Yield farming is becoming increasingly popular among investors in Decentralised Finance (DeFi). When done right, yield farming can generate exceptional profits, but it can also be very risky. Let’s dive a little deeper and see what yield farming is all about.

What is yield farming #

Yield farming, in essence, is the investment in cryptocurrencies or tokens via decentralized apps (DApps) to maximize profits. A proficient yield farmer can not only gain profit from price appreciation in their holdings, but also from yield generated by these holdings.

By locking assets in liquidity pools such as the ones found on PancakeSwap, or by lending their assets to other users via Venus, investors can generate passive income.

How yield farming works #

Most of the yield farming on DeFi is done via liquidity pools. A liquidity pool is a smart contract that holds on to and locks the cryptocurrencies/tokens of investors. Liquidity providers contribute to the liquidity of a trading pair pool, such as CAKE-BNB, by depositing their crypto (in this case CAKE and BNB) in the pool, receiving LP (Liquidity Pool) tokens in return.

The assets in a liquidity pool create a market where the assets can be exchanged by traders. If there were no liquidity pool, it would not be possible for a trader to swap tokens, as there would be no “other side” of the trade. When an investor swaps tokens (e.g. CAKE for BNB), he needs to pay a trading fee.

This fee is paid to the liquidity providers in proportion to the amount of liquidity (CAKE and BNB) they have added to the pool. An investor who “owns” a big part of the liquidity pool will receive more trading fees compared to an investor that provided little liquidity to the pool. The fee at Pancakeswap is fixed at 0.17% per token swap trading.

The Annual Percentage Yield (APY) of a liquidity pool generally gives a good indication how much trading fees can be earned in a pool. However, note that these rates are not fixed, and change daily based on historical trading data from the pool.
Other ways to

There are, other than trading fees, several other mechanisms that allow a yield farmer to generate yield:

Token rewards: Some DApps offer token rewards as an additional incentive. Sushiswap, for example, rewards its liquidity providers with the SUSHI token, on top of the collected trading fees. The SUSHI token of Sushiswap is a governance token. Governance tokens give their holders voting rights over future platform decisions and can potentially be staked or profitably traded.

Interest: Let’s take a look at Venus as an example. The Venus protocol allows investors to lend and borrow their assets to other investors via asset pools.

Like liquidity pools, the APY of an asset pool is the most interesting for a yield farmer. This percentage indicates how much interest a yield farmer recieves annually for depositing his token to a pool.

For lending and borrowing platforms like Venus, a part of the Annual Percentage Rate (APR) is paid to lenders by their borrowers, who need to pay interest when borrowing assets.

By making use of compound interest, yield farmers who lend their assets to borrowers receive interest on their initial deposit + previously earned interest. This means that when the first interest is paid out, the initial deposit of the yield farmer has grown, resulting in the next interest being paid out based on the new value of the deposit and so on.

Price appreciation: In addition to the previously mentioned ways of making profit, a yield farmer also benefits from price increases of the token that he is using to farm. This is a double-edged sword: value can be lost as the price of the token declines.
Due to this, it’s important to research both the DApp and its liquidity pools. Luckily, this is where rugdoc.io can help you out.

Risks of yield farming #

Yield farming is not for the faint-hearted. The most profitable yield farming strategies are very complex and only advisable for advanced users. Also, there are a lot of risks involved in defi yield-farming:

• Rug pulls: a malicious maneuver where the developers of a project drain their liquidity pools in order to take profits at the expense of other investors. This leaves the investors with worthless token purchased at the DeFi farm.
• Soft rugs: harder to identify than a regular rug pull. Soft rugs often happen after a solid form of trust has been built between the developers and the investors: liquidity pools have a timelock or the developers send their LP tokens to a burn address. The developers have a large amount of tokens in different wallets that they can sell for a profit after the price increases, resulting in major losses for investors.
• Flash loan attacks: enable crypto users to create a loan without providing any collateral in return. Flash loans are much more susceptible to exploits because hackers use them to “hack” decentralized exchanges and steal millions of dollars in the process.
• Contract/UI errors: typically out of the hands of investors. However, UI errors or smart contract errors can cause investors to lose a lot of money. For example, A Coinbase UI error causes users to lose thousands of dollars, but these transactions can often be reverted by the developers.
• Fake APR: can be very misleading. For example, if a liquidity pool is almost empty, it makes sense that the APR is so high and you earn more money per trade. Also, these types of APRs often don’t sustain. When more investors start to provide liquidity, the APR will go down. When the pool does have liquidity, check the pool through a DeFi dashboard to see if the APRs match. If these don’t match, look for similar pools on other DApps. If these steps do not work, we recommend providing a tiny amount of liquidity to the pool and calculate the APR yourself.
• Website issues: when a DApp’s website is not available. This eliminates the ability to withdraw your money from the liquidity pool via the DApp. This issue can be solved by using emergency withdraws (link).
• Token price collapse (dump/losing its peg): occurs when malicious developers of a token execute a rug pull. The token will lose its value immediately. Another possibility of a loss of value, is if the token is a stablecoin and losses its peg(when a price follows a fiat currency, for example BUSD, USDT, USDC peg to USD). If this happens, we recommend selling your token as soon as possible.
• Network risks (Ethereum, BSC etc.): These are more general risks that can affect the whole crypto market. A well-known network risk is the 51% attack, of which more than 51% of all network nodes have become malicious. This results in hackers being able to hack the complete blockchain network and being able to change its rules and steal crypto. Although, 51% attacks are very costly and even when fully executed these attacks don’t make up for the cost.
• Market risks: Market risks are caused by adverse price changes in financial products such as cryptocurrencies. Bear markets, recessions and negative catalysts.
• Asset depreciation: Yield farmers can earn a lot via interest, governance token rewards and trading fees. However, if their assets lose their value – which often happens with lesser-known or small market-cap tokens – their profits are gone.
• Risk of liquidation: There’s always the risk of liquidation when borrowing via, for example, Venus. This is because an investor needs to deposit 200% collateral to borrow 100% in another token. If the investor’s “collateral” is no longer at the required coverage ratio, the investor gets liquidated.

Conclusion #

Thanks to yield farming, investors can generate excellent returns on various smart contract compatible networks and their platforms. It’s worth comparing the risks and rewards before starting to yield farm to prevent any losses. Rugdoc.io can help you with picking the right DApps so you can start yield farming without unnecessary risk.