What Is Yield Farming?

There are very few things better in crypto than earning more crypto without having to sell your assets.

That’s the premise of yield farming. By depositing your crypto to lending protocols and AMM liquidity pools, you can earn a portion of the fees that the protocols generate from the borrowers and traders.

But isn’t it the same as depositing money to a bank account? Yes, yes it is. But it’s different. For one, most bank deposits today will pay you around 0.1% interest. CPI (Consumer Price Index, widely used to measure inflation) in January 2022 was 7.5%. The 0.1% interest paid by the bank does not help us at all. We’re losing purchasing power, and fast. Crypto yields are multiples higher compared to bank deposits.

History Of Yield Farming

Yield farming took off in June 2020 (the summer of 2020 is known as the “DeFi Summer” in the crypto space) when Compound protocol started to distribute COMP (Compound’s governance token) to its users. The holders of the COMP token acquired voting powers over proposed changes to the protocol, which in turn generated more demand for the token (and thus more users to the platform).

Voting power is important, as the holders of the token can vote on important matters such as how much it costs to borrow and what rates the depositors can earn on the platform.

Compound is still one of the biggest players in space. According to Defi Pulse, the most dominant platforms by TVL (Total Value Locked) are Maker ($17bn), Curve Finance ($11,5bn), and Aave ($10.75bn).

Since the DeFi Summer, yield farming has become a standard practice in the industry, and also the reason why DeFi market has exploded to $85 billion in total value locked.

How Yield Farming Works?

Let’s use Uniswap as an example. Uniswap is a DEX (decentralized exchange). It’s the most popular DEX in the market doing over $1bn of volume in a day. Most of the tokens you’d want to buy are on Uniswap. You head over to Uniswap and enter a purchase order, and somehow Uniswap magically sells you the desired token.

It’s possible because of the liquidity pools. In these liquidity pools, there are market pairs (two different tokens). And if you as a liquidity provider add funds to the liquidity pool, you can earn a portion of the fees the pool earns from traders (people trading the concrete token pair). This is how your yield is generated. The same logic applies to lending protocols like Aave. Only with the lending protocol, the liquidity is used to lend money to the borrowers, who pay fees for the loan. You as the lender (liquidity provider), will receive your share of the fees and thus generate yield.

To attract liquidity (liquidity is crucial for DEXes and money markets, as without liquidity, people can’t trade nor borrow money), protocols often look for new ways of creating incentives. For example, by distributing a new token on top of the liquidity pool yield — just like the distribution of COMP token which I described before. This enables to boost the advertised yield in hope of attracting more users and thus liquidity. It can get fairly ridiculous quickly, as we saw in 2021.

The most common type of funds that are deposited to farm yield are USD pegged stablecoins. The most popular stablecoins in DeFi are USDT, USDC, DAI, UST, FRAX, FEI, BUSD, etc. We’ll write more about stablecoins in a separate article, but it’s an absolutely amazing opportunity to earn a double-digit yield without being exposed to the volatility of the crypto assets. It’s probably the one thing my friends from traditional finance are most surprised by when I discuss the opportunities of DeFi with them, as their general argument is that crypto prices are too volatile.

If all of the above sounds simple, then yield farming doesn’t stop there. There are plenty of options to leverage your positions and make things infinitely more complicated. Different protocols often mint tokens that represent your deposited assets in the system. For example, if you deposit WETH to Yearn, you’ll get yvWETH. yvWETH is an interest bearing token.

Then, you can deposit that yvWETH to a different protocol (like Abracadabra) to borrow a stablecoin called MIM that you can deposit to a different platform (or swap to a different stablecoin like UST to deposit on Anchor), and earn more yield. Maximizing yield can get complex really quickly, and you may build a house of cards where you are incapable of assessing risks.

There are many unique and innovative yield incentives launched by different protocols in order to gain attention and traction. It’s not possible to cover all of them in this article and to be honest, the article would be outdated in a week (as new protocols are introduced daily and some inevitably die because their mechanics aren’t sustainable).

How Are Yield Farming Returns Calculated?

Returns are usually calculated on an annual basis. Typically, you’ll see APY (Annual Percentage Yield) or APR (Annual Percentage Rate). APR doesn’t take into account the compounding effect, while the APY does. Compounding means that your yield is re-invested and thus compounded in time. However, it seems that many projects are using both terms as if they meant exactly the same thing.

When you see an extremely high APY or APR advertised, it’s always good to understand that these are estimations. The best opportunities get crowded and yields drop in time, hence, it’s not really possible for a protocol to accurately estimate the annual yield. But for a short period of time, the estimated yield can be fairly accurate.

Getting Started With Yield Farming

It’s pretty challenging to start with yield farming unless you’re spending most of your time in crypto. The UX of many of these protocols (starting with Metamask, the web3 wallet) is fairly complex, and there are too many options to choose from.

For example, there are always new protocols on alternative L1 blockchains which require more know-how and time investment to first find these opportunities and then to learn how to use them. And once you figure out how one specific strategy works, there’s already a new one…

That’s the reason we’ve built Clip Finance. To simplify your journey while Clip protocol finds and farms the best opportunities for you and show in a transparent way into which protocols funds are allocated. We believe with full transparency you will also learn and understand decentralized finance. Our hope is to eventually bring yield farming opportunities to people who would otherwise never take the leap to the crypto world due to the complexity it entails.

Yield farming doesn’t have to be complicated. Join our community for more discussions about stablecoin yield farming!