Yield Farming in Web3: Fire’s Guide to Making DeFi Work for You

By The Fire Team
Overview of yield farming, showing the logos of top companie sin the space like Uniswa, Aave, and more.
Note: This article is for informational purposes only and does not constitute legal, financial or investment advice. Always do your own research and consult with professionals before making any decision.

If you leave your dollars in a bank account, inflation nibbles at them, diminishing your purchasing power a bit each year. That’s why most people invest their dollars into ETFs, real estate, stocks or cryptocurrencies.

But you can’t do much else with them—at least not without considerable effort. Cryptocurrencies are different: While they’re more volatile than fiat currencies, they are currencies.

And you can use your coins further to get a return on your crypto (beyond the price changes in the cryptocurrency itself). In decentralized finance (DeFi), this is called yield farming: The process of maximizing the return of your crypto assets.

What is Yield Farming?

Yield farming is a method of earning returns on your cryptocurrency holdings. It usually involves lending your tokens to others through smart contracts. We’ll explain more advanced steps later on, but that’s the simplest way to put it.

At its core, yield farming is the web3 version of the traditional finance saying “put your money to work for you”. While DeFi allows for more exotic applications, it remains the same principle.

While there are many yield farming opportunities, yield farming is not DeFi trading. You’re not monitoring charts to time your entry or exit and making a lot of active trading decisions. Rather, it’s a way of using DeFi to create passive income—to earn tokens without actively making decisions.

That might sound a bit abstract, but let’s dive into some yield farming examples:

Examples of Yield Farming

While yield farming can take many different forms, it almost always involves giving a protocol your tokens and earning a return from them that way:

Yield Farming on Decentralized Exchanges

Decentralized exchange (DEX) protocols like Uniswap, PancakeSwap, SushiSwap and others rely on liquidity providers to facilitate transactions.

Without getting into the technical details, decentralized crypto exchanges work by pooling tokens from users and paying them a percentage of the proceeds from trading fees. The combined deposited assets are called liquidity pools.

For each trading pair, there’s a liquidity pool. Liquidity pool returns differ depending on the supply and demand for a specific trading pair.

Here’s how it works and looks like:

  1. Own both tokens of the pair you want to provide liquidity for
  2. Approve Uniswap to use your tokens (find out more about token approvals here)
Uniswap token approval explanation using FWB token, showing infinite token approval for the Uniswap V3 smart contract in a Fire extension simulation window
  1. Check if everything is correct in the preview
  2. Confirm and accept the transaction. You will receive an LP token (or liquidity provider token) in exchange.
Uniswap liquidity provider NFT explained. USDC/ETH liquidity pool transaction on Ethereum with Fire extension window explaining the transaction.
  1. Watch the returns from your liquidity position pile up!

Yield Farming on Lending Protocols

Many yield farmers also like to get returns on borrowing/lending protocols like Compound and Aave, which are some of the longest-lasting DeFi protocols.

While they don’t have the highest DeFi returns, these are the simplest DeFi protocols and have so far been the most resilient to market conditions.

In essence, they work like banks:

  1. You deposit tokens (e.g. USDC) into their smart contract and get aUSDC (AaveUSDC) in return
Providing USDC on Aave explained. Fire extension transaction simulation showing exchange of USDC for aEthUSDC tokens.
  1. Someone takes out a USDC loan from Aave/Compound and pays it back with interest
  2. Part of that interest get passed on to you.

That’s exactly what banks do in traditional finance: They lend out your deposits to others and give you a return on it. But while a bank operates branches and pays thousands of employees to set interest rates, calculate returns and so much more, Aave doesn’t have those costs. DeFi protocols operate using smart contracts and calculates relevant numbers algorithmically, which lets them pass more APY returns onto you.

While both Compound and Aave give you an APY on your ETH, USDC, DAI or hundreds of other tokens, they also reward you in their native tokens:

  • Aave has the $AAVE token
  • Compound has the $COMP token

These are the governance tokens of the respective protocols, which allow you to vote on governance proposals. Some traders also see them as airdrops and sell them as part of a higher DeFi return.

Curve Yield Farming

While Uniswap and other automated market makers (AMMs) allow for basic yield farming using trading pairs, some of DeFi’s highest yields are usually on more exotic protocols and websites.

While Curve Pools are no obscure DeFi dApp, they do allow for more creative uses of blockchain tokens. Governed by CurveDAO, Curve is a decentralized exchange which allows more “out there” options, like pools composed of more than 2 assets, borrowing against speculative coins as well as rewards in their native token CRV.

These more complicated (and often more speculative) instruments sometimes offer higher rewards than other DeFi protocols, but also involve difficult-to-understand mechanisms and higher risks.

Stablecoin Yield Farming

Stablecoins (crypto assets pegged to fiat currency, usually the US Dollar) are attractive to people in web3 who don’t want to be exposed to the volatility of crypto assets. But shielding yourself from the fluctuations of Ethereum doesn’t mean you have to earn no rewards.

Stablecoin yield farming is one way to earn a return in DeFi and is possible using all the methods we outlined above. While providing liquidity in a pool requires you to own both tokens, lending stablecoins on DeFi protocols lets you earn yield with only one token—the stablecoin.

Yield Farming vs. Staking

Yield farming isn’t the only way to get a return with crypto tokens (without becoming a daytrader). Another is staking ETH or other tokens.

Staking cryptocurrencies works on any blockchain that uses proof-of-stake as a consensus mechanism (this applies to most blockchains except for Bitcoin, Litecoin and a few others).

At a high level, staking means locking up your tokens to keep the blockchain’s network secure. You’ll then get a return the longer you lock up your tokens. Between yield farming and staking, the experience can be similar: You give your tokens to a smart contract and earn returns.

You can earn staking rewards on many different blockchains. There’s ETH staking, Nexo staking, Cardano staking, USDC staking, Algorand staking… many DeFi protocols also offer their own staking programs for their own tokens.

While ETH staking and many other tokens are totally legitimate and help secure a blockchain, some staking programs serve no real purpose besides keeping people from selling the token. These are unlikely to last. Even when you get a high staking yield for a token, you’ll likely earn staking rewards in the token you staked, which doesn’t help you if the token price tanks.

Let’s use an example. Imagine a fictional coin $FAKE currently trades at $0.10. You see that the staking rewards are currently at 200% yearly.

  1. You buy 1000 $FAKE at $0.10 each for $100.
  2. You stake your $FAKE to start earning staking rewards.
  3. A year later, you claim your 3000 $FAKE.

In theory, you’ve tripled your money—but only if the $FAKE tokens have held up in price. If the price has dwindled to $0.01, then you only have $30 and in fact lost most of your money.

Stories like these are not uncommon in DeFi, where you can always find something that promises an APY of hundreds or thousands of percentage points. These are rarely long-term sustainable projects.

A big difference between yield farming and staking is that staking is usually the final step of the journey because your tokens are locked up and can’t be transferred, traded or otherwise used.

The only exception to that is liquid staking. Liquid staking protocols lock tokens up for you and give you a tradable token (called stETH, for staked ETH) in return.

Liquid Staking Explained

Staking ETH requires at least 32 ETH (about $56,000 in June 2023). Staking Polkadot requires at least 364 DOT, which is about $1600 at the time of writing.

That’s a high price just to get started! Plus, the lockup means you won’t be able to trade further with your tokens. That’s one of the risks of cryptocurrency staking.

Lido liquid staking explanation. Transaction showing sending of ETH to smart contract and receiving stETH token in exchange using a transaction simulation from the Fire chrome extension.

Protocols like Rocketpool and Lido stake your ETH for you (in exchange for some of your staking rewards) and give you an stETH (staked ETH) token. You can then trade further while still earning ETH staking rewards. While these protocols are great, they might pose a centralization risk to Ethereum. Find out more about that here.

Is Yield Farming Legit?

We’re writing this in the summer of 2023, but in web3 it feels more like winter. Most crypto prices have crashed since the NFT-driven hype of 2021 and 2022. And while we’ve highlighted some of web3’s most resilient projects like Aave, there are risks associated with yield farming:

  1. Yield Farming is as Volatile as Crypto

When you lend ETH to Aave and get rewarded in ETH and AAVE tokens, your dollar-based return is also dependent on the prices of those assets. Most cryptocurrencies are volatile, and earning them as rewards exposes you to some of that volatility.

  1. Yield Farming Scams Exist

Just as with airdrops or memecoins, scammers jump on every popular topic in web3—including yield farming. You might see:

  • Impersonations of trustworthy dApps and protocols like Uniswap, SushiSwap, Aave or Compound
  • Protocols promoting DeFi returns in the hundreds or thousands of percent—which drain your assets when you connect your wallet.
  • Traders offering to maximize your yield if you send your assets to them.

These are just a few common scams you might encounter. That’s why it’s important to simulate transactions with Fire (so you know what you’re signing) and not believe things that are too good to be true.

  1. Yield Farming on Shaky Protocols

When the crypto markets heat up, many DeFi protocols start to issue tokens and offer incredibly high staking rewards or yields for giving them your tokens. While these aren’t outright scams, they’re most likely unsustainable.

If rewards are denominated in a token that lets you multiply your holdings in a few days, it attracts many short-term opportunists. But with so many tokens being issues, it’s likely the token will hyperinflate and become worthless before you’ve cashed in your rewards.

How to Stay Safe When Yield Farming

Just as every farmer must protect their crops from pests and bad weather, every yield farmer must protect their tokens from scams and other risks.

Here are a few tips to help you stay safe:

  1. Do your own research (DYOR): Understand the fundamentals of the protocol you're using. Know the risks involved and consider the long-term viability of the protocol.
  2. Beware of high returns: Extremely high yields can be a red flag for scams or unstable protocols. If it seems too good to be true, it probably is.
  3. Use trusted platforms: Stick to well-known and trusted platforms. Be cautious of new platforms with little to no track record.
  4. Keep up with the community: Join the community forums or social media groups of the protocols you use. They're often the first to report any issues.
  5. Use Fire to simulate transactions: The best way to stay safe is to know exactly what you’re signing. That’s why we built our free Chrome extension: So you know what’s leaving and entering your wallet before you sign anything.

If you’re exploring Ethereum, check out Fire!

We’re a trusted chrome extension that simulates transactions before you sign any potentially malicious smart contract.
Check it out
To Summarize

Yield farming can be a lucrative practice if done wisely. It offers an innovative way to earn passive income from your crypto holdings. However, it's important to understand the risks involved and always keep the principles of safety in mind.

As with any venture in the crypto world, staying informed and vigilant is the key. And remember, while the fields of yield farming can be bountiful, they should be navigated with care. Happy farming, and stay safe!