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