentralized exchange (DEX), you’re providing the plaform with liquidity – that is, crypto on hand to perform transactions with. Exchanges need a supply of crypto for users to trade. And in return, liquidity providers earn a portion of those trading fees.
Traders on, say, Uniswap might trade DAI for ether. And as a liquidity provider, you need to supply equal values of DAI and ether to the DEX. If you provide 1% of the DAI-ether liquidity pool, you’ll earn 1% of the fee each time a trader swaps between the two assets.
But that reward isn’t risk-free: you’ll be exposed to something called impermanent loss. The math behind how impermanent loss is calculated can be complex. But without getting into that, it’s when the prices of coins in a liquidity pool change in such a way that you would have been better off just holding those coins in your wallet instead – and not providing that liquidity to the DEX.
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4. Lending and borrowing
Just as you earn interest when you deposit money into a savings account, you can earn yield when you lend your crypto to borrowers on DeFi lending platforms. Only, the yield you earn in DeFi is usually much higher than what you’ll get from a bank – but there’s a lot more risk involved too.
As a lender, your biggest risk is that your smart contract has a bug in its code – that lets hackers swoop in and drain your funds. So make sure to use reputable DeFi platforms and spread your crypto among a few different ones.
Yield farmers might also borrow from one platform and lend those same funds on another. That’s lending with leverage, in other words. Your potential return is very high, but so is your risk: it’s a double whammy not for the faint of heart.
- Yield farmers scour the DeFi-verse for the highest possible return on their crypto.
- Two common yield farming strategies are providing liquidity to decentralized exchanges and using lending and borrowing platforms to earn crypto interest.
- Yield farming can be lucrative if you know what you’re doing – but make sure to understand the (often big) risks before you jump in.
This guide was produced in partnership with Ledger.