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Yield Farming in DeFi: A Comprehensive Guide

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One of the fundamental investing principles in traditional financial markets and cryptocurrencies is making your assets work for you. 

Decentralized finance (DeFi) offers many opportunities for passive income, such as staking, lending, and yield farming. Yield farming, in particular, has become a popular asset investing strategy due to its high returns.

In this article, we’ll explain how yield farming works, popular yield farming strategies, and the risks involved.

What is yield farming? 

Yield Farming is a DeFi passive income strategy that rewards you for locking your crypto on decentralized exchanges or platforms. By doing so, you become a liquidity provider, i.e., you help facilitate trades between two or more cryptocurrencies on the platform. In return, the yield farming platforms share a percentage of the trading fees with all the liquidity providers in the pool. 

Let’s see how this works in practice. 

How yield farming works 

Yield farming works by locking up two or more cryptocurrency assets in a joint token pool in a fixed ratio. Depending on the pool type, the fixed ratio can be a constant product or a sum of the involved cryptocurrencies. 

For example, if you deposit $1,500 worth of ETH and $500 worth of DAI in an ETH-DAI trading pair, you have a total of $2,000 worth of assets in the pool. In a constant sum pool, you’re guaranteed that you’ll receive $2,000 worth of assets back. 

However, the split could be $1,000 worth of ETH and $1,000 worth of DAI, depending on the demand for the individual yield farming tokens. Similarly, in a constant product pool, you’re guaranteed a constant product value of these assets.

In contrast to centralized exchanges, which use order books, decentralized exchanges use smart contracts to automate this entire trading mechanism. 

Token pools or “automated market markets” are simply smart contracts that let users deposit their money into them.  These smart contracts record the tokens each user deposits to maintain the constant product or constant sum pool formula. 

On depositing their crypto, users receive equivalent liquidity provider tokens (LP) that represent their share in the pool. These LP tokens are interest-bearing, which means the smart contracts in yield farming distribute rewards to holders of these tokens.

Popular yield farming strategies 

Your choice of yield farming strategies depends on your individual risk tolerance, active participation levels, and investment goals. The three most popular strategies include liquidity mining, yield aggregation, and synthetic asset farming.

Liquidity mining

Liquidity Mining is the most basic and straightforward yield farming strategy where you receive interest for depositing your tokens into a single protocol. In return, you receive yield farming rewards from the ecosystem’s governance tokens or a portion of trading fees.

While liquidity mining provides steady returns, you risk overly relying on one ecosystem. 

Yield aggregators

Yield Aggregators use smart contracts to automate and optimize your returns across yield farming and DeFi strategies. These smart contracts pool investors' funds and invest them into a portfolio of pre-programmed yield-bearing methods. You can think of yield aggregators as automated fund managers.

One of the benefits of a yield aggregator is that it uses tried and tested strategies to diversify your funds across protocols. However, you also lose a level of control when you delegate investing strategies to a third party.

Synthetic asset farming

In traditional finance, derivative trading products like futures or options simulate their underlying assets of stocks, bonds, or crypto but do not physically own them. 

In crypto, synthetics take this concept a step forward by creating a token on the blockchain that tracks the real-world value of one or more assets. These assets can be other cryptocurrencies or assets like real estate or stocks.

Synthetic asset tokens have a lucrative yield farming ecosystem because of exposure to many assets beyond cryptocurrencies. Users can earn rewards by providing liquidity to synthetic asset pools or participating in creating and trading synthetic assets.

Yield farming security risks 

While yield farming is a lucrative way to earn interest on your crypto, you have to understand that high returns often come with equally high risks. Two core yield farming risks include smart contract risk and impermanent loss.

Impermanent loss

Impermanent Loss is the unrealized loss you incur when the relative value of your liquidity pool tokens changes drastically from when you lock them in a liquidity pool. 

Since the ratio in which you deposit your initial capital is fixed, you would end up with fewer tokens of the appreciating asset and more of the depreciating one over time. This happens due to arbitrage traders trying to profit from the token pool’s price discrepancies.

Remember, though: your money loss is “impermanent” until you redeem your assets back from the pool. If the market value of the assets returns to the ratio you deposited them in, your “loss” becomes zero. Therefore, you should continually monitor your yield farming assets when you invest them.

Smart contract risk

Liquidity token pools often handle large amounts of money, making them attractive targets for hackers and malicious intent. Any bug or vulnerability in the smart contract’s code can lead you to lose your money. 

Therefore, it’s important to do your due diligence while selecting a yield farming protocol. Prioritize protocols with a long-standing history or reputation, good teams, comprehensive yield farming security audits, and preferably open-source code.

Frequently Asked Questions (FAQs)

What is yield farming in DeFi?
Yield farming, also known as liquidity mining, is a practice in the decentralized finance (DeFi) space where users lock up their cryptocurrencies in smart contracts to earn rewards or yield.

How does yield farming work?
Yield farmers provide liquidity to DeFi protocols by lending or staking their assets. In return, they receive rewards in the form of tokens or interest payments.

How do I earn DeFi yield using Tangem Wallet?
The Tangem Wallet supports yield farming on stablecoins like OUSD and DeFi tokens like Origin ether (OETH). The yield is sent directly to the holder's wallets using Origin Protocol's unique rebasing function, with no gas fees required. Just buy and transfer your O-tokens to your Tangem Wallet and watch your balance grow over time.

What are the risks of yield farming?
Yield farming can be risky due to smart contract vulnerabilities, impermanent loss, and market volatility. It's important to thoroughly research and understand the protocols before participating.

What are impermanent losses?
Impermanent loss occurs when the value of the assets in a liquidity pool changes compared to holding them in a wallet. It's a potential risk when providing liquidity.

Which platforms are suitable for yield farming?
DeFi platforms like Uniswap, Compound, and Aave offer yield farming opportunities. Research and due diligence are crucial in choosing a platform.

How do I get started with yield farming?
To start yield farming, you'll need to connect your wallet to a DeFi platform, deposit assets into a liquidity pool, and follow the specific instructions provided by the platform.

Can I lose money with yield farming?
Yes, yield farming carries risks, and losing money is possible. It's essential to start with small amounts and only invest what you can afford to lose.

What strategies can enhance yield farming profits?
Strategies like yield optimization, yield compounding, and choosing the right tools can help maximize profits in yield farming.

How are rewards distributed in yield farming?
Rewards in yield farming can be distributed in various ways, including through platform tokens, interest payments, or a combination.

Is yield farming taxable?
Yes, in most jurisdictions, yield farming rewards are considered taxable income. It's essential to consult with a tax professional for guidance on reporting.

Remember, yield farming involves financial risks, and it's crucial to do thorough research and consider seeking advice from financial professionals before participating.

Final thoughts

DeFi yield farming is one of the popular ways to earn crypto with minimal active management of your investments. However, when you choose a volatile investment strategy like yield farming, it’s important to have a strong understanding of all the risks involved. Plus, ensure you follow yield farming best practices like vetting the protocol, using a trusted storage solution like the Tangem Wallet, and monitoring your assets regularly.