What is Yield Farming & How Does it Work?

Yield farming is a way to earn money from the tokens you don't want to buy or trade, and it's an increasingly popular concept within DeFi. Here, we break it down for you.

What is yield farming?

Similar to how a bank gives you interest on your savings, you can earn interest on your cryptocurrency by lending your tokens to a cryptocurrency project (company). The amount of return that you can earn depends on how much you lend to a project, what your tokens are used for, the total rewards on offer, and the perceived default risk of the project.

DeFi yield on Compound USDT on DeversiFi

The process of lending your tokens is trustless, meaning that you always retain control of your funds and can access them at any time. Instead of a project approving your lending, the whole process is open and permissionless, with the rules determined by computer code instead of a centralised gatekeeper (like a bank).

Collectively, the sector of the cryptocurrency world that seeks to replicate traditional financial products, such as lending & borrowing, banking, exchange and trading (etc), but on a public blockchain, with peer-to-peer interactions, is what is known as decentralised finance (DeFi).

DeFi yield farming started in the summer of 2020, with the launch of the Compound Finance yield farming program. Other DeFi projects to launch large-scale yield farming campaigns include YEARN Finance, Curve Finance, Uniswap, Sushi Swap, Balancer, Polygon, Ampleforth, DYDX, and Immutable X.

Why would a DeFi project want to borrow my tokens?

The companies that run DeFi projects & protocols usually do not hold any stock of tokens themselves that can be accessed by their customers. Those projects often need to reach a critical mass of tokens, or liquidity, deposited to their platform in order for the project to meet the needs of its customers.

Sounds complicated? An example will make much more sense.

Yield Farming Example

Compound Finance is a DeFi project that allows anyone to lend their crypto tokens to borrowers in a permissionless, trustless, and open way. Anyone can connect their crypto wallet and deposit their tokens into the platform in a process that is called ‘liquidity provision,’ becoming a liquidity provider in the process. Once liquidity providers have deposited their tokens into the protocol, those tokens can be borrowed by an external borrower within a predefined ruleset. A borrower pays interest to the lender.

On the flip side, a borrower on Compound Finance is someone who wishes to borrow a certain amount and type of a token. For example, they may have a large long-term holding of Bitcoin, but they may wish to borrow a number of digital dollars (USDC, USDT, etc) in order to pay for day-to-day expenses whilst they wait for the price of bitcoin to increase over time. The borrower will deposit Bitcoin to Compound as collateral (not lending) and can then borrow a certain amount of digital dollars against their collateral, usually in the region of 30-70% of their deposited collateral.

Ok so that was a bit of background about Compound Finance, but where does yield farming come into this story?

Compound Finance launched in 2018 and initially had $10m of tokens deposited to the platform. Over time this slowly grew to $100m, but stubbornly refused to grow further. $100m sounds like a lot of tokens, but the total amount of tokens available for borrowers in the protocol was spread over several tokens, meaning that the individual amount available for borrowing for each token was relatively small, with even small increases in the amount of borrower utilisation causing spikes in interest that prevented further borrowing.

The problem that Compound Finance faced was a chicken and egg problem. The protocol needed large lenders to deposit to the platform in order to serve potential large borrowers. However, lenders were not likely to deposit to the platform as interest rates for lending were very low as there were no large borrowers.

In order to solve this problem, Compound Finance launched a liquidity mining program that involved launching a token ($COMP) and giving it to all borrowers and lenders on the platform. The higher the amount of lending (for the liquidity providers) and/or borrowing (for the borrowers) the higher the amount of COMP token that was earned. The COMP token was also valuable in itself to hold as fees from the platform were shared between COMP holders and liquidity providers.

As liquidity providers and borrowers rushed to deposit and borrow tokens on the Compound Finance protocol, the number of total tokens deposited and borrowers jumped substantially. In turn, this made the COMP tokens more valuable to hold, as the amount of fees going to COMP holders was growing. As the price of COMP increased, the amount of rewards available for lenders and borrowers increased, initiating a positive feedback loop.

The process of earning the COMP tokens is known as ‘yield farming.’ From the example above you can see that if you were to lend your tokens to the project, you would have earned a return on your tokens in the form of both the interest paid by borrowers and also the COMP tokens that were distributed to you. The COMP token distribution essentially boosts your total earnings earned.

Interest rate for DeFi protocol, Compound Finance

Where can I yield farm?

As of September 2021, there are close to over 200 different DeFi projects where you can earn interest on your cryptocurrency. Some of the largest, safest, and most well established DeFi Yield farming opportunities on Ethereum are listed below

  1. Sushi (Formerly SushiSwap). The Automated Market Maker protocol has long shaken off its reputation as a copycat and offers some of the best interest-earning opportunities on Ethereum via their Onsen program. Yield range from 10% for large tokens, to 500% plus for very risk tokens
  2. Curve Finance. The original Automated Market Maker protocol for swapping stable assets (stablecoins etc) now has over $11bn of assets under management and is to ‘go to’ place for earning interest on your digital dollars. Interest rates are relatively tame compared to elsewhere in DeFi, but Curve is one of the most well-established and therefore safest platforms around. For those with a little more risk appetite, you can use a platform such as Convex Finance to leverage up your reward earning potential, but you take on more money lego risk by doing so
  3. Balancer. Another Automated Market Maker protocol that is aimed mainly at B2B. You can earn a reasonable 5-20% on some of the larger crypto tokens, such as ETH, Staked ETH, DAI and WBTC.


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