Yield Farming: What It Is, How It Works

Yield farming is a way of earning rewards by depositing cryptocurrency with decentralized finance services. Think of it as the extreme couponing or credit card churning of the crypto world:  Practitioners weave complex connections throughout the blockchain economy to wring out the highest possible returns. 

Yield farming has similarities to some established concepts in traditional finance. Earning interest in a savings account is one parallel. Another is selling stock options, a way to earn money on stocks you own by lending them to others.

But make no mistake: Yield farming is unlike anything offered by a bank or broker, and it can be vastly riskier than putting money in a savings account or making stock transactions. 

You won’t find Federal Deposit Insurance Corp. protections in decentralized finance. If the product you’re using goes bust, you’re on your own. The crypto assets you’re depositing and the rewards you receive are all risky assets, and chaining them across multiple platforms may compound those risks.

Prospective yield farmers should prepare for the potential of total loss before getting started. But those who successfully navigate the risks sometimes secure returns higher than those offered at a bank. 

How yield farming works

Before getting started, remember that yield farming is not necessarily for crypto beginners. You must be comfortable using your crypto without the aid of a centralized exchange, such as Binance.US or Coinbase. Instead, you’ll use more complex decentralized exchanges whose users create their own markets for swapping cryptocurrencies.

There are many approaches to yield farming, but the common starting point is depositing crypto you already own into a decentralized finance platform that promises returns or yield. The types of crypto accepted vary by platform, but stablecoins are widely used.

Depositing on a DeFi platform differs from depositing at a traditional bank. When you deposit cash in a conventional bank, the bank could use it in various ways, for instance, by lending to other customers. The eventual use of your deposited dollars has no relationship to the mechanics of your deposit. 

That’s different from DeFi platforms, such as Curve or Aave, where you instead choose from many options known as liquidity pools. 

Liquidity pools: What they are and how they’re used

Liquidity pools power decentralized exchanges. Liquidity pools serve as de facto trading partners with users of a decentralized exchange or DEX. In short, if a DEX supports trading among any two or more cryptocurrencies, it must have a reserve of all of them to make sure users can trade anytime.

DEXs use algorithms to determine a crypto’s price at a given moment. This differs from centralized exchanges, which match buyers with sellers to discover prices and carry out trades. Liquidity pools provide the financial backing behind these algorithms, enabling a customer’s transaction to be fulfilled upon request. 

A single platform could have dozens of different pools. Each represents various combinations of cryptos. Each pool offers its own (often variable) rate of return to its investors. So do your homework before choosing a strategy: A longstanding pool yielding consistent, reasonable rewards may offer more peace of mind than an untested pool promising sky-high returns.  

Yield farming example

Yield farming might be easier to understand through an example demonstrating what you get when you make a deposit. 

1. When you deposit your funds, you assign your crypto to a smart contract, a digital agreement that executes automatically when its conditions are met. On many platforms, you retain direct control over your crypto and can withdraw anytime. 

2. You’ll receive a token that represents your deposit. Think of it like the ticket you receive if you leave a jacket with a coat-check service, only you can sell that ticket to someone else, who can then redeem it for your coat later. So, for example, if you deposit supported crypto on Compound, you’ll get a “cToken” version of that coin representing the value of your deposit. So if you deposit $100 of USD Coin (USDC), you’ll get $100 worth of Compound USD Coin (CUSDC), which can then be sold or traded elsewhere. 

3. After you’ve committed your funds to a pool, you receive rewards for the duration your crypto is deposited. Rewards are sometimes issued in crypto native to the liquidity pooling service. For example, Compound gives COMP tokens as a reward, distinct from the “cToken” you receive to note your initial deposit. 

How some yield farmers aim for bigger returns

People looking to maximize returns take that core process — earning rewards for a deposit — one step further, often by employing the following strategies: 

Chase better rates. Because rates are constantly changing and you can withdraw funds anytime, some people search for more lucrative places to move their crypto. Like going to several different grocery stores to get the best price for each item on your shopping list, this method can get you a better deal, but it requires time and effort.

Earn rewards by depositing LP tokens elsewhere. Getting a token representing your deposit can be the first step in a long process. You may be able to deposit that token in a second pool to earn additional interest. If that second pool’s token, given in receipt for the deposit of the first pool’s token, is accepted by a third liquidity pool, the chain continues, with interest earned at each step along the way. Yield farmers have found combinations of platforms and tokens that enable this process to repeat multiple times. 

Borrow crypto. Borrowing to yield farm, sometimes called “leveraged yield farming,” has some similar risks and benefits to borrowing money to invest in stocks: You’re betting the growth of your investment will surpass the cost of repaying the loan, plus interest. However, this is a risky strategy with an already high-risk investment. With leverage, you could lose your entire investment and still owe creditors. 

Pros and cons of yield farming

Pros

• Enticing yields. With double-digit returns in some instances, there’s an unmistakable allure to watching your stash of crypto grow without the need to buy more.

• It’s automatic — once you get it set up. Depositing crypto on a DeFi platform requires technical knowledge. But once you deposit it, you need to do nothing until you’re ready to withdraw.

• It is one way to support crypto, generally. Decentralized finance services need liquidity to provide a stable, reliable experience. 

Cons

• Lending pool services are still new. The history of crypto is filled with projects that have suddenly gone bust, were hacked or were imploded in some other way. For example, in May 2022, the crypto website Cointelegraph reported more than $1.6 billion had been stolen from DeFi users through hacks and scams since January. One example: In 2022, the DEX Maiar Exchange was hacked, and crypto worth more than $100 million went missing.

• Rates are constantly fluctuating. Yield farming is only a set-it-and-forget-it investing strategy if you’re not particularly sensitive to the rates you’re receiving. The advertised returns might not last long as markets change, making some protocols less lucrative and others more. 

• It’s debatable whether yield farming is sustainable. Some experts have suggested that yield farming leads to highly inflated prices that will come crashing down at some point.

• Bugs in the code can cause headaches. If you yield farm, you don’t hand your crypto over to a custodian. Instead, it’s linked to a smart contract. Smart contracts execute automatically and are irreversible. If you lose some or all of your funds due to a bug in the code, there may be no remedy.