How does yield farming work and is it safe? CoinFlip explains | CoinFlip Bitcoin ATM

What is yield farming?

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Main Points

  • Cryptocurrency yield farming is a Decentralized Finance (DeFi) process in which you lend out your crypto in exchange for earning interest. 

  • To yield farm, users deposit their crypto holdings to liquidity pools that are used to give out loans to borrowers or provide liquidity to decentralized exchanges.

  • DeFi projects tend to offer much higher APYs than traditional finance, sometimes offering as high as 100% per year. 

Decentralized Finance is one of the most exciting areas in cryptocurrency today. DeFi eliminates the need for banks, financial institutions, or intermediaries and allows people to conduct financial transactions directly with one another. 

Among the most popular DeFi protocols are lending and borrowing services. These services are made possible through peer-to-peer enabled liquidity pools. The process of participating in and profiting from these liquidity pools is called yield farming. 

What is yield farming exactly and how does it work? What are some of the most popular yield farming projects? What are the risks? CoinFlip explains. 

What is yield farming? 

Cryptocurrency yield farming is a DeFi process that allows you to use your cryptocurrency holdings to earn passive income. Essentially, yield farming enables you to lend out your crypto in exchange for earning interest. 

The concept of lending out holdings in exchange for interest is not a new one. This is one of the main ways that centralized finance (CeFi) works. Banks use the money that is deposited into savings accounts to make loans to other people or businesses. In return, the bank pays the savings account holders a portion of the interest. In the United States, the average savings account earns an annual percentage yield (APY) of around 0.06% per year. 

Cryptocurrency yield farming works much in the same way. Users deposit a portion of their cryptocurrency holdings into liquidity pools used to give out loans to borrowers. The primary difference between CeFi and DeFi, other than the use of fiat currency vs. cryptocurrency, is that some DeFi projects offer much higher APYs, sometimes as high as 100% per year. 

Popular yield farming projects

Aave

Aave is a decentralized, open-source protocol built on the Ethereum blockchain that allows people to lend or borrow a wide range of cryptocurrencies in exchange for earning or paying interest.

It is a decentralized money market account where users can obtain crypto loans from a pool of deposits. Those looking to make the most of their crypto holdings can deposit to the various crypto pools. Currently, you can deposit or borrow 31 different cryptocurrencies. Among the cryptocurrencies available for yield farming are USD Coin, Ethereum, Chainlink, and Aave token. 

Each cryptocurrency has different rates for borrowing and lending, which you can find on the Aave website. Aave uses an algorithm to determine current rates based on the utilization rate - the ratio of current supply versus the amount borrowed. If most of the crypto in a pool is lent out, the interest rate is high to entice depositors to bring in more of that cryptocurrency. If hardly any of the crypto in a pool is being used, the interest rate charged is low so that more people borrow. 

Uniswap

Uniswap is a protocol for creating liquidity and trading ERC-20 tokens on the Ethereum network. It is a decentralized cryptocurrency exchange and Automated Market Maker (AMM) that pools liquidity from its users, unlike traditional exchanges that use liquidity providers known as market makers to ensure its order book is liquid. 

Uniswap liquidity pools are decentralized and run on smart contracts that allow users to swap tokens and add liquidity. The smart contracts are designed so that the pools keep track of reserves and update and rebalance those reserves after every trade. This allows all transactions to be made without a counterparty on the other side of a trade.

Each token on Uniswap has a pool that users are encouraged to contribute to. The prices for each token are worked out using a math algorithm run by a computer. When a liquidity provider removes their funds from the pool, they receive a portion of the total trading fees charged by Uniswap from the reserve relative to the percentage of the amount they contributed to that particular pool.

Yearn Finance

Yearn Finance (YFI) is the so-called yield farming platform for the masses. It is a collection of protocols on the Ethereum blockchain that moves users' funds around different lending and liquidity protocols to maximize crypto earnings. 

YFI's Earn protocol identifies the highest interest rates users can earn by searching various lending protocols to find the best rates. Then, users can deposit different stablecoins, including USDC, on the yearn.finance platform to receive those interest rates. 

YFI's APY protocol looks through the protocols used by Earn to give the user an estimate for how much interest they can expect to earn, on an annualized basis, for a certain amount of capital. 

What are the risks of yield farming?

Yield farming can be an excellent way to maximize your crypto earnings, but it is not without risks. As a process that relies mainly on smart contracts, you risk being potentially exposed to hackers that find and exploit bugs in the contract's code. 

In August of this year, the DeFi platform Poly Network was hacked, and more than $600 million was stolen in one of the largest DeFi hacks to date. The hacker was able to do so by exploiting some faults in the platform's code. 

Additionally, DeFi at large is currently unregulated, unlike the traditional financial sector, which is heavily regulated. Regulations are sure to come and, in many ways, are welcomed to bring clarity to the space. However, laws that are too harsh could seriously stifle innovation and potentially create complications for the process of yield farming. 

Final Thoughts

Yield farming is a process that allows users to provide liquidity to various DeFi projects in exchange for earning interest. For now, DeFi liquidity building through yield farming is one exciting way to participate in the cryptocurrency space. However, as a relatively new sector, DeFi, and therefore yield farming, faces some risk so it is important to be cautious when participating.