Yield Farming Explained: A Beginner’s Guide to Make Money
Finding new ways of making money and putting the existing money to work has been a characteristic trait of human beings. Investments and trading are two concrete examples to support the statement. How could it be any different for cryptocurrencies? Crypto investors have found tricks to earn passive income from cryptocurrencies as well. In this guide to yield farming explained, we are going to explore a similar way.
You may think of the process as fixed deposits where the users earn interest on their savings. If you are a beginner in this space, this is the perfect guide for you to get started and farm yields.
What is Yield Farming in Cryptocurrency?
Yield farming is the practice of maximizing the returns over investments by locking your assets and yields in the liquidity pools, one after the other. In this, an investor lends their pre-owned assets to a decentralized protocol. This is done in order to facilitate the various types of transactions waiting to be executed on the platform, such as lending, borrowing, or trading of assets on the platform.
The assets lent to the pool may include cryptocurrencies, NFTs, and other crypto-based assets. In return for their willingness to lend money to the decentralized protocol, the investors are awarded rewards. The rewards may include tokens or concessions on the transaction. Once the liquidity providers collect the rewards from the platform, they can lend them again to a different liquidity pool on the same platform or a different platform. They keep on doing so until they have earned maximum yields on their initially-owned assets.
Now you may ask about how much you can make via yield farming or how you earn yields on your investments. The number of rewards depends upon the individual shares of the liquidity providers and the duration of the locking period. But don’t worry, we will get there. Before we begin discussing the details of the rewards, let’s first understand how yield farming works.
Yield Farming Explained: How does Yield Farming Work?
The entire process of how yield farming works can be summed up in four simple steps.
- The liquidity providers deposit their assets in the liquidity pool.
- Now that there are assets available in the pool, the users can select the operation they would like to perform. Whether they wish to buy, sell, or trade assets, they need to pay some fee to the protocol depending on the selected transaction.
- When the users pay the fee, the protocol rewards the liquidity providers with that fee. However, the liquidity providers obtain the rewards in the form of native governance tokens and an increase in capital.
- Lastly, when the liquidity providers obtain the rewards, they can lend these rewards again to a different liquidity pool and earn yields from them. The liquidity providers continue farming until they have gained maximum yields.
It can be a great way of generating passive income. However, the scope of earning rewards is highly uncertain. There have been times when the liquidity providers have earned rewards in double-digit numbers. At the same time, some providers have recorded their gains to be in a thousand percentages.
Is Yield Farming Profitable?
Yield farming can be highly profitable if you are someone whose stars have aligned themselves in the most positive directions. It is because the profits are largely dependent on the crypto markets. In addition to this, since there is a gas fee that the liquidity providers have to pay while participating in the liquidity pool, there are additional risks involved in yield farming. This is because, if the values of the locked assets reduce, it can considerably affect the number of your gains.
Also, it is possible that the yields are lower than the value of the gas fee that you have paid. Moreover, the yields depend upon the individual shares of the other liquidity providers in the pool. So, you can never actually predict the number of gains that you will make from the pool. Therefore, yield farming can be profitable. But you must always stay aware of all the risks associated with the process as a way of earning passive income.
Yield Farming Explained: How to Yield Farm?
The process is yield farming is quite simple. Here are the four steps to get you started with earning passive income from your existing crypto assets.
- The first step is to choose a suitable yield farming platform to deposit your money and earn passive income.
- Secondly, the liquidity providers have to connect their crypto wallets to the platform so that the lending of tokens can happen in one place.
- Thirdly, the investors have to select the number of tokens they would like to lend to the decentralized pool. Once they decide, they have to approve the transaction.
- Finally, the assets of the liquidity providers get locked in the pool. Now the liquidity providers can sit back and see their assets in action.
At the end of the liquidity pool, the liquidity providers may collect their rewards to farm them again and over again on various pools.
How Much Money Can You Make Yield Farming?
As mentioned earlier, the amount of money that a liquidity provider can make from yield farming depends upon a number of factors such as the locking period, the share of the farmer in the pool, the share of other liquidity providers in the poo, the interest rates offered by individual platforms, the type of tokens lent to the decentralized pool and so on.
Since some of these factors are out of the control of the liquidity provider, you can never predict the exact amount of money that you will be making from yield farming. However, there is a formula to calculate the estimated returns. You can also use an online yield farming calculator to find out your potential gains.
Now you may wonder how the investors earn rewards from the liquidity pools. There are different types of rewards that the investors can earn profits. Some of these rewards are crypto tokens (usually native governance tokens), transaction fees, and the increased price of the lent tokens.
Also, while calculating the returns from the yield farming calculator formula, there are two types of metrics, one is APY and the other one is APR. APY stands for Annual Percentage Yield. It is the amount of yield an investor earns over the money that they have invested in the liquidity pool. APR, on the other hand, stands for Annual Percentage Rate. It is the amount of interest born by a borrower for taking a loan.
This is why APY is something that you should look at while choosing the best farming platforms. Speaking of yield farming platforms, here are some of the best platforms that you should try to kick-start your yield farming journey.
What are the Best Yield Farming Platforms?
The famed Compound and AAVE crypto projects had laid the initial foundations for yield farming. It was not very late that other projects also stepped into this superior trend and passive income generator. With hundreds of platforms offering yield farming services, investors may often feel overwhelmed to choose the best out of the rest. So, here we have eased the effort and compiled this list of 5 best yield farming platforms to get started.
Here, the investors can earn profits ranging from 4.78% to 13.49%. The investors earn these yields in the form of fee savings, voting powers, and compound interest. To yield farm on this platform, the investors have to lend their AAVE tokens to the liquidity pool.
The yield on this platform may not be very attractive, typically ranging from 0.21% to 3%. However, the fact that the team constantly monitors the system to find and fix any security breaches is something that pleases thousands of investors. While yield farming, the investors can earn interest on their assets and the governance token as rewards.
The investors can earn an APY of up to 400% on this platform. It primarily focuses on integrating the features of Web3 with the gaming industry. It offers various types of lotteries, NFT collectibles, and team battles to the users. Also, the users can swap their BEP tokens through PancakeSwap.
As the name suggests, UniSwap allows users to lend a pair of ERC 20 tokens in equal proportions to earn rewards. Some of the rewards include transaction fees and the native tokens of the platform. The entire work of yield farming on UniSwap occurs through the automated market maker model.
This platform awards the investor with the native SushiSwap tokens. In addition to this, the investors can test the waters of staking to learn the differences between yield farming vs staking, liquidity mining, etc.
Yield Farming Explained: Is Yield Farming Safe?
To say yield farming is safe and doesn’t contain any risks would be a lie. It is because, like any other investment option, it has numerous risks attached to it. However, some of these risks can easily be avoided by doing some basic research and using some tips and tricks. Let’s discuss some of the yield farming risks and know how to combat them.
Smart Contract Risks
Even though the process of lending and borrowing tokens in the case of decentralized pools is governed by smart contracts, they are written by human beings. So, there are chances that there can be bugs or errors in the codes. Now hackers keep hunting for such codes to manipulate the entire DeFi system and steal money from it. Therefore, it becomes extremely crucial for investors to choose platforms having a high level of integrity and security to protect them from suffering such yield farming risks.
Impermanent losses are the type of yield farming risks that appear due to price fluctuations in the crypto market. When the price of a crypto token falls on the decentralized exchanges, there is a very short period of time between the changes and the reflection of those changes in the liquidity pool. During this time, many investors take advantage and sell their tokens at high prices to the pools. On the other hand, the investors who are already there in the pool have to incur these losses.
The key to succeeding and making passive income from yield farming is to prepare a detailed entry and exit strategy. Usually, at the beginning of the farming period, the liquidity providers are less, and hence, the rewards are higher. But as the pool grows and gathers more liquidity providers, the rewards keep declining. Therefore, you must have a great strategy highlighting when to enter and exit the pool to ensure maximum gains and minimum risks.
Gas Fee Risks
Gas fee risk is one of the major yield farming risks that the investors must stay aware of. When the price of the token falls in the exchanges, the potential rewards that the investor was going to gain from the liquidity pool become low. Sometimes, the rewards become even lower than the gas fee that the investor pays for participating in the pool. Therefore, investors should consider the gas fee while choosing the best yield farming platform for themselves.
Yield Farming vs Staking: Which is Better?
Before we declare the verdict on which is better between yield farming vs staking, let’s first look at some of the key differences between the two of them.
- Staking is governed by a Proof of Stake consensus algorithm which makes staking extremely sustainable for the environment as compared to other forms of mining. On the other hand, the underlying technology for yield farming is the Automated Market Maker model where there are no third parties involved.
- Secondly, staking offers the participants an opportunity to feed transactions in a new block over the native blockchain of the platform. In contrast to this, yield farming is solely a way of generating passive income.
- The rewards earned from staking may include native governance tokens of the platform. However, there are certain exceptional platforms like UniFarm where the participants stake on tokens and farm many different types of tokens. The rewards in the case of yield farming are native tokens, discounts on the transaction fee, capital increments, etc.
- Then talking about the risks, staking risks are much simpler and the participants can easily avoid them. On the other hand, yield farming risks are much more complex and certain risks like impermanent losses are not under the control of the liquidity providers.
- Lastly, it can be a difficult process as the liquidity providers may have to spend a considerable amount of time researching the various farming platforms. However, in the case of staking, all the participants have to do is choose the right staking pool and stake their assets.
When choosing between yield farming vs staking, the investors must consider the points given above. As mentioned, the investors should define their objectives and risk profile well in advance. They should have a clear idea of how much money they are looking to make from each of these processes. Staking offers a better option for someone looking for steady gains without a lot of diligence or severe risks involved. Yield farming, in contrast, is a good option for those who aren’t afraid of losses and are ready to bet on the price fluctuations of the crypto market.
Leveraged Yield Farming: Special Case of Yield Farming
Leveraged yield farming is the process of levering your position in the liquidity pool by borrowing assets from one pool and lending those assets as liquidity in some other pool. This maximizes the scope of the use of the protocol as all the investors with or without owning assets can yield farm on the platforms and earn passive income.
How does Leveraged Yield Farming Work?
The whole process of leveraged yield farming is hinged on three main parties, that is, liquidity providers, money lending platforms, and borrowers. The liquidity providers provide liquidity to the decentralized pools from which the borrowers borrow the assets and ramp their position in the pool. The money lending platforms facilitate the lending and borrowing of assets by offering collateralized loans to the borrowers.
In turn, both the liquidity providers and borrowers earn APY rewards for their willingness to increase the working action of the liquidity pool. It should be noted here that the value of borrowed assets is greater than the collateral provided by the borrowers. This is how leveraged farming becomes beneficial for both the liquidity providers and borrowers.
As you can see, there is a very high potential for earning passive income from yield farming. However, like any other investment opportunity, it also has some downsides linked to it. So, the investors must always spend a good amount of their time learning about the process and the various risks. Do your due research and get started now!