Note: This article is not financial advice. Hubble Protocol does not endorse any tokens or platforms mentioned in this article.
Key Takeaways
- Yield farming involves providing liquidity on a DEX.
- Users earn rewards tokens on top of fees earns from trading when yield farming.
- Yield farming can be risky, producing mixed results based on multiple factors.
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 widespread strategies in DeFi. If users believe in a project's mission, then they want to keep that project’s tokens; otherwise, they can also swap the tokens they receive to lock in rewards immediately.
The Basics of AMM Crypto Swaps
DeFi swaps heavily rely on the liquidity provided by users. A crypto Automated Market Maker (AMM) is one of DeFi’s most decentralized 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 where liquidity providers have a role on a DEX.
Providing liquidity usually involves depositing a project’s token and another token, typically a stablecoin, into a DEX liquidity pool, such as Raydium or Orca on Solana. When users provide liquidity on an AMM, they receive an LP token as a “receipt” of their deposit.
The tokens users deposit in a liquidity pool will be used to facilitate swaps, and users earn trading fees for each swap that utilizes that pool. In return, the LP token collects fees in tokens from users making swaps that use its liquidity. When a liquidity provider returns their LP token to a DEX, they receive their deposited tokens plus extra tokens from fees.
However, to incentivize their own pools and attract liquidity, AMMs and protocols can provide additional token rewards to depositors. By doing so, users are incentivized to deposit in those pools to earn more rewards in addition to just the trading fees. This mechanism is called “yield farming.”
Stake Liquidity to Participate in Yield Farming
Once users provide liquidity to a DEX liquidity pool, they get a receipt of deposit in the form of an LP token. This token can sit in a user's wallet until they redeem it for their deposited tokens, or they can “farm" it by staking the LP token to earn rewards.
Earning token rewards by staking an LP token is the basis of DeFi yield farming. There are several venues where users can deposit their LP tokens to receive liquidity mining rewards.
The DEX where users provide liquidity can provide its own token as a reward for depositing LP tokens on its platform. For example, if a user deposits their LP token on Raydium, they can potentially earn $RAY rewards.
The project they’ve provided liquidity for can also reward users for depositing an LP token. For example, if users deposit X Token on Orca, they can potentially earn X Token rewards in addition to $ORCA rewards.
Steps to Start Earning Crypto Yield Farming Rewards
DeFi yield farming requires multiple clicks of the mouse 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 the LP token to receive liquidity mining rewards from a DEX and/or other protocol.
- Begin earning yield farming token rewards as soon as LP tokens are staked.
Users can usually collect, claim, or harvest rewards at any time. They can keep these rewards tokens to support the project, or they can swap these rewards for stablecoins or other tokens at the time of receiving them.
Another option is compounding yield farming crypto rewards into an LP position. This will increase the amount of liquidity being provided as well as increase the yield potential for rewards for providing more liquidity.
There are projects, such as Tulip Protocol on Solana, that will auto-compound rewards, so users don’t have to.
Yield Farming VS Staking
Yield farming and staking are two different strategies to earn yield in crypto. As previously mentioned, 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 users who stake tokens are rewarded for helping the blockchain function securely.
For instance, Solana staking validators currently offer staking yield to every $SOL delegator that provides tokens for staking. This yield can be variable, and it is rewarded in $SOL.
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.
The Risks of Crypto Yield Farming
DeFi yield farming can seem like a way to earn passive income, but it’s far from a “set it and forget it” strategy. Users should monitor their yield farming crypto position and make sure they have a plan for why they are providing liquidity in a pool.
Impermanent loss (IL) is one of the biggest risks when yield farming. It happens when the total worth of tokens users have deposited (e.g., SOL-USDH) start to differ from their original price at entry.
This loss is impermanent because if the LP token recovers its initial price, then the loss is negated or minimal. Yield farming rewards can help reduce the effects of IL on a user's position.
It is also useful to know that studies have shown most yield farmers exit their position within the first 48 hours after the rewards program begins. Rewards will decline as more people participate in the same yield farming pool, and as many of these users swap their rewards tokens for stablecoins, the market value of the token can decline.
Users should always do their own research (DYOR) before yield farming. As always, one should never participate in DeFi with more than they can afford to lose.
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