In 2021, the so-called “DeFi summer” happened in the crypto space. DeFi summer was the boom of decentralised finance protocols, whose token valuations were exploding thanks to skyrocketing amounts of total value locked in their protocols. An enormous amount of money poured into decentralised finance thanks to yield farming, so it’s worth exploring what yield farming is, how it works, and what is going to happen next.
What is yield farming?
The essence of yield farming is lending or staking (depositing and locking up) crypto assets to earn hefty returns and cryptocurrency rewards. The market cap of DeFi assets exploded from $500 million in 2019 to $100 billion (!) in 2021. These DeFi protocols offer monetary incentives to investors in the form of interest on money lent and additional rewards like the protocol’s native token. Investors can choose to convert these rewards to other currencies like ETH or stablecoins or hold on to the tokens, hoping they appreciate in value (which many of them did).
Yield farmers can earn impressive annual percentage yields (APYs), sometimes exceeding 100% and even going as high as 1000%. That means a $1,000 investment would earn $10,000 per year in yield. Of course, these protocols are incredibly risky, and even for the few legitimate ones offering such astronomical yields, those don’t last nearly as long as a year.
Popular yield farming protocols
In comparison to popular centralised exchanges like CoinSpot or BTC Markets, yield farming protocols run on decentralised platforms. The most popular example is Aave, an open source decentralised lending and borrowing protocol. With Aave, the user can essentially become the bank and borrow from or lend to other users. Another popular protocol is Compound, which was also one of the first-ever protocols offering yield farming. It pretty much works identically to Aave.
Uniswap is a decentralised exchange, where users can swap different ERC-20 tokens on the Ethereum blockchain. Yield farmers can provide liquidity in these tokens and Ether in a 50-50 ratio and earn a share of the transaction fees and the native UNI token as a reward. Pancakeswap on the Binance Smart Chain (BSC) works in the same fashion, only that it offers swaps for tokens on BSC.
All these popular and well-known protocols are regarded as fairly safe, which is why they don’t offer crazy three-digit APYs. However, you can still earn a fair bit more than you would be depositing your money at a bank.
When yield farming goes wrong
High yield also implies high risk, and there are numerous risks when it comes to yield farming. First, users can lose money to impermanent loss. If one of the tokens in a liquidity pool is volatile, the user could incur a nominal loss. If he were to retrieve his provided liquidity, this loss would be realised. Impermanent loss is also described as the opportunity cost of just holding the two assets independently.
Another big risk is hacks and fraud, which are prevalent, especially among new and unknown DeFi protocols. There have been several multimillion hacks of well-known projects such as Yam.
Overall though, yield farming is here to stay. Shrewd investors can still earn an excellent return on their money with the right risk management.