Yield Farming: Advanced DeFi for Maximizing Crypto Earnings

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10 Apr 2024

Yield Farming: Advanced DeFi for Maximizing Crypto Earnings

Crypto yield farming is an emerging sector of DeFi that enables you to earn rewards and interest on your crypto.

By Cryptopedia Staff

Summary

Yield farming crypto can generate passive returns on holdings using decentralized finance (DeFi) protocols — but participating in it is very rarely a passive endeavor. Yield farmers often execute complex strategies, moving crypto assets between platforms to maximize liquidity mining returns. More recently, leveraged DeFi yield farming protocols have begun to issue under-collateralized loans to liquidity providers and yield farmers. Through this mechanism, users borrow crypto assets to increase exposure to risk and reward.

What Is Yield Farming?

The rapid growth of decentralized finance (DeFi) has been partially driven by interest in yield farming, also known as liquidity mining. Yield farming is the practice of maximizing returns on crypto holdings through a variety of DeFi liquidity mining methods. While it can be lucrative, it requires a thorough understanding of DeFi protocols to be successful. In most cases, yield farmers enact complicated and evolving strategies, frequently moving crypto assets between lending marketplaces to maximize returns.
Because of this, building a working knowledge of yield farming can be intimidating for newcomers. It’s important to be equipped with best practices before engaging in this new sector.

Decentralized Exchanges (DEXs) and Crypto Liquidity Pools

Within the DeFi ecosystem, decentralized exchanges (DEXs) have become some of the most widely used crypto protocols. Unlike centralized exchange (CEX) order books, DEXs utilize liquidity pools to facilitate peer-to-peer (P2P) trades. Structures known as liquidity pools help many DEXs maintain fair market values for the tokens they hold thanks to automated market maker (AMM) algorithms, which maintain the price of tokens relative to one another within any particular pool. Crypto liquidity pools in different protocols may use algorithms that differ slightly. For example: Uniswap liquidity pools use a constant product formula to maintain price ratios, and many DEX platforms utilize models with varying degrees of similarity.
AMM liquidity pools used by today’s leading DEXs reduce or remove the need for a centralized entity, and as a result, they require a sustained outside source of liquidity to function properly. This is where liquidity providers (LPs) enter the equation. Liquidity providers are individuals who either create a liquidity pool of their own making or, more often, deposit tokens into an existing one so that traders can purchase tokens on a DEX.
Let’s use an example: On the PancakeSwap platform, an LP could deposit $100 USD worth of CAKE and $100 USD worth of BNB to the CAKE/BNB liquidity pool. As a reward for providing this liquidity to the PancakeSwap DEX platform, the PancakeSwap LP would receive FLIP (PancakeSwap's Liquidity Provider token) as a reward. LPs earn a return on these tokens as long as they hold them, expressed as an annual percentage yield (APY). This return comes from the average trading fees generated by the CAKE/BNB liquidity pool. Earning LP tokens is a fundamental step in many DeFi yield farming strategies.

Yield Farming Crypto: DeFi Liquidity Mining
Strategies

Acting as a LP is often an early step in establishing a yield farming strategy. However, liquidity providers are not bonafide yield farmers until their LP tokens are maximized by being staked into multiple protocols and/or pools. In many cases, liquidity miners deposit tokens across different liquidity pools and DEX protocols.
Let’s take a look at another example. A simple strategy for yield farming crypto might include the following steps:

Deposit CAKE and BNB to the CAKE/BNB liquidity pool on PancakeSwap.
Receive CAKE-BNB FLIP tokens.
Deposit CAKE-BNB FLIP tokens into the corresponding CAKE crypto liquidity pool, amplifying returns.

The DeFi liquidity mining space is abundant with this kind of staking or farming opportunity, and more pools and protocols emerge by the day. Those yield farming crypto can stake their LP tokens in various protocols and liquidity pools for as long as they may choose — from a few days to several months.

The Crypto Yield Farming Ecosystem

Given the diversity of crypto yield farming strategies, there's no one way to yield the highest returns. In addition, the rapid pace of development creates an ecosystem that constantly evolves, requiring an ongoing assessment of DeFi yield farming opportunities. While not exhaustive, the list below includes some of the core yield farming platforms.

Aave: A decentralized, open source, non-custodial crypto lending and borrowing protocol. Users can create money markets, borrow assets, and earn compound interest in the form of AAVE tokens.
Compound: A money market protocol that facilitates crypto lending and borrowing utilizing algorithmically adjusted compound interest rates. Users can also earn COMP governance tokens by accessing the protocol.
Curve Finance: A DEX protocol that enables stablecoin exchange for users and other decentralized protocols. The Curve protocol uses a unique market-making algorithm to ensure low fees and minimal slippage.
Uniswap: A DEX and AMM that facilitates the exchange of almost any ERC-20 token pair.
PancakeSwap: A DEX and AMM on the Binance Smart Chain (BSC) that enables the exchange of BEP-20 tokens.
Venus Protocol: An algorithmic money-market platform that integrates lending and credit systems on BSC.
Balancer: An automated trading and portfolio manager that utilizes flexible staking for its liquidity protocol.
Yearn.finance: A decentralized, automated aggregation protocol for which user-generated algorithms find profitable crypto yield farming services.

Staking Crypto vs. Yield Farming

Although yield farming and staking crypto are two different practices, some mistakenly refer to them interchangeably. Yield farming — or liquidity mining — is a method of generating rewards with cryptocurrency holdings. The primary purpose of staking, on the other hand, is as part of the consensus mechanism of a Proof-of-Stake (PoS) blockchain network — a process for which stakers also receive rewards. While acting as a staker also generates a return, it's typically much lower than the return on DeFi yield farming protocols. In general, staking yields pay out annually, ranging between 5% to 15%. In comparison, yield farming rates in crypto liquidity pools can exceed 100% and pay out on a continual basis, allowing for withdrawals at any time.
However, while crypto yield farming is typically more profitable than staking, it's also riskier. For example, when yield farming on Ethereum, the network gas fees required to collect rewards can reduce earnings from APY rates. In addition, if the market becomes volatile in either direction, impermanent loss can occur and drastically reduce profitability. This is when the value of tokens held in an algorithmically balanced liquidity pool lose value relative to assets in the open market. Finally, because liquidity pools use smart contracts, there's also a chance hackers could find and exploit vulnerabilities in the underlying code.

Yield Farming Crypto With Leverage

Leverage is the use of borrowed money to fund an investment. Just as leveraged trading can amplify returns and risks across traditional asset classes and crypto alike, yield farming crypto with leverage can amplify the returns issued by DeFi protocols. The primary benefit of leveraged yield farming is that farmers can borrow more than the collateral they put up, further amplifying returns. For example: if yield farming with "X" yields "Y" returns, then yield farming with "10X" yields "10Y" returns. It’s imperative to keep in mind that losses work in a similarly amplified fashion if price targets are missed. Leveraged trading and crypto yield farming are practices best reserved for very experienced investors.
Leveraged yield farming platforms are a new but fast-growing sector of DeFi, and protocols utilize a varied methodology that brings together protocols, lenders, yield farmers, and liquidity providers to create opportunities to borrow and farm tokens in various liquidity pools and rewards-generating markets.
Some of today’s most notable leveraged yield farming crypto platforms include:

Alpaca Finance (BSC): Marketed as the largest lending protocol to enable leveraged yield farming on the BSC. The protocol aims to deliver safe and stable yields to lenders while providing undercollateralized loans for yield farmers.
Tulip (Solana): Operates as the first yield-aggregation platform built on Solana. The platform offers auto-compounding vault strategies and leverages the Solana blockchain's low cost and high efficiency.

DeFi yield farming protocols will continue to evolve even more complex strategies. Already, leveraged yield farming has introduced some of the first under-collateralized loans — managed by smart contract — in the crypto industry. This functionality seeks to address several DeFi shortcomings, including capital efficiency and the providence of deeper capital markets. In addition to these systemic improvements, crypto yield farming is helping to establish more mature DeFi protocols and increase their earning potential, fueling growth across the entire ecosystem.