Yield Farming 101
Yield farming is undoubtedly one of the hottest topics in DeFi today. The reason however isn’t far fetched, yield farming is one of the best ways to earn passive income in the crypto industry. Investors have staked billions of dollars in cryptocurrencies to earn more income.
Learn more about what yield farming is here
While there’s a lot of potential returns to be made through yield farming in DeFi, users still need to conduct proper research before staking their crypto assets. Understanding the various yield farming techniques is vital for the user to make net profits.
Types of Yield Farming
Single Asset Yield Farming
In this simplest form of yield farming, the investor stakes the DeFi platform’s own token and gets rewarded in the same token or some other token available on the platform. For example in PancakeSwap’s SYRUP Pool, the yield farmer stakes CAKE (PancakeSwap’s token) and is rewarded with more CAKE tokens or another token available on the platform. The significant thing to note here is the asset that is staked. Only the DeFi’s own token is staked hence “single asset”, and the rewards are based on the amount of tokens staked.
Multi-Asset Yield Farming
In this case, the investor stakes two pairs of tokens as opposed to a single token in a yield farm. In return the investor earns rewards called liquidity provider (LP) tokens as proof of depositing tokens to the specific pool. For example in PancakeSwap’s Farms, the investor, who becomes the liquidity provider, stakes two different tokens in pairs and gets LP token rewards for the staked token pairs. The LP token is later redeemed to realize profits or losses when the investor decides to withdraw from the pool.
Leveraged Yield Farming
This is another form of yield farming introduced by Alpha Finance Lab. In a typical scenario, if an LP were to provide liquidity of 500 USDT and 1 BNB (on the assumption that 1 BNB = 500 USDT and the pool requires equal ratios in terms of token value) to a liquidity pool. With leveraged yield farming, the LP could borrow external liquidity (e.g. 2 more BNB) to add to their liquidity in the yield farm. As a result of this, the LP gains more rewards and a larger share of the trading fees.
Returns in yield farming are measured by:
Annual Percentage Return (APR) — used to depict the simple interest rate imposed on borrowers and later paid to the liquidity providers or capital investors.
Annual Percentage Yield (APY) — used to depict the annual rate of return charged on liquidity borrowers and then paid to liquidity providers. APY reflects the compounding of interests in order to yield more returns for the investor.
Risk with Yield Farming
One major risk associated with yield farming is impermanent loss. Impermanent loss describes a situation where the liquidity provider experiences a temporary loss of funds due to the price volatility of the trading pair. It also shows how much money the LP could have realized if they simply held on to their assets instead of locking them in the pool.
Typically, two assets are often staked in liquidity pools, mainly stablecoins and a volatile cryptocurrency (say USDT and ETH). Now imagine this scenario, you as a liquidity provider stake equal amounts in value of USDT and ETH in the liquidity pool and suddenly the ETH price goes up. This would then require arbitrage because the current market price of ETH does not match the price in the liquidity pool. Traders in the market would take advantage of this opportunity by purchasing ETH at a discounted rate to ensure an equilibrium is maintained between the ratio of USDT and ETH in the pool.
The LP may then end up with more USDT and less ETH after arbitrage occurs. Impermanent loss then shows the amount the LP could have gained based on the current value if they had just simply held onto their assets. However, this loss could then be permanent if the LP decides to withdraw their stake from the pool. Although, if the LP decides to remain in the pool, the loss could eventually cancel out but it’s still a risky road to take.
This phenomena occurs in Automated Market Maker (AMM) pools that are common across yield farming pools. Remember, impermanent loss always works against you, so one would need to estimate the overall net returns considering the APY and impermanent loss.
On a Final Note
Investments that come with high rewards also come with high risks. It’s a two sided coin. Yield farming is indeed gaining unprecedented attention in the DeFi ecosystem and rightfully so. It provides great opportunities for passive income. Investors must however, tread cautiously with their investments and always seek out the best strategies to maximize profits and reduce risks.
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