Yield farming is a decentralized finance (DeFi) primitive that was introduced in the summer of 2020. It’s a way for projects to incentivize users to provide liquidity, and it’s also a way a user can earn a project’s tokens to hedge the risks of becoming a liquidity provider (LP).
Providing liquidity for a project to be rewarded with that project’s tokens is one of the most used strategies in crypto. If you believe in a project’s future, then you want to keep that project’s tokens, as they might appreciate in value; otherwise, you can also sell the tokens you receive to earn a direct profit.
The Basics of AMM Crypto Swaps
DeFi swaps heavily rely on the liquidity provided by users. An Crypto Automated Market Maker (AMM) is one of DeFi’s most powerful tools for swapping tokens without the need for an intermediary (like a centralized exchange).
AMMs have historically been the most commonly used models for Decentralized Exchanges (DEXes). However, an AMM needs users to provide tokens to facilitate swaps, or it cannot operate. This is what a liquidity provider does.
Providing liquidity usually involves depositing a project’s token and another token, typically stablecoins, into a DEX liquidity pool, such as Raydium or Orca on Solana. When you provide liquidity on an AMM, you receive an LP token as a “receipt” of your deposit.
The tokens you deposit in a liquidity pool will be used to facilitate swaps, and you earn trading fees for each swap that utilizes that pool. In return, your LP token’s value increases as you collect fees from users making swaps that used your tokens. When you return your LP token to a DEX, you receive your deposited tokens plus extra tokens from fees.
However, to incentivize their own pools to attract liquidity, AMMs and Protocols give additional token rewards to depositors. By doing so, users are more likely to deposit in those pools to earn more rewards, in addition to just the trading fees. This mechanism is called “Yield Farming”.
Stake your Liquidity to Participate in Yield Farming
Once you've provided liquidity to a DEX liquidity pool, you get a receipt of deposit in the form of an LP token. This token can sit in your wallet until you redeem it for your deposited tokens, or you can “farm it” by staking it to earn rewards.
Earning token rewards with your LP token is the basis of DeFi yield farming. There are several venues where you can deposit your LP token to receive liquidity mining rewards.
The DEX where you provided liquidity could give you its own token as a reward for depositing your LP token on its platform. For example, if you deposit your LP token in Raydium, you can potentially earn $RAY rewards. The project you’ve provided liquidity for can also reward you for depositing an LP token. For example, if you deposit $HBB into Orca, you can potentially earn $HBB in addition to $ORCA.
Steps to Start Earning Crypto Yield Farming Rewards
DeFi yield farming requires multiple clicks of the mouse in order to get started.
Here is a quick rundown of the steps necessary to start DeFi yield farming:
- Acquire a project’s tokens and an equal amount of stablecoins.
- Deposit project tokens and stablecoins on a DEX liquidity pool to receive an LP token.
- Stake your LP token to receive liquidity mining rewards from a DEX and/or other protocol.
- Begin earning yield farming token rewards as soon as you stake.
You can collect, "claim", or "harvest" your rewards at any time. You can keep these tokens and hope that they appreciate in value over time, or you can swap these tokens for stablecoins to capture the value they represent at the time you receive them.
Another option is compounding your yield farming crypto rewards into your LP position, so you increase the amount of liquidity you are providing as well as receive more rewards for providing more liquidity.
There are projects, such as Tulip Protocol on Solana, that will auto-compound your rewards, so you don’t have to.
Yield Farming VS Staking
Yield farming and staking are two different strategies to earn yield in crypto. As we previously saw, in DeFi, yield farming is a way to attract liquidity and bootstrap crypto swaps.
On the other hand, staking is essential for Proof of Stake (PoS) blockchains, such as Solana. Staked Layer 1 tokens, such as $SOL or $ETH, are used to validate transactions on the blockchain, and those "stakers" are rewarded for doing so.
For instance, Solana staking validators currently offer up to 8.2% APY to every $SOL delegator.
In the end, yield farming incentivizes people to help DEXs operate tokens exchanges, while staking incentivizes people to validate the transactions of a PoS blockchain.
Users can also stake project tokens to gain rewards from the project. By staking $HBB in Hubble, for example, you can be rewarded with $USDH.
The Risks of Crypto Yield Farming
DeFi yield farming can seem like a great way to earn passive income, but it’s far from a “set it and forget it” strategy for building wealth. You should monitor your yield farming crypto position and make sure you have a plan for why you are providing liquidity in a pool.
Impermanent loss (IL) is one of the biggest risks when doing yield farming. It happens when the total worth of tokens you have deposited (e.g., SOL-USDH) start to differ from their original price.
This loss is impermanent because if the LP token recovers its initial price, then the loss will be wiped away. Yield farming rewards can help reduce the effects of IL on a user's profit margin.
It is also useful to know that studies have shown most yield farmers exit their position within the first 48 hours. Rewards will decline as more people participate in the same yield farming pool, and as many of these users sell off their rewards tokens to make a profit, the price of the token can decline.
You should always do your own research (DYOR) and determine if the project you’re providing liquidity for is going to be successful in the long run.
Should You Do DeFi Yield Farming?
There are many ways to approach your participation in crypto DeFi. If you want to hold project tokens and benefit from their appreciation in value, DeFi yield farming is definitely a strategy that works for projects that are going to make it.
If you want to actively participate in DeFi and help provide liquidity, you can also just deposit tokens into a liquidity pool and reap the fees generated from other users' trading tokens.
However, if you want to up your risk/reward ratio as you participate in DeFi, you can yield farm instead of just holding onto your LP token. You can receive yield farming crypto rewards that could go 10x in a year or fall 99% in value in a day, and that’s why it’s important to always DYOR, and be keenly aware of the risks.